Overview

Main Menu Name: Deferred

Calculates the future value of deferring current compensation if tax rates are expected to increase. It compares the future after-tax value of the deferred compensation with the amount that would otherwise be accumulated if compensation were received currently, subjected to current tax rates, and invested until the time when it would have been received under the deferred compensation plan.

In this article:

• Background
• Getting Started
• Entering Data
• Results

Background

The use of nonqualified deferred compensation arrangements has grown substantially in recent years. This growth is attributable to many factors including restrictive limits on contributions or accruals for the benefit of the highly compensated under qualified retirement plans, the increasingly burdensome compliance requirements of qualified plans, and the need for more flexible, selective, and cost-effective mechanisms for compensating key employees.

There are many different types of deferred compensation plans, but they all generally have several features in common:

• First, they are not subject to the nondiscrimination rules of qualified plans; therefore they may be used to reward only a select group of employees. An employer is free to pick and chose who will be covered and what levels of benefits and terms each will receive.
• Second, the deferred compensation is generally credited with interest to compensate the employees for the time-value of money while the compensation is deferred.
• Third, if properly arranged, the deferred compensation will not be taxable to the employees until they actually receive it.

Although tax deferral is generally beneficial, it can be counterproductive if an employee's tax rate increases by the time the compensation is actually received. In the current environment of constantly changing tax policy, growing federal and state deficits, and economic uncertainty, predicting future tax rates can be difficult if not impossible.

Therefore, the critical issue for many employees and employers who are contemplating the use of nonqualified deferred compensation arrangements is whether deferral is a sound financial tactic. That is, will employees be better off with the deferred compensation arrangement than they would be without it?

Clearly, if tax rates do not rise, a highly compensated employee will almost always be better off deferring some of his or her compensation until a later date. However, if tax rates do rise, an employee will be better off deferring the compensation to a later date only if the compensation is deferred for a sufficient period to time--the break-even period.

Specifically, if compensation is deferred, the employee will be taxed in a future tax year at a higher future tax rate on the entire amount including the interest credited on the account. If compensation is not deferred, he or she will pay tax at the current lower tax rate immediately and therefore have less available for investment.

The tradeoff is between the current lower tax rate, which must be paid immediately and which reduces the amount available for investment, and the higher future tax rate, which must be paid later and which allows the entire before-tax amount to earn interest.

If the period of time is sufficiently long, the benefit of earning interest on the before-tax amount of deferred compensation will exceed the cost of the higher tax rate that is applied to whole amount when it is ultimately received.

Nonqualified deferred compensation is not deductible by the employer until the compensation is paid to the employee, which means that the employer loses the benefit of an immediate income tax deduction if the compensation is deferred. The program looks solely to the possible benefits to the employee and does not calculate the possible cost of deferral to the employer.

Getting Started

Using non-qualified deferred compensation arrangements has become more common in recent years. Reasons for this include the following factors:

• The restrictive limits placed on contributions or accruals for the benefit of the highly compensated under qualified retirement plans.
• The increasing number of compliance requirements placed on qualified plans.
• The desire for more flexible, selective, and cost-effective methods of compensating valuable employees.

While different types of deferred compensation plans are used, most of these plans share some common features. First, nondiscrimination rules of qualified plans do not apply to deferred compensation; therefore, these plans can limit compensation to a select group of employees. Second, these plans apply interest to the deferred compensation to compensate the employees for the time-value of money. Third, deferred compensation is not subject to tax until the employee receives it.

Tax deferral is usually beneficial; however, if an employee's tax rate rises before the deferred compensation is received, the tax deferral may not be advantageous. Unfortunately, predicting future tax rates is difficult, if not impossible.

Generally, if tax rates do not rise, a highly compensated employee will usually fare better deferring some of his compensation until some point in the future. However, if tax rates do rise, an employee who defers compensation will fare better only if he defers payment until the break-even period. The break-even period is the point at which the benefit of deferring the compensation surpasses the higher future tax costs. If the compensation is deferred and the deferral time is long enough, the interest earned on the before-tax amount of deferred compensation will be greater than the cost of the higher tax rate applied to the whole amount when it is received.

Entering Data

1. Amount to be Deferred:  Enter the amount of the compensation to be deferred.
2. Current Tax Rate:  Enter the current tax rate.
3. Number of Years Compensation Will be Deferred:  Enter the number of years the compensation will be deferred.
4. Assumed Future Tax Rate:  Enter the estimated future tax rate.
5. Assumed Before-Tax Rate of Return:  Enter the estimated pre-tax rate of return applied to the compensation.

Results

The Summary Tab displays the after-tax sum that will have accumulated both with and without the deferred compensation arrangement at the time when the deferred compensation is scheduled (if deferred). Also calculated is the amount of net gain or loss resulting from the deferred compensation arrangement. Since tax rates could increase at any time before the deferred compensation is received, three different accumulated values are displayed to reflect three different assumptions as to when tax rates will increase (Early, Middle, Late). The calculation's results assist in determining if it is beneficial to defer compensation rather than receive it today and pay the current tax rate.

Early

This column assumes that the tax rate increase occurs immediately after the compensation (not deferred) is paid. In other words, it assumes that the compensation, paid now, is subject to the current tax rate, but all investment earnings on the after-tax amount are subject to a higher future tax rate.

Middle

This column assumes the tax rate increase occurs halfway to the time when the deferred compensation will be received. In other words, it assumes that the compensation is paid now, and the investment earnings on this after-tax amount are subject to the current tax rate for the first half of the period and to the higher future tax rate for the second half of the period until the deferred compensation would be paid.

Late

This column assumes that the tax rate increases just prior to receipt of the deferred compensation. In other words, it assumes that if the compensation is paid now, the investment earnings on this after-tax amount are subject to the lower current tax rate, instead of the higher future tax rate.

The calculation's results also include a break-even analysis table that is accessed by clicking on the Break Even Analysis tab in the lower portion of the input screen. This table shows how many years the compensation must be deferred in order for the deferral to be more beneficial than receiving the compensation immediately. The table reflects investment rates of return ranging from 5% to 20% and various assumed future tax rates. These results are based on the assumption that a tax rate increase occurs halfway to the end of the break-even period.