The Pros and Cons of Deferred Compensation Plans

For many high earners, a 401(k) is just one of several tools available for retirement savings. If you’re consistently maxing out traditional retirement accounts like a 401(k) or 403(b) and still looking for additional tax-advantaged options, a Deferred Compensation Plan (DCP) offered by your employer could be worth exploring.

While DCPs offer valuable tax benefits and an opportunity to boost your retirement savings, they also come with certain risks. Here are a few key considerations to keep in mind before deciding to defer a portion of your income.

What Is a Deferred Compensation Plan?

A Deferred Compensation Plan allows you to delay receiving a portion of your income until a future date, typically during retirement. This strategy can help reduce your current taxable income and potentially allow you to access those funds later when you may be in a lower tax bracket.

Unlike a 401(k), which ERISA (Employee Retirement Income Security Act) governs and sets specific contribution limits and legal protections for, a Deferred Compensation Plan operates as a non-qualified plan. As such, it doesn’t follow the same rules and lacks some of the safeguards associated with traditional retirement plans.

Pros:

Tax Deferral on Income

By deferring part of your income, you can reduce your taxable income in high-earning years. You can also potentially pay a lower tax rate on distributions in retirement. By comparing your current tax bracket to the one you expect during retirement, you may be able to invest now and lock in a lower future tax rate on your assets.

Higher Contribution Limits

401(k)s have annual contribution limits ($23,000 for 2025 if you are under 50). But with a deferred comp plan, you may be able to set aside much more, depending on your specific employer plan rules. For high-income earners, that flexibility can significantly boost long-term savings.

Strategic Income Planning

If you are planning to retire early or take a break from high-earning work, you can time your distributions to align with years when your overall income will be lower. Proper planning using these distributions can minimize the taxes on the distribution. It can also maximize the savings compared to the tax bracket during working years.

Cons:

Your Money Is Not Guaranteed

This is one of the most important factors to consider when evaluating a Deferred Compensation Plan. Unlike a 401(k), which you own directly, your employer technically retains ownership of deferred compensation until it’s paid out. If the company goes bankrupt, your deferred funds are at risk, and creditors would treat you as an unsecured claimant. During the 2008 financial crisis, some employees lost their deferred compensation when their employers filed for bankruptcy. That’s why the financial stability of your employer is a critical consideration before opting into one of these plans.

Limited Access and Flexibility

When you elect to defer compensation, the decision will typically lock you in for the year. You cannot pull the money early like you might from other savings, even with penalties. Additionally, your distribution schedule must be set in advance, often with limited options to change it.

Distributions Are Taxed as Ordinary Income

While your investment grows tax-deferred, you’ll pay ordinary income tax on the entire distribution when you receive it, just like with a 401(k) or IRA. This makes planning crucial to avoid substantial increases in your tax bracket in retirement.

Risk of Tax Law Changes

Because Deferred Compensation Plans often span many years, they are subject to potential changes in tax laws or regulations over time. While the future is uncertain, this remains an important factor to consider when evaluating the long-term benefits of the plan.

Is a Deferred Compensation Plan Right for You?

Here are the key questions to ask yourself:

• Are you maxing out other retirement accounts?
• Do you have a solid emergency fund, and do you have excess savings in a taxable brokerage account?
• Given your current tax situation, does it make sense for you to defer your taxation to retirement?
• How financially stable is your employer?

Deferred Compensation Plans are powerful tools, especially for those in higher tax brackets, but shouldn’t be used in isolation. Without proper financial planning, these plans can lead to unintended consequences. In the short term, the lack of liquidity may create financial strain if not accounted for. Over the long term, poor planning could result in a higher tax burden.

Before committing to a Deferred Compensation Plan, it’s important to carefully evaluate the trade-offs within the context of your overall financial picture. At Wiser Wealth Management, we help high-income professionals and executives navigate complex benefit decisions like these. If you’re considering a Deferred Compensation Plan and want guidance from a financial advisor, we’d be happy to help. Click here to schedule a complimentary consultation.