What is Deferred Executive Compensation (DCP)?
Deferred executive compensation is a written agreement between an employer and an employee where the employee voluntarily agrees to have part of his compensation withheld by the company, invested on his behalf, and given to him at some pre-specified point in the future. Depending on the plan, that date could be in five years, 10 years, or in retirement. Deferred compensation is typically only available to executives who are highly compensated employees of companies. DCP is also known as nonqualified deferred compensation (NQDC) plan.
What’s the Upside Using DCP?
DCP allow executives to defer a much larger portion of their compensation, and to defer taxes on the money until the deferral is paid. You can decide how much to defer each year from your salary, bonuses, or other forms of compensation.
Deferring this income provides a tax advantage: You don’t pay income tax on that portion of your compensation in the year you defer it (you pay only Social Security and Medicare taxes), so it has the potential to grow tax deferred until you receive it.
For high income individual, it’s another way to control your tax situation. Essentially, you are deferring income from your high earning years to low earning years like during retirement, thereby lowering your income during peak earning years.
Most companies provide NQDC plans as an executive retirement benefit, because 401(k) plans often are inadequate for high earners. Let’s take a following example
- Take an executive earning $500,000 a year: The $18,000 limit on annual 401(k) contributions represents only 3.6% of his or her annual income.
- At that rate, the executive could never save enough (pretax) to make up the typical 70%–90% replacement income goal for retirement.
- By contrast, the executive could choose to set aside a much larger percentage of his or her salary into an NQDC plan each year, creating an appropriate retirement cushion.
- For this executive, the federal tax rate for anything above $400K is 39.6%. For that 100K, he will pay $39,600 of tax to Uncle Sam off the top, if instead, the executive puts away $100k into NQDC. He saves $39,600 that year and puts into work through investment.
- 20 years later, when he retires and ready to withdraw that money. Presumably his income level would come down substantially and would be in a much lower tax bracket.
NQDC plans aren’t just for retirement savings. Many plans allow you to schedule distributions during the course of your career, not just when you retire, so you can defer compensation to cover shorter-term goals like paying a child’s college tuition. You also can change your deferral amount from year to year.
Another great quality about DCP is that there is no upper limit unless 401k and IRAs, your can direct 100% of your income bonus and commission to this plan. Obviously you should make sure you have enough to live by now as it’s difficult to take out this money.
Plan have rules on how long you must keep the contribution in the account for at least three years, and based your distribution plan. You can change the plan once a year.
What’s the Downside of Using DCP?
Unlike Qualified plan like 401k, you can’t take loans from NQDC plans, and you can’t roll the money over into an IRA or other retirement account when the compensation is paid to you (see the graphic below).
Unlike a qualified plan, where benefits are segregated from the employer’s general assets, your deferred compensation deferred into the NQDC remains the employer’s general assets and is subject to potential loss. The plan essentially represents a promise by the company to pay you back. At most, the company may set aside money in a trust (called a rabbi trust) to pay future benefits when they become payable. The funds in this trust are still part of the company’s general assets, and would be subject to creditors’ claims in a corporate bankruptcy. Though with the maturing of the NQDC and the many protection put in place, this is a very unlikely event.
Most of these plan also have a separation clause, meaning once the executives leaves the company, the distribution would start rather than waiting till your retirement years. Depends on your plan and your choice, the distribution could be over a period of 20 years, which is still very helpful to even out the income.
Bottom line, for highly compensated executives, DCP is a great way to defer income from your high earning years to low earning years.