Nonqualified Deferred Compensation: The Election Windows That Matter

Key takeaways

Deferral elections are made before the year the compensation is earned, and the distribution schedule is chosen at the same time and is very hard to change under Section 409A.
The tax benefit is the spread between today's bracket and the bracket in the payout years, multiplied by years of tax-deferred growth; it is largest for executives who will retire to a lower bracket in Florida.
The money is an unsecured promise of the employer; a bankruptcy puts the deferred balance in line with other creditors.
Payout timing should be planned against Social Security, RMDs, Roth conversions, and IRMAA, because a lump sum in year one of retirement can undo the benefit.

For senior employees, the 401(k)'s $24,500 limit is a small fraction of what they could be saving, and the nonqualified deferred compensation plan is where the rest of the tax deferral lives. The plan lets an executive elect, in advance, to have part of salary and bonus paid in a future year instead of now, with the deferred amount credited with a notional return in the meantime. Done well, it moves income from a 37% year to a 24% year and compounds it untaxed in between. Done carelessly, it drops a lump sum in the wrong year, or produces a balance that disappears along with the employer. The decisions are about elections and timing, and the rules don't forgive much.

How the plan works

Each year, during an election window (usually November or December), the employee elects a percentage of next year's salary and of the bonus to be earned next year to defer. The deferred amounts aren't paid and aren't taxed; they're credited to a bookkeeping account that tracks a menu of notional investments, similar to 401(k) funds. Payroll taxes (Social Security up to the wage base, Medicare) are generally due when the compensation is earned, but income tax waits until payment.

At the time of the election, the employee also chooses when and how the deferred amount gets paid: at separation from service, at a specified date, or at the earlier or later of the two, and as a lump sum or in annual installments over a chosen number of years. Many plans allow a different schedule for each year's deferral, which leaves you with a set of "buckets" that pay out at different times.

Section 409A

The 2004 law that governs these plans imposes three rules that shape every decision.

Elections in advance. The deferral election for a year's compensation must be made before that year begins (with a narrow exception for performance-based bonuses, which can be elected up to six months before the end of the performance period). There's no changing the deferral mid-year.

Distribution schedules are fixed. Once chosen, a payout date or schedule can be changed only by an election made at least twelve months before the original payment date, and the change pushes the payment out at least five years. A payout can't be accelerated except in limited events (death, disability, unforeseeable emergency, change in control if the plan provides for it).

Specified employees wait six months. For the top officers of a public company, distributions triggered by separation from service are delayed six months.

Violations get taxed harshly: immediate inclusion of all deferred amounts, a 20% additional tax, and interest. Plans are drafted to comply. The risk sits in the participant's choices.

The tax math

The benefit of deferring is the gap between the tax rate at deferral and the rate at payout, plus the growth on the pre-tax balance in between. An executive at 37% who defers $200,000 and receives it ten years later in retirement at 24% saves 13 points on the principal, and the growth compounds without annual tax. With the Florida move built in, the state layer disappears too. For an executive earning in New York or California during the working years, the state savings alone can be 10% or more.

The math turns against deferral when the payout year's rate isn't lower: when a lump sum lands on top of a final bonus, a severance, or a business sale; when the payout years coincide with RMDs and Social Security; or when tax rates rise. It also turns against deferral if the employer's credit is shaky. Which brings us to the risk.

The risk

Deferred compensation is an unsecured promise. The employer may set assets aside in a rabbi trust, but those assets stay the employer's and are available to its creditors in bankruptcy. An executive with $2 million deferred at a company that fails stands in line with the other unsecured creditors and typically recovers a fraction. Employees of Lehman Brothers and Enron learned this the hard way. So the deferral decision has to include a judgment about the employer's durability over the payout horizon, and the amount deferred should be one the household could lose without changing its plan. Your salary, your equity, and your deferred comp already sit with the same employer. Keeping the deferral proportionate is how you avoid piling more on; our post on concentrated employer exposure makes the same point about stock.

Choosing the payout schedule

The election that matters most is the schedule, because it's made years ahead and is nearly immovable. The choices we walk through:

Installments over many years spread the income and keep each year in a lower bracket. Ten or fifteen annual installments starting at separation are the most common design for an executive who plans to retire at the separation date.

Specified dates rather than separation, for executives who might leave earlier than planned and don't want a lump sum landing in a high-income year. A payout beginning at a fixed age, say 65, lines up with the retirement plan no matter when employment ends.

Coordination with everything else. The installments land in the same years as the Roth conversion window, the Social Security claiming decision, and, from 63, the IRMAA tiers. Deferred comp installments use up bracket room that would otherwise go to conversions. A schedule that front-loads installments into the years before Social Security and back-loads conversions after, or the reverse, is a design choice, and the projection shows which one wins.

Re-deferral is possible, once, for a bucket at least twelve months before payment, pushing it out at least five years. It's the escape valve when circumstances change, and it should be pulled with the whole projection in view.

The annual decision

Each fall, the election for the coming year comes down to a projection: what the marginal rate will be next year, what the household needs in cash, how much of the bonus to defer, and whether the payout schedule chosen for that bucket still fits the retirement plan. We run it alongside the year-end tax checklist, because the deferral, the 401(k) maximum, the equity exercises, and the charitable giving are really one calculation.

Where we come in

For executive clients, we map the deferred compensation plan bucket by bucket: amount, notional investment, payout date, and schedule, laid over the retirement projection year by year. Deferral amounts get set annually against the bracket and the employer risk, and payout elections are chosen to fit the plan's tax picture across retirement. We treat it as part of equity compensation planning because it's the same problem: pay in a form that has to be timed.

Frequently asked questions

Is deferred comp better than a Roth 401(k)?

Different tools. The Roth gives certainty and no creditor risk on a small amount; deferred comp gives large deferral capacity with employer risk. Most executives should max the qualified plans first and defer beyond them.

What happens to my deferred comp if I'm fired?

The plan pays according to the schedule elected for a separation from service. Unvested employer contributions may be forfeited; your own deferrals are always vested, though still unsecured.

Can I roll deferred comp to an IRA?

No. Distributions are ordinary income when paid and can't be rolled over. That's a key difference from a 401(k).

How do I evaluate my employer's credit?

For public companies, the credit rating and the balance sheet. For private companies it's harder, and the appropriate deferral is smaller. A plan with a rabbi trust is better than one without, but neither protects you in a bankruptcy.

Joseph G. Valerio, CFP®, EAFounder and Lead Advisor at Valerio Wealth Management, a fee-only, fiduciary virtual family office in Miami, Florida. One advisor, credentialed in both financial planning and federal tax. About Joseph

This article is general education, not individualized advice, and it is not tax, legal, or accounting advice. Figures reflect federal law for the year stated and can change. Valerio Wealth Management does not prepare or file tax returns. Speak with a qualified professional about your own situation before acting.