Saving for retirement is something we all aim to do so that, later in life, work can become optional. Some people will try their best to max out their 401(k) account by contributing up to the annual limit, while possibly also setting up an IRA on the side. However, if you’re a top-level executive, your income may preclude you from receiving much of a tax benefit from contributing to an IRA. That leaves you with a 401(k) account and one other retirement option that many executives have questions about, namely a deferred compensation plan.
One of the frequent questions I field as an executive financial advisor involves understanding the difference between deferred compensation plans vs. 401(k) plans. The short answer is that there are pros and cons to both, which is why I’d like to explore these differences in more detail. By educating yourself on the benefits and negative aspects of both plans, you will be able to better determine how to allocate your retirement funds, with the help of an experienced wealth manager.
Contribution Limits in Deferred Compensation Plans and 401(k)s
As an executive, there’s a good chance that you will have the opportunity to contribute to a 401(k) plan at your place of employment. A qualified 401(k) account is an effective retirement savings vehicle because it allows you to contribute money to the account pre-tax. This lowers your taxable income, therefore helping you to avoid taxes on money you are earmarking for retirement. You will eventually pay taxes on that money but not until you withdraw it from your account, which will likely coincide with your retirement. The thought is that your tax bracket will be lower since you will no longer be working full time when you need to start withdrawing the money.
As of 2018, you are allowed to contribute up to $18,500 ($24,000 if you’re over the age of 50) to your 401(k) account each year, which is up from the annual limit of $18,000 in 2017. While this increase is beneficial, it likely won’t make much of a dent in helping you lower your overall taxable income. This is where a 401(k) account is limited when it comes to helping executives save money and avoid higher taxes.
On the other hand, with a deferred compensation plan, you can typically contribute up to 50% of your annual salary. This is a major difference to consider when comparing a deferred compensation plan vs. a 401(k).
For example, as a top-level executive, if your salary is $600,000, and you were only able to contribute a maximum of $18,500 to your 401(k) each year, you would only be saving a little over 3 percent of your annual income toward retirement. In contrast, you could be deferring up to $300,000 of your annual income in a deferred compensation plan. The money you contribute would not be subject to income tax until you withdraw your funds. In theory, you would be able to plan ahead to ensure you defer enough compensation to stay under the top-tier tax brackets.
Before making any contribution decisions, however, you should consult with an experienced wealth manager that can help you develop a savings plan that accounts for all of your assets and financial needs.
Liquidity and Risk Differences in Deferred Compensation Plans vs. 401(k)s
When it comes to liquidity and risk, deferred compensation plans vs. 401(k) plans have some differences. In terms of liquidity, the funds in your 401(k) account are not typically eligible for withdrawal until age 59 ½, although under certain circumstances you can take a hardship withdrawal or a loan from the account. If you do not encounter one of these qualifying events but still want or need to withdraw funds from your account prior to age 59 ½, you will be hit with a 10% early withdrawal penalty in addition to the income tax.
You should consult with your tax professional in regards to taxation on distribution prior to taking them, but if your 401(k) plan is a Safe Harbor plan (you can tell whether or not it is by reading your summary plan description), the following circumstances allow for a hardship withdrawal prior to age 59 ½:
- Medical expenses for you or a family member.
- Any costs directly related to the purchase of your main home.
- Tuition and other college-related fees for you or your immediate family.
- Funeral expenses for you or an immediate family member.
- Expenses related to the repair of your main home.
In terms of risk, you accept your own investment risk by choosing the investments within the 401(k) account itself. As far as credit risk or company financial risk goes, 401(k) accounts are not subject to creditors if your company were to fold or file for bankruptcy. The 401(k) accounts are not considered part of the company’s general assets, which lessens your overall risk as an employee.
Meanwhile, if you are contributing to a deferred compensation plan, you will likely not be able to access the funds until you are 100% vested in the plan. Companies vary, but in my experience, most companies allow you to vest 25% per year so by year four or five, you should be 100% vested. Each company is different, so be sure to iron out the details with your employer before entering into this agreement.
After all, a deferred compensation plan is, in essence, just that—an agreement between you and your employer. You agree to defer a set percentage or dollar figure of your compensation to be withdrawn at a later date, and your employer agrees to house these funds for you as they sit free of income tax until you need them.
A deferred compensation plan is also different from a 401(k) account in that it is part of the company’s assets and could be subject to creditors if the company files for bankruptcy or falls into financial problems. While this is not something you want to think about because you are likely a driving factor in the success of the company, when it comes to risk analysis, you need to account for some of these possibilities. This is another reason why it is important to work with a third party that can take a look at your financial plan with an unbiased eye. This is something that an experienced executive financial advisor will be able to help you with.
|Deferred Compensation Plan vs. 401(k): A Quick Comparison|
|401(k) Account||Deferred Compensation Plan|
|Contribution Limits||$18,500/year||Up to 50% annual salary|
|Liquidity||Funds can be withdrawn without penalty at 59 ½ or in case of a qualifying event||Must be 100% vested to withdraw funds|
|Risk||Not subject to creditors||Subject to creditors|
When considering a deferred compensation plan vs. a 401(k) to help you save for the days when work becomes optional, consider the pros and cons laid out here. You should also consider other aspects of your personal financial situation as well. For instance, if you haven’t had your stock options quantified within the past few years, and your company is doing well, you might actually be at the point where work is optional for you without even realizing it.
Your executive financial advisor should be able to give you tangible data that helps you better understand your financial situation. Discussing the differences in deferred compensation plans and 401(k) accounts is certainly a conversation you should be having. In reality, you likely will want to contribute to both, if possible, to optimize tax deductions as an executive. Once you have a strategy in place, knowing where your money is going and how you can access it in the future will give you the peace of mind needed to get through the next hectic work week while looking forward to a time when work is no longer mandatory.
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 has developed and utilized multiple strategies to reap the benefits of deferred compensation plans and 401(k)s while helping executives reach work-optional status. For more information on how Wade and the Carpenter Team can advise you on your retirement plans, reach out today for a complimentary consultation.
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