It all sounds good. Because highly compensated senior managers’ 401(k) deferrals are limited to a lower net percentage of salary (due to the $20,000 cap on contributions) as compared to line employees, they can only defer a small percentage of their income in a pension or 401(k) plan. To allow corporate execs to defer more income, non-qualified deferred compensation plans were created. These plans, that may be held in “rabbi” trusts, became a strategy that allowed a portion of senior exec compensation to be held and not received by the exec. The thinking has been that if a senior employee puts off accepting the compensation now and pays taxes on that compensation when they are retired, that their tax bracket will be lower after retirement, when they are earning less. The employee's funds held in the non-qualified deferred compensation trust are subject to claims from creditors. Under these circumstances, the IRS says that the employee has avoided "constructive receipt" so that the money is deferred from taxes. Only, things may not be working out as planned.
Molly is a CEO earning $800,000 a year. She has nearly $2 million stashed in her company’s deferred comp plan representing nearly 30% of her net worth. All of these assets, as she withdraws them, will be taxed as ordinary income. Her advisors think she is very top heavy in the amount of deferred compensation that she has and she agrees with their advice not to elect to defer further.
Now, Molly is faced with two issues: how long should she keep her money with her corporation (particularly after she retires and no longer has a hand in the fortunes of that company) and how fast should she withdraw the assets as they are now going to be taxed as ordinary income.
Money left at Molly’s firm after she retires is then subject to the firm’s creditors, so a five-year payout spreads the tax bite and such a schedule does not leave the assets at risk for too long a period after she leaves the company.
There is great uncertainty surrounding tax laws. Molly stands a good chance that tax rates will never be lower than they are today, so paying taxes on her income until retirement and diversifying assets in an investment portfolio that pays specific attention to investments with very low taxable events unless she sells, such as exchange traded funds, is a good move. Additionally, the investment options are not always good in deferred compensation plans. Even with income taxes, a good investment portfolio may outweigh benefits of deferring payment of taxes in a deferred compensation plan with poor choices of investments.
Molly has a lifestyle that she can afford in retirement based on her savings. Her withdrawals will keep her in a higher tax bracket than she might have envisioned when she began deferring compensation into her company’s plan, so waiting until retirement to take the income may not be a net benefit.
Molly is pleased to have a strategy now for managing her non-qualified deferred compensation.