Based upon your plan options, generally, you may choose 1 of 2 ways to receive your deferred compensation: as a lump-sum payment or in installments. Here are a few considerations:
- Lump-sum distributions: Choosing a lump-sum distribution gives you immediate access to all your deferred compensation upon the distributable event (often at retirement or separation from service). That may be important if you’re not comfortable with your former employer controlling your previously deferred compensation. Once you receive a lump sum, you’re also free to reinvest it how you see fit, free from the restrictions of your company’s non-qualified deferred compensation plan. (NQDC plan). However, you will owe regular income tax on the entire lump sum upon distribution. That can result in a larger tax bill than if you were to choose installment distributions (see below), in part because it may push you into a higher tax bracket. You also lose the benefit of tax-deferred compounding when you withdraw money from the plan. If you choose to take your deferred compensation in a lump sum, you might be able to offset some of the tax on it by bunching tax deductions, such as making two years of charitable contributions or real estate tax payments in the same tax year that you receive the lump sum.
- Installment distributions: Receiving your deferred compensation in installments over several years can reduce your tax bill, because the smaller installment payments will typically be taxed at a lower rate than a larger lump-sum payment will be. With an installment plan, you take smaller distributions over time—typically on a yearly, quarterly, or monthly schedule. The remainder of your deferred compensation remains in the account, where it can continue to grow tax deferred. Spacing distributions over several years may reduce your overall tax bill, especially if your personal income tax rate declines. However, if you choose an installment plan, you must be comfortable remaining one of the company’s unsecured creditors. You also may have the option of taking a special state tax benefit when payments are made over 10 years or more.2 Payments structured this way are taxed in the state of residence when paid, not in the state in which the income was earned. This is a tax benefit for those planning to move to a state with lower income tax rates. You also must plan your distributions around other sources of income, such as mandatory minimum IRA withdrawals, to accommodate your cash flow needs and tax situation.
Whatever form of distribution you choose, be sure to consider the timing of those distributions relative to other company benefits, such as the vesting of restricted stock and the exercise of stock options, as well as income from other retirement plans.
Depending on your plan provisions, the payment of the deferred compensation can also be structured to reduce your tax liability based on a series of installment payments or lump sum payments based on a specified time. By spreading out the payments, you potentially could reduce your income for each applicable year.
Distribution strategies and tax planning
One important note: No matter which distribution strategies you choose, it’s difficult to change the schedule once you’ve created it. A subsequent distribution election, if allowed by the plan, cannot permit the payment to be paid earlier than originally elected except in cases of extreme hardship, death, or disability—so you can’t simply change your mind and ask for your deferred compensation a year or two earlier than your scheduled distribution date.
Your plan might offer you several options for the benchmark—often, major stock and bond indexes, the 10-year US Treasury note, the company’s stock price, or the mutual fund choices in the company 401(k) plan.
