A listener wrote in with a situation I see often. His company’s deferred comp election window opens every November, and for years he’s simply defaulted to a lump sum payout at separation without giving it much thought. He’s 51, plans to work roughly another decade, and someone recently told him that these elections are essentially irrevocable and that the default option is usually the worst one. They were right. Before this year’s window closes, here’s what he, and anyone in a similar spot, should be evaluating.
Deferred Comp Isn’t a 401(k) With a Different Name
People get excited about deferred comp plans because they sound like an extra retirement account. In a sense, they are: you defer income now, at a high tax bracket, and pay tax later when you pull the money out. But unlike a 401(k) or 403(b), which you actually own and which sits in your name, a nonqualified deferred comp plan (often a 457) is simply an IOU from your employer. You’re agreeing to let the company hold onto money it owes you until a future date. If the company runs into financial trouble or goes bankrupt, that money is still considered a company asset, and you don’t have the same protections you’d have with a qualified plan. We’ve seen this happen even with large, established employers. So the first thing worth evaluating isn’t the election itself, it’s how much of your total net worth sits in this kind of exposed account. If deferred comp represents 5 to 10% of your assets, that’s manageable. If it’s a much bigger slice, that’s worth addressing before adding more.
Why the Default Is Usually the Worst Option
Here’s the problem with defaulting to a lump sum: whatever balance has built up in that account gets paid out to you in a single year, the year you separate from the company. If you’ve built up $500,000 over your career, that’s a $500,000 paycheck landing in one tax year, likely pushing you into as high a bracket as you were trying to avoid by deferring the income in the first place. It defeats the entire purpose of deferring compensation. This is exactly the trap our listener has been walking toward every November without realizing it.
Stretch the Payout Instead of Taking It All at Once
The fix, where plans allow it, is to change your distribution election so the payout is spread over several years rather than delivered in one lump sum. Many plans let you elect distributions over 5, 10, or even 15 years after separation. The longer that window, assuming you don’t need the cash immediately, the more you can smooth out the tax hit. Instead of a $500,000 paycheck the year you leave, you might take $50,000 a year for a decade, which is far easier to manage against your other income and your bracket each year. Because these elections often come with built in delay requirements, sometimes five years before a change takes effect, someone in his position, with roughly a decade left before retirement, should still have plenty of runway to make this change and have it apply.
Decide Whether to Keep Contributing at All
Once you know whether your plan allows a longer distribution schedule, the next question is whether to keep contributing new money to the plan. If your company won’t let you change the election, or caps how far out you can stretch it, there’s little reason to keep adding to an account that’s just going to create a larger tax problem down the road. In that case, it often makes more sense to redirect those deferrals into a taxable brokerage account you actually control. If the plan is flexible, project what the account will grow to by the time you retire, divide that by your chosen distribution period, and get a real sense of how much annual income this will generate. That number matters a lot once you start layering in Social Security and any Roth conversion plans in early retirement.
Match the Timing to Your Bracket, Not the Calendar
The bigger picture question is when you actually want that income to show up. If you’re already in your highest earning years and expect a lower bracket in early retirement, before required distributions and Social Security kick in, it may make sense to stretch distributions into those lower bracket years, or even take in service distributions while still working if your income fluctuates. This is the kind of decision that benefits from sitting down with us, your advisors, before the window closes, because once you lock in an election, you’re often stuck with it for years. Don’t let a form you’ve filled out the same way for a decade quietly determine one of the biggest tax events of your career.
This post is adapted from a recent episode of the Scholar Wealth Podcast. For more perspective on deferred compensation elections, listen to the full podcast episode here.