How far ahead are you planning for taxes?
I find that a lot of people tend to think about taxes for a single year. They review their income and look at deductions and deferral opportunities for the current tax year. The main goal seems to be doing everything you can to reduce taxes for the next tax return.
Executives and highly compensated employees who have access to a Nonqualified Deferred Compensation Plan (NQDC) can be especially guilty of this. And with good reason – a NQDC plan can offer significant tax deferral, even above the limits placed on qualified plans like a 401(k). The opportunity to defer taxation on a larger portion of one’s income can seem very attractive.
However, there is a potential pitfall if one uses these plans without planning ahead for future taxes.
Since the taxation is deferred on the compensation contributed to the plan, income taxes will have to be paid later when the compensation is received. The election on when that income is to be received is determined by the plan itself; but once that election is made, it is irrevocable.
What this means is that executives and highly compensated employees who participate in these plans will receive their deferred compensation on a fixed schedule after they retire, which cannot be adjusted. If an employee elected a lump sum payout or has several years of deferred compensation paid out consecutively, the deferred compensation may constitute a significant source of income in retirement.
While many participants in NQDC plans assume they’ll be in a lower tax bracket in retirement, things can change along the way.
I’ve worked with clients who ended up doing consulting work, adding part-time employment, or began other retirement income benefits that, when added to the deferred compensation, kept them in higher tax brackets than they expected. I’ve had clients who made a lump sum election several years earlier and did not realize they would have to receive that compensation without flexibility or consideration of their current sources of income.
It can be helpful to consider the tax savings now and the potential tax impact later, before setting strategy for contributing to a nonqualified deferred compensation plan. Participants should consider working with their financial and tax professionals to figure out what is best for their long-term well-being.
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