Early Retirement Extreme Forums

I need a sanity check on whether it makes sense to defer compensation, so thoughts welcome.

Assumptions:
1) Taxable Income = Salary - 401k contributions - HSA contributions - exemptions/deductions - deferral, if any
2) I will be working for the next 10-15 years until I'm 50 - 55.
3) 401k match of 4.5% of non-deferred compensation; match of 1.5% of deferred portion

Pros:
1) Deferred income would otherwise be taxed at the marginal rate and deferring it pushes the income into the future (paid out over 5, 10 or 15 years after separation), which produces a nice tax arbitrage and a calendared future income stream.
2) Deferred compensation at a pre-tax amount is matched 1.5% and is "invested" in a hypothetical fixed income fund yielding 3%. Invest is in quotes because all I would really have is an unsecured claim against my former employer, which claim accrues at 3% annually.
3) If I didn't defer, I'd save the same amount but on a post-tax basis (~70%).
4) Reduces the appearance of income for FAFSA purposes come college application time (4, 7 and 9 years from now)

Cons / reactions (numbers matched against pros):
1) Loss of flexibility/control over the money should a need arise (but I have a very liquid 4x extravagant expense buffer already) and over investment options. Also, the deferral is an annual decision (although you can't undo prior years' decisions).
2) For the deferred portion, lose a 4.5% company match on the 401k. The loss in the 401k from losing the match is more than made up for in the deferral's pre-tax advantages.
3) Even earning 10% on 70% would require about 7 years to break even with earning 3% on 100%, but assuming I could earn 10% consistently in this environment is...maybe...a little hopeful?
4) Asset levels might screw up FAFSA anyway.

I'm leaning towards doing the deferral. I ran the numbers and all else equal, for each $10k/year deferred, it earns me an extra $50k over the 15 year period.

What am I missing?

Does the 5-15y payout start immediately upon termination of employment? Or is it delayed a few years? How concerned are you about your employer's ability to pay up over that time period?

One of my concerns with these types of schemes is that you are basically taking a non-diversified bet on your own company, but with limited upside. IOW, if the company becomes insolvent at any time before you get paid, that money is gone. This is contrary to the common advice to short your own company because poor performance of the company correlates with you being laid off and needing that money immediately.

So it's like buying a non-marketable corporate bond at face value with pre-tax dollars, with the caveats that 1) your employer is the issuer of the debt, 2) the bond payout is phased over 5-15 years following termination of employment. As TD said, the upside is limited. Additionally, it increases the consequences to you if the company goes insolvent. You're not only out of a job, but also get stiffed on the deferred comp.

I would approach this as a speculative investment and not a tax optimization problem. Best not to proceed if you still have any money-related insecurities.

@TD, it starts the July in the year following the year of separation

@fish, yeah, I'm thinking about it a little like an annuity rather than a bond. It has the same "feel" - concentrated risk, built-in (crappy) interest rate, "salary"-like annual payments. Annuities don't interest me generally due to the concentrated risk, but the tax advantages here intrigue me.

@aug, 3% floor, could potentially float up to 4-5% with some lag as rates move up, same as the fixed income option in the 401k. Depends on the compounding rate. At 10%, it takes ~7 years to break even; at 7%, a little more than 10 years, in each case compared to a 3% compounding on pre-tax dollars.

@all three, I've thought about the enron risk, but a couple of differences come to mind -- I work for a large regulated financial institution and those never go insolvent (cough cough Lehman cough cough). It is run fairly conservatively, and unsecured credit risk is different from equity risk. Even Lehman's general unsecured creditors got like 20 cents on the dollar and Lehman was levered to the hilt. And as an investment lawyer, I am well acquainted with my institution's asset position (es bueno). It's still concentrated risk, but I find myself dismissing it.

The biggest hesitation is this is once again me planning for the future when what I really want is some freedom/progress/happiness/something TODAY. Whether deferring comp is a smart thing or not long term is somewhat irrelevant to today-me. Today-me will save that money either way for future-me. But today-me wishes there was something he could do to help today-me. Future-me is set up just fine.

There are plenty of forum threads at Bogleheads and White Coat Investor about deferred compensation plans. Read them; they cover a lot of angles. The recurring themes are: 1) Time to retirement. 5-10 years before retirement seems to be the sweet spot for starting DC contributions. 2) Things not going to plan and distributions getting taxed at high marginal rates because an employer was bought out (triggering an immediate lump sum payout) or due to changing jobs before retirement.

This link could be helpful. Per the decision chart, you should invest in taxable due to poor investment options in the DC plan. https://www.whitecoatinvestor.com/shoul ... your-457b/

If you want to game FAFSA, you could upgrade your house, purchase permanent life insurance, whatever it takes to deplete your taxable accounts. See: https://fafsa.ed.gov/help/assetnetworth.htm Also, there has been a recent change where the income part no longer uses the prior year's tax return but instead relies on data from 2 years prior. So assuming your oldest starts attending college in the 2022-2023 school year, your income (and therefore the deferred comp decision) for 2020 matters. So you have 18 months to make your move.

suomalainen wrote: ↑

Thu Jun 14, 2018 8:20 pm

The biggest hesitation is this is once again me planning for the future when what I really want is some freedom/progress/happiness/something TODAY.

I don't get it either. Since you have such a high discount rate on [what you want but don't have] I'm baffled by why you decide to sit down at the financial chessboard and plot your next move (analyzing to a depth of 10 moves ahead), when you could be playing other games with more immediate rewards. Perhaps you enjoy the planning more than you admit, or you do it precisely because finances is one of the few domains in life where you have a high degree of control, and also has the potential to bring about the thing you want (albeit indirectly).

I've never seriously looked into deferred compensation plans since it's not something my employer offers. 401(k) plans were initially conceived as deferred compensation plans, I believe, and only later were drafted into the role as the primary retirement savings vehicle for many in the corporate world, so in a sense deferred comp sounds like an expanded 401(k) plan. I would tend not to utilize one unless there is a clear expectation of a tax advantage (retirement income << present income). Even then I might not. There's something to be said for having the money in one's immediate possession and having control on how it is invested/allocated. The net difference seems to me to boil down to an unknowable amount of overall tax advantage/disadvantage. Since that's wrapped up in the vagaries of politics, it's not a risk-free proposition either way. It's been a long time since I looked at FAFSA, but my foggy memory was that is was hard to do much except gain eligibility for certain types of loans. Maybe there are more handouts now. Regardless, that's a facet I can't comment much on.

I don't think there's a necessary dichotomy between freedom/progress/happiness today and planning for the future, unless "freedom/progress/happiness today" means spending a lot more money today. If the concern is the time spent engaged hand-wringing over the option, then just decline it or flip a coin or something.

Be careful not to overlook the consequences of post-retirement income on healthcare costs. Most early retirees must pay for their own health insurance. Subsidies are based on the prior year's taxable income. Too much income can disqualify you from receiving subsidies. For early-retirees with a paid off house, health insurance can be the largest expense.

@fish, thanks for the pointers and considerations. I was also thinking about the timing aspects (maybe wait till I'm 7 years out or 2 years ahead of college, etc).

Fish wrote: ↑

Fri Jun 15, 2018 4:10 am

I'm baffled by why you decide to sit down at the financial chessboard and plot your next move (analyzing to a depth of 10 moves ahead), when you could be playing other games with more immediate rewards. Perhaps you enjoy the planning more than you admit, or you do it precisely because finances is one of the few domains in life where you have a high degree of control, and also has the potential to bring about the thing you want (albeit indirectly).

Perhaps it's because it's a disease. Stuck in a recursive loop that I can't force quit. Planning isn't something I "enjoy". It's something I "have to do", and only in the sense of fulfilling my genetic destiny is it "enjoyable", like how an OCD person could "enjoy" clicking the light switch three times every time. You know how you're always answering people's questions on this forum? And you have GOOD answers even? Whatever it is that causes you to do that (want to answer questions, want to be helpful, want (and have the ability) to figure out the answers), I have that too. I'm a born problem solver, even if that means I focus on the wrong problems or solve problems that don't even exist. Maybe problem solver is too generous - problem chaser might be too harsh, but perhaps closer.

EDIT: Also, the window to make the choice is June for tax year 2019, so this particular problem was sorta foisted on me. The first few years I ignored it. Last year I looked into it a little bit. This year it's a little more tempting as I'm getting closer and closer to retirement (youngest graduates in 9 years now).

@ID "just decline it or flip a coin or something". Yes, you are absolutely right. But how do I get to "just"? Don't answer that, this is veering into journal territory again. Ha ha ha.

@paula I think that's part of what I'm trying to game. If I can spread my deferred comp over 15 years and calculate it correctly, it can bridge me from 50-65 (or 55-70). It's almost like arranging a 15 year dividend stream with pretax dollars - like a larger 401(k) as @ID mentioned. In theory, I could defer any amount I wish in order to make the 15 annual distributions anywhere from $0 - $100,000+ / year. Since this is all future speculation about college costs, tax rates, health insurance costs, living costs (we're not an ERE family by any stretch), etc, etc, it's hard to know how to calculate/discount it all. Maybe the thing to do is just (ha @ID) defer a little bit of income with a broader portfolio-type view of the question. Will read a bit of the resources @fish pointed me to.

I never gave my employer’s DCP serious consideration but my head is now spinning with the possibilities. For example, put 5 years of expenses in, then you can quit whenever and take a guilt-free mini-retirement or extended sabbatical or whatever you want to call it. Would work nicely as a bridge to semi-retirement even. For some reason, salaried humans have an aversion to spending capital, but not income.

With adequate savings in taxable accounts, the default risk doesn’t seem like such a huge disadvantage. It’s a promise just like any other form of money. A difference in degree, not in kind.

Paula does have a good point, this could result in paying a lot more for health insurance under current rules. It would really hurt to pay retail, especially for a family, but it might not be such a big deal since I plan to keep working in some capacity. (One’s 30s are filled with a boundless optimism and energy which disappears completely by the time one reaches their 50s. Eventually I’ll speak unthinkable things like “Money is just another tool and I’ll use it without hesitation if it’s the best tool for the job.” I just know it’s going to happen! Check out my journal in 20 years...)

What if inflation picks up? Will the DCP still be earning 3% or will it adjust automatically?

Just another point to consider maybe.

Personally it seems too little of a reward for me to take the risks.

@fish I know, right? The possibilities are really cool if your plan has good options and your megacorp seems stable enough. I read through some of the bogleheads forum thoughts today and it certainly does seem like it's a nice tool to consider using if you're in the 5-10 year range to retirement. The problem, again, is that our expenses as a non-ERE family would require income sufficient to put us out of ACA subsidy range...so somebody needs to work for health insurance anyway to do it earlier than I'm thinking is possible. Sigh. The possibilities really go way up when you can get your expenses down. That's a tip, kids, write it down.

EDIT: and it's the giant (~30%) tax savings that make the possibilities more intriguing than simply a humans like to spend income vs capital question. Not many things in life give you a 30% guaranteed return (ignoring the "annuity provider" risk, blah blah blah).

@seppia My DCP only offers this hypothetical 3% crediting rate, but it could float up (lagging) as rates float up. Certainly something to consider, but I'm starting to look at it this way: if I would put X amount in "cash" (money market, CDs, savings account, stable value in 401k) in other accounts, why not put pre-tax money into a quasi stable value account? From a portfolio perspective, I can adjust my deferments and my holdings in my other accounts (taxable, 401k, HSA, Roth) so that on a portfolio basis, I'm allocated across asset classes as I wish. Given all the "recession in 2H19 or 1H20" talk, being in cash doesn't seem like a bad thing to have some money in (even if it is locked in for up to 25 years...).

What I'm leaning towards after all the thoughts and reading is to defer 100% of my bonus this year to dip my toes in the water (I have the option to make a bonus deferral at X% and a salary deferral at Y%, either of which can be from 0-100 independent from the other) since it's not going to be a giant amount and bonuses are earmarked for 100% savings anyway. If I get to the point where I can see like a 4 year runway to retiring, then maybe I turn on the spigot to defer up to my maximum comfortable "cash" (and megacorp credit risk) allocation.

While the tax savings might be 30%, receiving the deferred income precludes performing Roth conversions on your pre-tax accounts at favorable marginal rates. Suppose you work to 55 and receive DC until age 70, you might be subject to RMDs on your traditional IRA/401k (on top of SS, if it still exists). Instead of Roth-converting at 0%/15%, the DC will push your marginal rate on some/all of those conversions to 25%. (The ever-changing tax rules add another dimension of uncertainity to this...) So you'd have to run some IRA/401k distribution/conversion scenarios to calculate the actual benefit.

After reading the experiences on Bogleheads I don't have much confidence that I'll be able to time it optimally, e.g. my payout might be triggered by jumping ship to a more lucrative job and then I'll pay federal tax on DC at even higher marginal rates. Insurance seems like the right way to think about it. If you quit and are unable to find paid work, it can cover your expenses. Otherwise it'll still pay out but with a larger tax bite. Too much deferred comp will dampen incentives to work post-separation.

The psychological aspect of spending income vs. capital is more important to me because it seems like a loophole in this weird truce I have with my DW about early retirement (this post). As long as I have "income" who cares what my job title is?

Although you already have a spreadsheet, here's a decent calculator for comparing a DCP vs. saving in taxable. It has a nice interface. You'll want to check the assumptions in the "advanced deferral options" menu. I used: 3%, 28*%, 10*%, 15*%, 0%. (*Don't forget to add state tax, I listed the federal-only values). The defaults favor the DCP, this is more "fair and balanced" IMO.
https://www.principal.com/individuals/n ... alculator/

It seems the most obvious application of a DCP is to act as an early retirement bridge until SS kicks in. I like that idea; it's intuitive. I've been experimenting with large deferrals, like 50%, which produces yet another source of FI when combined with my working timeframe of about 15 years when both kids leave the nest. What I don't like is that while I have access to low-fee index funds in my DCP, I need to be mindful not to duplicate the investments in my 401k/IRA or the same failure that sinks my DCP portfolio also torpedoes my safety net. So your lack of investment options may not be as much of a bug. It's more important to have high yield/total return in the 401k/IRA because that one has a longer horizon (you draw out of the DCP first), and is held in trust unlike the DCP.

That's a neat calculator. I just think DCP is a neat tool if the plan gives you the right options to bridge from X to Y such that it doesn't impact your other accounts. Like, putting them all together (taxable, 401k, roth, DCP), you can really create a web of different income streams from financial assets to jump from one tax-optimized stream to another.

DCP rules on separation and change of control differ. Mine doesn't force any lump sum payments on any trigger (unless total saved is <100k), so if I quit or get fired, I would start my 5, 10 or 15 year payments in the following year. So for me, it's almost like prefunding unemployment insurance!

Mentioned this to wife last night and she is "open" to discussing how to minimize expenses, but not to halving them! If she got a job with health insurance...the options, man, the options.