Deferred Compensation

[woodguy00]

I've been offered the opportunity to defer some or all of my annual bonus to a non-qualified exec retirement plan. The plan provides for 'notional investments' in Fidelity funds where you have the ability to decide how it is invested. There is a S&P500 index fund with 10 bp fund ratio available which is appealing. Everything else is at least 60 bp. Being a non-qualified plan, you are a general creditor of the company which is a large, very solid megacorp.

I would be looking a putting about $100K in the deferral each year for the (hopefully) three years I have remaining before ER. If I take the bonus normally, I'd be paying 35% federal and 5% state each winter when the bonus is paid. If I defer receipt until after retirement I'd likely be at a blend of 15% and 25% on the payouts. For easy math, I split the difference. As we likely will move to a no income tax state at ER, that tax goes away too (I confirmed this) It looks to me like a $20K tax savings. The flip side is that if I take the bonus each year while working and pay the taxes as I go, after retirement I would be able to keep my O-MAGI below $62K and qualify for Obamacare rates which would save about $6000. If I'm thinking correctly, my net savings is $14,000 in less taxes for each year's bonus.

The plan requires you to select a distribution option with the best choice being a combo of the earlier of separation (paid the following January) or a designated date certain at least three years out. There are not great provisions for changing your mind once you make the election.

I have sufficient after-tax assets for the first part year of retirement if I make the deferral, so no issue there. My plan is to live off after tax assets from 56-65, qualify for Obamacare below the cliff and make Roth conversions if possible. If I go with the deferral, this plan would need to change for a few years while I would receive the payouts. Once Medicare is available I'd convert IRA's to Roth like a madman until age 70 RMD's. I plan to wait for SS until age 70. DW has been a SAHM for many years.

I am inclined to make the deferral recognizing I'm taking on some creditor risk and a loss of flexibility. Am I missing anything here?

Discovered the thread from last month that covers many of the same issues but wondering if perhaps there are more thoughts / guidance to share.

Thanks

 

[savory]

I executed a similar plan during my career and it has (is) worked out well. My money was a loan to the company and had a formula return which was very good during the market downturn. I executed my distribution plan to go for several years, during my 60s and allow me to delay my SS until 70.5. That is the good news. In the meantime, I have had some concern. My Megacorp went through some bad times and was sold. During that period, lots of anxiety. However, they are honoring the original commitment. My current issue is with the conversion of my IRA to a Roth. I have not made the conversion and now, while my tax rate is down from when I was working, the deferred comp has pushed me into a higher bracket. Looking back, I wish I had understood how all these variables were coming together. While I do not think the outcome will be bad, perhaps I could have manipulated things better.

 

[pb4uski]

OP, I think you will find that by limiting your income to 400% FPL to gain Obamacare subsidies that you will give up a lot of opportunity to do Roth conversions to the top of the 15% tax bracket (and also make HSA contributions which converts taxable funds to tax-free funds).

I would defer the income but get it back in the early years of retirement and live on it, but a bronze plan that is HSA eligible and then maximize HSA contributions and do Roth conversions to the top of the 15% tax bracket until I was 70.

If you wait until 65 to start doing Roth conversions, you probably will not be able to do enough to make much of a dent in your tax deferred accounts to avoid the 25% tax bracket once SS and RMDs start.

That seems to be the way it is working out for me but YMMV based on your specific circumstances.

 

[woodguy00]

Davef, Thanks for the response.

pb4uski, Assuming we will need about $90K annual living expenses during early retirement, I would look to take the deferred comp in each of the first three years after retirement as you suggest. I would be into the 25% bracket as a result but OK with that.

From age 59-65, if I use other after tax money to live on and do smaller Roth conversions to stay just under the 400% FPL limit, wouldn't the tax savings on the extra $30K rollover (staying within the 15% bracket) be about $3000 vs the Obamacare savings of perhaps $6000 annually? During this time period I would be able to convert perhaps $350K vs $540K if I go to the top of 15%.

From 65-71, I'd roll as much as possible to Roth, perhaps $90K per year. This would move about $540K. At age 71, I'd be in a position to then have the balance and RMD low enough to not be that far into the 25% bracket.

Does this make sense or are there serious flaws in my math or logic?

 

[pb4uski]

For us 400% FPL is about $62k so if we make max HSA contributions we can have up to $71k of income. After deducting $30k for income from our taxable portfolio and CGs from sales to raise cash to pay for living expenses, that allows us only $41k of Roth conversions each year if we limit our income to 400% FPL.

The top of the 15% tax bracket for a MFJ couple is $74k plus $12k standard deduction + $8k for personal exemptions + $9k for HSA contributions would equate to $103 of income and allow us to do Roth conversions of $73k a year.

So from ages 58-70 inclusive, we can do $416k more of Roth conversions by foregoing Obamacare subsidies of ~$4k a year and probably avoid the big step between 15% and 25% after age 70.

In evaluating this one important consideration is that your tax-deferred accounts are growing with investment performance so Roth conversions don't end up reducing them as much as you think they might. For example, if you have $1m in tax-deferred accounts and total return is 7% a $90k Roth conversion in the first year only reduces the tax-deferred account by about $20k-$26k depending on whether you do the Roth conversion at the beginning or end of the year.

The tax on the Roth conversion is less than 15%. The effective tax rate on our 2013 Roth conversion was ~7%; our federal tax was nil with no Roth conversion and ~$5.3k with a $73k conversion.

 

[woodguy00]

pb4uski,

Great info, particularly on the rollover not reducing the balance as much as planned due to growth.

Foregoing the Obamacare subsidy appears to be somewhat neutral depending on each of our assumptions. I originally thought it would be a bigger impact. Based on that, it makes the deferral bonus decision easier.

Many thanks.

 

[523HRR]

The DW and I both worked for a mega corp for many years and we each deferred all bonuses and, in some years, a percentage of salary. Deferred salary is earning 10- 12% fixed interest and bonuses are invested in an S&P 500 index. ER'd at age 49 a couple of years ago, so now all of this deferred compensation is paying out over the next 10-20 years. My only regret is not choosing the longest payout period possible for each election. Payouts are distributed as ordinary W2 income, so would prefer to have a more extended deferral period as don't need the taxable income.