What You Should Know About Deferred Compensation

Deferred compensation is one of the most valuable benefits available to Triangle area executives, but it comes with real tradeoffs. Deferred compensation lets you set aside income over and above the 401(k) limits and defer the taxes until you receive the income usually in retirement. Whether it’s the right move depends on your tax bracket today vs. your tax bracket in retirement, your cash flow, your total accumulated wealth, and your risk tolerance.

What Is Nonqualified Deferred Compensation?

Nonqualified deferred compensation (NQDC) is a contract between you and your employer. You agree to defer a portion of your current compensation, and the employer agrees to pay it to you later, at retirement or separation.

While this sounds similar to a 401(k), there are important differences.

Your 401(k) is protected by ERISA. It’s an asset your creditors can’t touch. Deferred compensation is an unsecured debt of your employer. Until the employer pays you, the money technically belongs to the company. If the employer goes bankrupt, you become a creditor along with other claimants.

The advantages of deferred compensation are there are no IRS contribution limits, although company plans normally have limits. Contributions to deferred comp reduce your current taxable income. But when the money comes out, it’s taxed as ordinary income. In most cases you won’t owe FICA on any distribution.

Should You Participate in Deferred Comp?

Whether deferred compensation makes sense for you comes down to one main question: will your tax bracket be lower when you receive the money than it is now? If yes, the math argues for deferral. If no, you may be better off paying the taxes today and investing in a taxable brokerage account. The other consideration is your cash flow. Opting to forgo deferred compensation participation and invest excess savings into a taxable brokerage account provides more optionality for the future.

Deferred Comp Has Handcuffs

Unlike a taxable account, you can’t access deferred comp contributions when you need it. The distribution schedule is set in advance, and Section 409A of the tax code makes those elections essentially irrevocable. One caveat – most plans allow you to extend or lengthen your payment schedule but you aren’t allowed to accelerate it.

How Much Should You Contribute?

Before contributing to deferred compensation, we think you should max your tax-advantaged accounts first. NQDC is the last bucket, not the first.

The savings order for most people would be:

• 401(k) to the max ($24,500 in 2026, plus catch-up if eligible)

• Non-deductible / Mega Backdoor Roth 401k contributions (if plan permitted)

• Backdoor Roth IRA ($7,500 in 2026)

• HSA if enrolled in a high-deductible plan ($4,400 individual / $8,750 family in 2026)

• Then either contributions to a taxable investment account or NQDC, based on your specific circumstances

Your contribution amounts can also be impacted by personal factors such as:

• Expected time from deferral to retirement / commencement of distributions Investment choices within the deferred comp plan

• The bottom line is don’t defer more than you can afford to have locked up. If losing access to that money for 10+ years would change your financial plan, the deferral amount is too high.

The Enrollment Window

Under IRC Section 409A, deferral elections must be made before the year you earn the income. Most companies offer deferred compensation participation in the fall for the upcoming year. In many plans, each year’s deferral is its own “tranche” with its own distribution and investment election.

How Should You Take Distributions?

Ideally, deferred compensation can serve as a bridge from early retirement to Social Security. For example, our client Bob, age 58, is an Research Triangle Park pharmaceutical executive who plans to at 64. He and his wife are currently in the 35% tax bracket. By deferring ~$60,000 each year until retirement he’s able to:

• Reduce his marginal tax rate to 32%, an immediate tax savings of ~$2,000.

• Accumulate an additional retirement nest egg of ~$400,000 – which he will receive in annual installments between the ages of 65-69.

• Based on our tax projections and cash flow planning he’ll pay an effective rate of ~13% in the first 5 years of retirement.

• This results in an estimated $88,000 of cumulative tax savings (22% tax arbitrage on $400,000 deferred compensation distributions).  

  
  

Managing Investments Inside the Plan

Most deferred compensation plans offer investment options similar to your 401(k). But it is critical to manage these asset allocations as you approach the distribution dates. For example, you would assume a great deal of principal risk to have a tranche invested 100% in equities a year or two prior to distribution. 

Deferred Comp FAQs

Can I Roll My Deferred Comp Into an IRA?

This is one of the most common questions.  The answer is no: NQDC distributions cannot be rolled into an IRA or any other retirement account.

When the money comes out, it’s reported on your W-2 as ordinary income. There’s no 1099-R. There’s no rollover option. You can’t convert it to Roth. It’s taxable income in the year you receive it, period.

This is a fundamental difference from a 401(k). When you leave an employer, you can roll your 401(k) to an IRA and continue deferring taxes. With deferred comp, the tax bill comes due on the employer’s distribution schedule. That’s why the distribution election is so important. It’s the only tool you have to control the tax impact.

How Safe is Your Employer?

NQDC is an unsecured promise. That’s significantly different from the protections afforded 401(k) assets.

Company risk varies from industry to industry, and from company to company. A company considered “low-risk” today could change 5 to 10 years from now.

Enron is perhaps the poster child for deferred comp losses – and abuses that led to significant regulatory changes. Enron employees had a collective $465 million in deferred comp that got only pennies on the dollar in bankruptcy.

However, in the weeks immediately preceding the bankruptcy filing, Enron allowed over 130 active executives to fast-track and withdraw $53 million from the deferred compensation pool to save their own money. Meanwhile, around 400 retired or recently departed senior employees who formally requested early withdrawals during the exact same period were denied access to their accounts and lost nearly everything.

It’s important to understand that deferred compensation carries both a liquidity concern AND a counterparty risk. Both must be assessed before deciding whether or not to participate and at what level.

How Does Deferred Comp Affect Your FICA Taxes and Social Security?

Here’s a detail that surprises a lot of people: NQDC is subject to FICA tax when you earn it, not when you receive it. The IRS calls this the “special timing rule.”  The majority of employees participating in deferred comp are well over the FICA wage threshold ($184,500 in 2026), so this isn’t a material issue for the vast majority of deferred compensation participants.

Can I Change My Deferred Comp Election After I’ve Enrolled?

Once you set your savings amount (deferral) for the current year, it is locked in. You cannot lower, increase, or stop your contributions until the next open enrollment period for the following year.

If you want to push back when you receive your money, you can make a change one time per account, subject to three strict conditions:

• 12-Month Notice: You must submit the change at least 12 full months before your original payout was scheduled to begin.

• 5-Year Extension: Your new payout start date must be pushed back by at least 5 additional years. For example, if your payout was scheduled for 2027, the earliest new date you can choose is 2032.

• Payment Structure Drops/Locks: You cannot change how you get paid (e.g., switching from a single lump sum to monthly installments). Whatever format you originally selected is permanent.

These rules make it very important to make good decisions at deferral about both the payment commencement date AND the period over which the payments will be made.

What Happens If I Leave My Employer Before Retirement?

Your payments usually get paid out upon termination of employment. You’ll need to review your plan document to determine the exact distribution schedule. Some employees (those deemed “Key Employees”) can face a mandatory 6-month delay after separation before any payment can begin. That delay can affect your cash flow planning in the first year after leaving.

Should I Take Deferred Comp Distributions as a Lump Sum or Installments?

This requires tailored financial projections based on your unique situation. Most plans offer a variety of installment options. This is perhaps the most important decision one makes relative to deferred comp, so thorough planning is critical.

Do Deferred Comp Payments Impact IRMAA?

Your deferred comp distributions count toward the income thresholds that determine how much of your Social Security is taxable and whether you’ll pay IRMAA surcharges on Medicare premiums.

Making the Best Decision Requires Coordination

Deferred compensation is one of those decisions that seems simple, but in practice requires coordinating tax planning, retirement planning and investment decisions to be truly effective.

The team at Ark Royal is well-experienced in helping make thoughtful planning decisions around this important employee benefit. Let us know if we can help you!