Rethink That Deferred Comp Plan Now
Before 2005 executives who opted to delay pocketing some or all of their pay by stashing pretax income in an employer-sponsored investment account could have their cake and eat it too. By putting money in a nonqualified deferred compensation plan, they could secure tax-advantaged investment growth without having to worry much about the perk's major downside—restricted access to the money. To raid these accounts at times different from those elected at the outset, an executive merely had to pay a 10% penalty. "There was a lot of flexibility," says Robert Barbetti, executive compensation specialist at JPMorgan Private Bank (JPM).
Three years ago, Congress put an end to this flexibility, partly in response to perceived abuses at Enron, where top brass had liquidated these accounts before creditors could seize them. As a result, executives who have taken advantage of this perk since 2005 have had to follow strict timetables for withdrawals, or risk a 20% excise tax on their deferred pay, plus ordinary income tax and interest. This is not just a problem for those in the corner office. A survey by Clark Consulting, an employee benefits consultant in Dallas, found that 66% of companies in the Fortune 1000 even allow those who earn $150,000 or less to defer compensation.
This year many executives will be able to revise those timetables. Last fall the IRS extended the deadline by which companies must adopt the new rules to Jan. 1, 2009. As a result, many employers are letting executives rethink decisions they've made since 2005 about when to tap this pot of money and whether to do so in a lump sum or installments. "After this year, it's going to be virtually impossible to change your mind," says Robert Salwen, a consultant at Executive Compensation Corp. in Scarsdale, N.Y.
So now is an excellent time to revisit decisions about deferred compensation. Many expect tax rates to rise by 2011, when the Bush tax cuts expire, boosting what will be owed when money is pulled from the plans. Moreover, times are tough, and if your employer runs into trouble you may not be able to recover the money in your plan. Unlike savings in a 401(k), deferred comp isn't protected from creditors in a corporate bankruptcy.
You may also benefit from rethinking payout decisions if your personal circumstances have changed. Perhaps you need cash to see you through an unexpected financial setback such as a divorce or layoff. Alternatively, if you expect to move to a state with no income tax, such as Florida or Texas, you may be able to avoid paying state income taxes if you spread your payments over 10 or more years, rather than taking the money in a lump sum, says Barbetti.
If you want to change the arrangements you've made since Jan. 1, 2005—money deferred before then generally remains accessible, subject to the 10% penalty—ask your employer if policy allows that. Companies aren't required to offer executives the option to make alterations, and some may be reluctant to add to plan administrators' workloads. But, says Barbetti: "Most of the companies I know are allowing employees the flexibility to make changes."
To make changes, you may need to wait until the fall benefits enrollment season. And then you may find that your plan doesn't grant all the flexibility you'd like. Some, for example, let employees designate specific years to withdraw money. Others simply require them to cash out after retiring or leaving the company. But most let employees choose between lump sum and installment payouts. Here are reasons to consider revising deferral decisions:
LOOMING TAX HIKES
Scenario Say you're scheduled to take withdrawals in 2011 or later. That's when the Bush tax cuts expire, so you may be subject to higher income tax rates. The top marginal rate, for example, is scheduled to revert to 39.6%, from 35%.
Problem If your returns are poor, you may not make up for the higher tax hit. It may be better to drain the account and pay taxes at today's rates.
Advice The longer you defer, the better your odds of coming out ahead, even after a tax hike. Why? Your investments will have more time to compound tax-free. As a rule, it's a good idea to defer for five or more years, says JPMorgan Private Bank's Barbetti.
A CASH CRUNCH
Scenario When you designed your payout schedule, you weren't worrying about job security. Now your—or your spouse's—paycheck may be in jeopardy.
Problem In some instances, a layoff will trigger an automatic payout. In others, though, the money will remain off-limits until your scheduled distributions start.
Advice If you're worried about cash flow, ask that your payouts be timed to coincide with your separation from service.
AN OUT-OF-STATE MOVE
Scenario You plan to move to Florida, Texas, or another state with no income tax.
Problem If you take a lump sum, you'll owe income tax to the state in which you earned the money. But if you spread the payouts over ten or more years, you can report the income to your new home state—and no state income tax will be applied to your withdrawals.
Advice Switch from a lump sum to an annuity-style payout.