Does it make sense to defer a bonus?

Before you elect to defer a bonus, make sure you understand the risks, possible rewards, and tax implications.

September through November is generally “bonus deferral season." In these few months, eligible employees can elect to defer a percentage of their bonus to pay out at a future date. It’s not a decision to take lightly as the decision is usually irrevocable. This year is especially tricky given the current income tax rates are set to expire in 2026.

For my clients, we schedule a call to discuss the specifics of their company’s plan, their cash flow for the upcoming year, and weigh the advantages and disadvantages. If you are wondering if you should participate in your company’s deferred compensation plan, here to help are a few tips from my experience in advising executives and high-income professionals with their plans:?

First understand the basics

Deferring a bonus means foregoing some of your pay today for a promise to pay you in the future. Why would anyone give up cash today for a promise to be paid in the future? Three reasons:

1.?????Taxes. If you defer a bonus today, you have less taxable income than if you didn’t defer. And less income means you should pay less in income taxes. This is helpful if you have other substantial income like restricted stock vesting. It’s also helpful if you defer a bonus from your high-income years to be paid out in low-income tax years like in retirement.

2.?????Tax deferral. The money you elect to defer can usually be invested in a suite of mutual funds. All the earnings, dividends, and appreciation from the mutual funds within the deferred compensation plan can compound without paying taxes. Tax-deferral is a major reason high-income earners like to use deferred compensation plans. Income taxes are due when the money is withdrawn (more on that later).

3.?????Company match. Sometimes, not always, the employer will match a percentage of your deferral. A company match is like free money, you will want to know how it works, it’s best to check the benefits booklet or ask HR.

The caveats – or somethings to consider

There is no free lunch as they say. Deferred compensation plans are an unsecured liability of the employer. This means it is possible to lose your entire account if the employer goes bankrupt, you are an unsecured creditor. Make sure you are comfortable with this risk before you defer. Even large, well-heeled companies can go belly up.

Future tax rates are another caveat. Deferred compensation plans are set to pay out in the future. When the money is withdrawn, it is taxed as ordinary income. Ideally, it is more advantageous to have the money paid out when you are in a lower tax bracket than you are in today.

No guarantee on the investment performance. Your mutual funds are subject to the whims of the stock and bond markets, so you could lose money. If you are concerned about principal fluctuation, some plans offer a guaranteed interest account. The interest may be low, but it is tax-deferred.

Planning considerations

Generally, I find the merits of deferred compensation compelling enough to recommend clients consider deferring some of their bonus. The company match, tax-deferred earnings, and the potential to defer into a lower tax bracket like in retirement are compelling enough to consider doing something.

However, you have to weigh the credit risk and plan accordingly. This may include not deferring for too long or not stretching the payouts for too long either. Also, being aware of your overall company exposure is a good idea. A client who owns a lot of their company stock, restricted stock, or has a large amount of savings already in their deferred comp plan from past bonus cycles may want to be more sensitive to their employer’s credit risk.

Something else to consider is the State Source Tax which governs which state will tax the income withdrawn. A client currently residing and working in a high tax state like New York but wanting to retire in Florida which has no income tax, needs to be familiar with both the State Source Tax rules and how their former and current state of residence taxes deferred comp. In the previous example, since the income was earned in New York, the client could end up paying New York state tax on the income when withdrawn even if he or she is currently residing in Florida.

This is a small sample of what to think about when deciding whether to defer a bonus. Other considerations include: Should the eventual payout be in a lump-sum or stretched out over multiple years? How should you invest the money in the deferred comp plan? What happens if tax rates do rise? And if you made deferred comp elections in the past, should you change the timing of when they are paid out? Unless you are well versed in this area, I suggest speaking to an experienced tax or financial advisor.

The author is a Certified Financial Planner, Practitioner and advisor to executives and corporate professionals.

Is your advisor helping you on these topics? If not, click here to schedule a complimentary consultation to review and discuss your financial planning or email me at [email protected].

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For more great insights on managing company stock, 401ks, and other executive perks go to: https://michaelaloi.com/for-executives

Disclaimer: Investment advisory and financial planning services are offered through Summit Financial LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not a guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Summit is not responsible for hyperlinks and any external referenced information found in this article. 09092022-0647