I heard an interesting fact the other day: The average American will work for the same employer for four years. Unless you only have a few working years left, there is a high probability that you won’t be employed by your current company when work becomes optional for you. This is why rollover and exit strategies are something you seriously need to consider and discuss with your wealth manager before opting into retirement accounts offered by your employer, especially executive deferred compensation plans.
High income earners are capped on their 401(k) accounts and receive no tax deferral benefit from IRAs. Deferred compensation plans can be a viable option to lower taxable income and defer taxation on money earmarked for your work-optional years. However, rollover strategies are limited for these plans, so it’s important to understand how they work and to know what your options are for rolling over your funds before you opt in.
What Is a Deferred Compensation Plan and How Does it Work?
A deferred compensation plan is an agreement between an employee and an employer. It stipulates that a certain percentage or dollar figure of the employee’s income will be held by the company in a non-qualified account and paid to the employee at a later date. Even though the income is held in a non-qualified account, it is not subject to income tax until the money is withdrawn from the account.
For executives, the main selling point of the deferred compensation plan is its ability to lower taxable income while growing money in a tax-deferred account. According to the IRS, if the deferred compensation meets Section 409A requirements, it doesn’t affect the employee’s taxes and is taxed as if it’s not covered by Section 409A. If Section 409A requirements are not met, the deferred compensation can trigger more taxes, including an income tax of 20%.
The Section 409A requirements include:
- You must notify your employer in writing (or electronic form) that you want to defer a portion of your compensation. There isn’t a particular form necessary for the election, and it does not have to be filed with the IRS.
- The election must be made before the work period begins.
- The election must be irrevocable.
- How the compensation will be paid must be stated in the election.
The plan itself will have a distribution schedule that is set by the employer prior to any employees enrolling in the plan. While this is something that the employer could make changes to in the future, the current distribution schedule is an important item to review when deciding whether to opt into the plan. This schedule will show you when and how you can withdraw your funds from the deferred compensation plan when you end your employment with the company, whether you quit, retire, or are let go. Some employers will actually allow you to set your own distribution schedule upon leaving the company and accessing your funds.
Once you have gathered your plan information, you will want to consult with an expert executive financial advisor who can help you analyze your options and develop a strategy around them. One consideration to discuss with your advisor is deferred compensation plan rollover and if that is really even possible.
Considerations for Executive Deferred Compensation Plan Rollovers
When it comes time for you to leave your current employer, whether work has become optional or for any other reason, rollover strategies for executive deferred compensation plans are limited. Here is what you should know:
- Deferred compensation plans cannot be rolled over into an IRA, like a traditional 401(k) or 403(b) account. However, you do have options in regards to how you receive your funds, which makes this an important topic to discuss with a trusted wealth manager.
- You will incur income tax on these funds when you withdraw them because the funds held inside of your account have been tax deferred. Some plans will have a few set withdrawal options, paid over two, five, or 10 years, for example. Other plans will allow you to set your withdrawal amounts and withdrawal period in terms of number of years. All of these options can be overwhelming. Once you consider your taxable situation at the time and roughly what it will look like in the future, however, you can develop a solid withdrawal strategy.
- The financial security of the company you work for is extremely important. This is arguably one of the most crucial aspects of your planning for executive deferred compensation plans. You see, the deferred compensation funds are treated as unsecured general assets of the company, which means that they are subject to creditors if the company were to file for bankruptcy. This is a huge risk to account for when considering your withdrawal options.
Most advisors would tell you to not take your entire account in one lump sum. That would generate a massive tax implication for most people. You do, however, want to be very cognizant of the financial security of the company and factor this into your strategy for withdrawing funds from a deferred compensation plan.
Rollover strategies tend to be limited for deferred compensation plans, which is why the best thing to do is to consult with a trusted wealth manager to develop an exit strategy before signing on the dotted line. By working with an executive financial advisor, you can enjoy the peace of mind that comes with knowing you have evaluated every option and determined the right one for your unique financial situation.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for integrated asset allocation and equity compensation management. He can provide expert guidance on executive deferred compensation plan rollover strategies. For more information on how Wade and the Carpenter Team can advise you on your deferred compensation strategies, reach out today for a complimentary consultation.
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