Should You Defer Compensation?

It used to be that if you were lucky enough to be offered the option of a deferred compensation plan, which lets you stash pretax income in an employer-sponsored investment account where it can grow tax-free, you took it. Now, with more individuals and companies facing an economic squeeze and taxes expected to rise, that decision is a lot tougher.

While deferred comp plans may encompass both salary and bonus for high-paid employees, most deferrals are just for bonuses. June 30 is the deadline for deciding whether to defer 2009 performance-based bonuses. But the economic uncertainties are so great that many people are deciding to take the cash. After all, if you defer, you won't have access to that money if you need it. Ann Costelloe, an executive compensation consultant in the San Francisco office of Watson Wyatt (WW), expects deferrals of incentive pay to be 20% to 50% lower this year than last. "A lot of folks are saying, 'Gee, things are getting tenuous out there for me and my family,'" Costelloe says. "They may not be able to defer money this year, because their bonus will be far less, or maybe they aren't going to get a bonus."

If you've been offered the deferral option, should you take it? First, evaluate your finances and your company's financial stability—if your company goes bankrupt, you could lose the money. While 401(k) participants are protected in bankruptcy, those in deferred comp plans line up with other unsecured creditors. Then consider the quality of investment options offered in the plan and the impact of future tax rates, which are expected to rise in 2011 when the Bush tax cuts expire.

Those looming tax increases are one of the biggest factors to consider. If you defer, you must decide how long to defer; the minimum period is two years. That means if the Bush tax cuts expire, you'd be taking the money out at a higher tax rate—39.6% vs. 35% in the highest bracket. So you'll need to offset that either by earning more in the plan or by investing over a long enough period that compounding will make up the difference.

Robert Barbetti, an executive compensation specialist for J.P. Morgan (JPM)'s private clients, argues that if you can defer for only a few years, it isn't worth it. Consider: If you receive a $100,000 bonus and don't defer, you'd keep $65,000 (at the highest tax rate, excluding state taxes). If you then got 6% on your investment, you'd have $81,144 aftertax in five years. If you deferred that $100,000 and made the same 6%, withdrew the funds in five years, and paid the higher tax rate, you'd have $80,829—so deferring wouldn't pay.

Given the prospect of higher tax rates, Barbetti advises clients to defer for closer to 10 years, if not longer. If you deferred $100,000 for 10 years and earned 6% a year, then paid taxes at the higher rate, you'd net $108,167 vs. $101,410 if you didn't defer. "You need to defer long enough to make it worthwhile if you're going to take money out at a higher tax rate," he says. "But people are concerned about job security, so they don't want to tie it up too long."

State taxes matter, too. Deferring is especially worthwhile if you move from a high income tax state, such as New York or California to a low- or no-tax one, such as Texas or Florida, by the time you get your distribution.

To make the best decision, look at your entire portfolio. Do you have better investment options outside the plan? Might be best to pass on deferring pay. Do you have other assets to tap if you're laid off, making long-term deferral less risky? Then deferring would probably be worthwhile. Says Doug Frederick, head of consulting firm Mercer's national executive benefits group: "The gut check is whether you know that the money you could have taken today you won't need tomorrow."

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