If you participate in a nonqualified deferred compensation plan, you may recall reading something about the money being subject to the claims of your employer’s creditors. With big companies dropping like flies, the risk of losing your deferred compensation money is greater than previously understood. The tax benefit you get from the plans may not be worth the risk to your retirement security.
In general, deferred compensation plans allow certain employees to defer a portion of their pay until some future date, usually around their retirement age. When you defer the money, you aren’t subject to income tax on those funds until they are eventually paid to you. This can provide a nice tax savings.
In the meantime, your employer gets to keep the money that you elected to defer. But because these plans are not qualified retirement plans, the money you have in a deferred compensation plan is generally not protected from the company’s creditors. So if your employer gets into financial difficulty, or goes bankrupt, your savings may be seized to pay the company’s liabilities.
This is completely different than the money you have in a 401(k) or profit sharing plan, which is considered a qualified retirement plan. The money in these accounts is exempt from your employer’s creditors. If your employer gets into financial trouble, your money in the 401(k) is safe.
Prior to this recent financial crisis, I don’t think the risk of loss for deferred compensation was perceived as very significant, especially if you worked for a large, publicly traded company. But given what has happened over the last year, it’s important to reassess the risk.
The decision basically comes down to a trade-off between potential income tax savings vs. the risk of losing your savings in the event of your employer’s financial collapse.
- While it’s difficult to estimate the total tax savings because each individual’s circumstances are unique, a rough estimate is that a deferred compensation program may save you between 5 percent and 10 percent in taxes once all is said and done. Remember, you get a tax deferral, not exclusion. So you’ll eventually pay income tax on this money, you just get to delay it for a while.
- Next, you have to compare that tax savings to the risk of total loss if your employer goes under. This risk is tough to quantify, but it certainly isn’t zero.
- Over the last year, we had a number of big companies go under, or barely avoid going under thanks to government bailouts, which you of course can’t count on. So over a 20 year cycle, what is the risk of a potential bankruptcy? Truly nobody knows, but given what just happened, I would ballpark it at somewhere between one percent and three percent, even if you do work for a big company. And smaller companies may be more at risk.
Since the consequences could be terrible for you, even a one percent probability may be too high when weighed against the overall tax benefit.
Bottom line. Deferred compensation plans offer some tax savings but expose your money to a complete risk of loss. You’ll have to decide if the tax savings are worth it. But the last year has highlighted systemic risks that we didn’t think existed. I would take note.
As with all financial matters, consult your individual advisor prior to making any financial decisions.
