Understanding the tax implications of your financial decisions is crucial for managing your money effectively. One area with complex tax considerations is deferred compensation.
Deferred compensation plans are a common feature in many workplaces, offering employees the option to defer a portion of their salary or bonuses to a future date, typically upon retirement.
While these plans offer benefits like tax deferral and potential investment growth, they also have significant tax implications that can impact your financial future.
Let’s explore the tax implications of deferred compensation and discuss how you can navigate them to optimize your financial planning.
What is Deferred Compensation?
Deferred compensation is an arrangement where a portion of an employee’s income is withheld and paid out later. It can take various forms, including:
401(k) plans: A 401(k) plan is a tax-advantaged retirement savings plan many employers offer their employees. It allows employees to contribute a portion of their pre-tax income to the plan, which is then invested in various investment options. The contributions and any investment earnings grow tax-deferred until the money is withdrawn, typically after retirement. At that time, the withdrawals are taxed as ordinary income.
Some employers also offer matching contributions to encourage employees to save for retirement.
Stock options: Stock options are contracts that give the holder the right, but not the obligation, to buy or sell a specific stock at a predetermined price within a certain time frame. They are commonly used as compensation for employees, allowing them to purchase company stock at a discounted price.
There are two main types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). They are treated differently for tax purposes (as discussed below).
ESOPs: An ESOP, or employee stock ownership plan, is a type of retirement plan where the company contributes its stock to the plan on behalf of the employees. It’s often used to provide a market for the shares of an owner of a profitable company. The employees can contribute cash to buy the stock, or the plan can borrow money to purchase the shares.
The employees become partial owners of the company and receive shares of the stock.
ESOPs are often used to give employees a stake in the company’s success and incentivize them to work hard to increase its value.
Pension plans: A pension plan is a retirement savings plan sponsored by an employer and provides a defined benefit to the employees upon their retirement.
The employer contributes funds to the pension plan, which is then invested to provide a return.
The employees receive a guaranteed payment from the pension plan when they retire, based on a formula that considers factors such as their salary and length of service with the employer.
Nonqualified deferred compensation plans: Nonqualified deferred compensation plans (NQDC) are agreements between an employer and an employee to defer part of the employee’s compensation to a future date. Unlike qualified plans, like 401(k)s, NQDC plans are not subject to the same restrictions and requirements as qualified plans, so they can be customized to fit an employer’s and employee’s specific needs.
Cash balance plans: Cash balance plans are defined benefit plans that resemble a defined contribution plan. It provides employees with a hypothetical account balance that
the employer is responsible for funding. The employer bears the investment risk.
The account balance grows yearly at a fixed percentage or interest rate and is paid to the employee upon retirement.
Phantom stock plans: Phantom stock plans are a type of deferred compensation plan that gives employees the right to receive cash or stock at a future date based on the performance of the company’s stock.
Phantom stock plans are similar to stock options in that they allow employees to benefit from the company’s stock’s success without owning any shares.
Restricted stock units: Restricted stock units (RSUs) are a form of equity compensation that gives employees the right to receive a certain number of shares of a company’s stock at a future date.
RSUs typically vest over time, meaning the employee must remain with the company for a certain period before the shares are granted. Once the shares vest, the employee can sell or hold onto them as an investment.
Taxation of Deferred Compensation Plans
Here is a summary of how each deferred compensation arrangement is treated for tax purposes:
401(k) Plan: Contributions to a 401(k) plan are made on a pre-tax basis, which means they reduce your taxable income for the year. The contributions and any investment earnings grow tax-deferred until the money is withdrawn, typically after retirement. At that time, the withdrawals are taxed as ordinary income at your marginal tax rate. Some plans allow the employee to save after-tax dollars through Roth contributions. Those contributions and investment earnings grow tax-deferred. If certain requirements are met, distributions in retirement are tax-free from Roth contributions.
Stock Options: Stock options are taxed when they are exercised. If you exercise an incentive stock option (ISO), you may be taxed at a preferential rate if specific requirements are met. Taxation of ISOs is complex. You will need to consult with a qualified tax professional.
If you exercise a non-qualified stock option (NSO), you will be taxed at ordinary income rates on the difference between the exercise price and the stock’s fair market value at the time of exercise. This difference is called the “bargain element.”
ESOPs (Employee Stock Ownership Plans): ESOPs are generally tax-deferred until the employee receives the stock. At this point, they are taxed at ordinary income tax rates on the value of company contributions to the plan, plus capital gains on the appreciation in share value when they are sold.
Pension plans: Pension plans are tax-deferred until the employee receives distributions, taxed as ordinary income.
Nonqualified deferred compensation plans: Nonqualified ones are taxed as ordinary income when paid out. The employer must pay payroll taxes on the contributions.
Cash balance plans: Cash balance plans are tax-deferred until the employee receives distributions, taxed as ordinary income.
Phantom stock plans: Phantom stock plans are taxed as ordinary income when paid out.
Restricted stock units: RSUs are taxed as ordinary income when the shares are vested at the fair market value that day. However, Section 83(b) election could allow the employee to pay the tax when those shares are granted. This election could potentially significantly reduce the taxes over the long term. With so many nuances, working closely with a CPA to optimize which treatment is best is important. Forfeiture risks also need to be weighed in on this decision. Under either scenario, when the shares are sold later, the employee is subject to capital gains taxes , either short-term or long-term, depending on the holding period.
Tax Deferral Benefits
Tax deferral is advantageous for several reasons:
Lower Tax Bracket: If you expect to be in a lower tax bracket when you receive the deferred income, you may pay less tax overall.
Tax-Deferred Growth: Any investment earnings on the deferred amount are not taxed until withdrawal, allowing for potential growth over time.
Flexibility: With some deferred compensation offerings, you can choose when to receive the deferred income, allowing you to plan withdrawals to minimize tax impact strategically.
Downsides of Deferred Compensation
There are also downsides.
The amount of the deferred compensation isn’t guaranteed. If your company goes bankrupt, you become an unsecured creditor.
Changes to your distribution election (when you start receiving deferred compensation) can be inflexible. You have to make the requested change at least a year before you are scheduled to receive it, and the new date can’t be earlier than five years after the original distribution date.
Your investment choices may be limited…and costly.
Final Thoughts
Deferred compensation can be a valuable tool for saving for retirement and managing your tax liability. By understanding the tax implications of deferred compensation and implementing strategies to navigate them, you can optimize your financial future.
Consider consulting with a financial advisor or tax professional (or a financial advisor who is also a CPA) to develop a plan that aligns with your goals and maximizes the benefits of deferred compensation.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. All investing involves risk, including loss of principal. No strategy ensures success or protects against loss.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. LPL Financial does not offer tax advice or services.