The following article, ghostwritten for Tom Posey, is scheduled to appear in the Houston Business Journal in October 2002.

Elective Deferred Compensation:  Is It Worth It?  

Deferred compensation can be a great deal for executives and companies alike.  Companies use deferred compensation programs to incentivize their executives based on achieving important company objectives.  Executives benefit because companies pay more compensation when it is subject to reasonable restrictions, such as staying with the company for a period of time.

By deferring compensation, executives pay income tax only on money they actually receive during the year.  The deferred compensation is invested and grows tax-deferred until retirement or some other triggering event occurs, depending on the type of program the employer offers.   As a result, many executives are taking this concept one step further, electing to defer additional compensation to try to reduce their taxes.

However, before electing to defer additional compensation beyond that provided by the company, there are a few facts executives should know.

The Tax Advantage Myth

First, the tax advantages from electing to defer additional compensation are not what they appear.  To illustrate, let's take a look at Sally and Mike, both executives whose company offers an elective deferred compensation program.  Sally elects to defer $100,000 in compensation.  Mike, in contrast, chooses not to defer, instead paying 38.6% income tax, or $38,600, and investing the remaining $61,400 in his taxable investment account. 

Assume that both accounts earn a 7% rate of return.  After 20 years, when Sally and Mike retire, the balance in Sally's deferred compensation account has grown to $386,968, much more than the $237,599 balance in Mike's investment account.  But Sally now has to pay income tax.  Assuming the same tax rate of 38.6%, when Sally withdraws her balance, how much does she have left?  $237,599 – the same amount Mike has in his investment account!  

            The reason is simple:  whether Sally pays her tax up-front or at the back end it's still 38.6% - and if she defers the tax, she'll eventually have to pay it on both the invested balance and on the appreciation.  Sally would gain a potential investment advantage if tax rates are lower twenty years from now, but that's unlikely to happen.  In any event, there are other factors to consider.

What About Capital Gains?

            By electing to defer compensation, Sally also has deferred capital gains taxes on investment gains in her deferred compensation account. This apparent benefit, however, also appears greater than it really is.

            Let’s assume that Mike, who did not defer compensation, is assessed a 20% capital gains tax each year on the gains in his taxable investment account.   If his rate of return continues to be 7%, then 20% of the gains, or 1.4%, will be taxed away each year.  This means that Sally has a 1.4% investment advantage over Mike.

However, by deferring the capital gains tax now, Sally will have to pay ordinary income tax on her investment gains later.  Converting capital gains to ordinary income eats away at Sally's investment advantage. 

Moreover, the investment choices inside Sally's deferred compensation account almost certainly will be limited compared with those available to Mike in a taxable investment account.  A good financial advisor may be able to find better asset managers for Mike, further reducing Sally's investment advantage.  After all, to break even with Sally, Mike needs only an additional 1.4% after-tax return. 

In the final analysis, deferring capital gains tax in a deferred compensation account is likely to produce a small net-after-tax investment advantage.  There is, however, one more factor to consider:  risk.

Are You Truly Financially Independent?

            Some deferred compensation programs require distributions to be deferred until retirement, while others allow considerable leeway for earlier distributions.   In either case, there is some loss of flexibility and control of the funds.  Should the company develop financial problems resulting in bankruptcy, the executive's deferred compensation account generally will be considered an asset of the company, leaving it exposed to the company's creditors and leaving the executive vulnerable.

            True financial independence means funds are not excessively exposed to risk, or the risk is sufficiently diversified.  I’ve observed that a high proportion of many executives' assets are subject to the financial health of the company that employs them.  Executives with deferred compensation accounts, stock options, and company 401(k) plans may not be developing a sufficient level of diversification. 

            Is elective deferred compensation it worth it? Elective deferrals in some deferred compensation programs, particularly those that offer a company match, may be an excellent idea and worth the risk.  The key is for the executive to review his or her individual financial picture with someone qualified to weigh the risk and make appropriate recommendations.