Deferred Compensation—401k Strategy

February 12, 2018 by Laura Kotenko, CPA, M.S.T.

What usually comes to mind when referring to deferred compensation is income that you might get later in life. While this is technically correct, there is so much more to the definition. In most cases you receive deferred compensation after you’ve retired or lost a job. A deferred compensation plan usually means there is no special tax treatment provided; however, an exception to the rule would be a 401k account, an account that you and/or your employer will invest funds into and you’ll get this after you retire instead of at that time. As stated earlier deferred compensation means that there is no special tax treatment on money earned; however, you generally won’t pay taxes on the money while you earn it you will pay taxes when you receive it.

For instance let’s say that you make $75,000 a year in salary, and you put away $15,000 as deferred compensation in a 401k plan and you do this for 10 years of working at the same job with the same salary. You will only be taxed on the $60,000 you are earning and bringing paychecks home for. So you have your 10 years in and are finally ready to cash out this big lump sum you’ve saved which equals $150,000, which at this point you will be taxed at. The reason that people are so fond of a savings plan like this is because usually at this age their tax brackets will decrease after they’ve stopped working and can’t itemize on their annual tax return. Of course, this is only an example. Different plans are in place for different employers, and the employee needs to find the plan that fits their needs the best.

When you have a plan with a large lump sum the smartest option may not be to take the whole lump at once, think about being taxed at $60,000 per year versus $150,000 all at once, the tax implications may be higher, and you may end up losing out on money if you decide to take the lump sum. Receiving installments of your 401k plan would be the smartest path to take because generally taking payments over 5 to 10 years will lower the bracket of $150,000 to the bracket of $30,000 to $15,000 respectively, making much more sense in the long run.

Always try to keep in mind that, while the federal implications of installments or a lump sum for your money will be the same regardless of what state you live in, the state implications may vary from state to state, so it is always best to talk with your financial advisors to find out what the best plan is for you.