Deferred compensation refers to money received in one year for work performed in a previous year — often many years earlier. Typically, you receive deferred compensation after retiring or leaving employment. Although tax-advantaged retirement plans such as 401k accounts are technically deferred compensation plans, the term deferred compensation in general use refers to "nonqualified" plans, or those that don't provide any special tax treatment. If you're receiving deferred compensation, or considering an offer than includes a deferred compensation plan, it's important to understand what you can do to reduce your tax bill.
How deferred compensation is taxed
Generally speaking, the tax treatment of deferred compensation is simple: Employees pay taxes on the money when they receive it, not necessarily when they earn it.
- For example, say your employer provides you $80,000 a year in salary and $20,000 a year in deferred compensation.
- You work there for 10 years, and after retiring, you get your deferred compensation in a lump sum.
- Each year you work, you'll be taxed only on $80,000 worth of income.
- The year you receive your deferred money, you'll be taxed on $200,000 in income—10 years' worth of $20,000 deferrals.
There are different ways to structure the payment of deferred income, but your options depend on the plan details as set up by the employer. The distribution schedule is almost always pre-determined and specified in the plan document that controls the administration of the deferred compensation plan. In other words, it's critical to understand from the beginning what your options will be down the road.
Installment plans can reduce tax bite
If you make $20,000 for 10 years, you'll pay considerably less in taxes than you would if you made $200,000 in one year, because of the progressive nature of U.S. income tax, in which people at higher incomes pay higher rates.
This is also true with deferred compensation. If you get your deferred money in a single lump sum, it could push you into a much higher tax bracket for that year. As a result, you'll pay more of your deferred compensation in taxes than you would if you had received the money in installments over five, 10 or more years.
"The absolute biggest mistake that most individuals make when they elect to take deferred compensation is choosing the lump-sum option" instead of installments, says Ted Jenkin, co-CEO of Oxygen Financial in Atlanta and columnist with the Wall Street Journal's "The Experts."
Residence can affect overall tax status
Your federal tax obligations for deferred compensation will be the same regardless of where you live when you receive the money. However, where you live could have a significant impact on your state tax liability—if your payments are structured the right way.
"Generally, deferred compensation is taxable in the state where the employee worked and earned the compensation, regardless of whether the employee moves after retirement," says David Walters of Palisades Hudson Financial Group in Portland, Oregon.
"However, if the employee has elected to take the deferred compensation payments over a period of 10 years or more, the deferred compensation payments are taxed in the state of residence when the payments are made." This can make a big difference if you move to a state that has no state income tax, such as Florida, Washington or Nevada, or at least to one with a lower income tax than where you earned the money.
Bunching tax deductions can offset lump sum
If your deferred compensation comes as a lump sum, one way to mitigate the tax impact is to "bunch" other tax deductions in the year you receive the money. "Taxpayers often have some flexibility on when they can pay certain deductible expenses, such as charitable contributions or real estate taxes," Walters says.
Doubling up on these expenses in the year of the distribution by accelerating the following year's charitable contribution or real estate tax payment (paying next year’s ahead of time so that you get a bigger tax deduction in the year of your distribution) can keep the lump sum distribution income from being taxed at the highest tax rates.