Why the Lump-Sum Election Can Be Dangerous

Posted in: Decisions, Financial Planning

By Russell Holcombe, MTx, CFP®

The deferred compensation plan (DCP) is a non-qualified executive benefit plan which allows  employees to defer wages to a future tax year. This can be an amazing benefit that creates an income bridge in retirement, allowing you to retire earlier and save taxes at the same time. 

Despite its benefits, many executives avoid this plan or don’t utilize it in the most tax-efficient way. This is particularly true with the lump-sum election, which is often chosen by default and out of convenience. Unfortunately, the lump-sum election often doesn’t maximize the retirement or tax benefits the DCP can offer, and it can even be detrimental to your long-term financial plan. 

In this guide, we’ll review the basics of a deferred compensation plan and why the lump-sum election can be dangerous.

The Bridge to Retirement

For executives and other highly paid professionals, deferred compensation plans can be a great way to reduce taxes and maximize retirement savings. This is because DCP deferrals reduce your current-year taxable income. 

Like most people, I hate paying tax. You would think that more people would take advantage of these plans simply for the tax benefits—yet participation rates are low because DCP assets are not secured. The company merely “promises” to pay out the funds when you retire, but they may not be able to if the company files bankruptcy. Thankfully, this is a very rare occurrence, but the financial stability of your company is still a critical factor when deciding to defer or not to defer. 

If your company is stable and you’re comfortable with deferring, the DCP can create an income bridge that would allow you to retire earlier and save tax at the same time.

Here’s How it Works

When you defer compensation into the DCP, you defer current compensation into a future year. The election tells your employer when you want your money back. This election has a very strict deadline and must accompany the deferral election. Depending on your plan, your deferral election can be for a period of years while still employed, a lump sum, or installments beginning at termination of employment.

With most plans, you can elect an installment method up to 10 or 15 years in length. The exact installment method you choose will depend on your age and individual circumstances. In general, the installment income stream can provide a liquid cash flow that would reduce the need to withdraw funds from other assets, giving them more time to grow. Sadly, most people make the wrong election and suffer significant income tax that could be avoided.

The Lump Sum Can Be Expensive

While the DCP offers lump-sum and in-service distribution options, both of these choices defeat the purpose of the deferral. You will only be deferring income from one high tax year to the next. 

Below is a DCP analysis that illustrates the downsides to the lump-sum election. Keep in mind that this example will not relate to everyone, but for most participants, the deferral offers the ability to make the most of the lower tax brackets when you receive your DCP payments. 

The 2022 marginal tax rates for married filing jointly are listed below: (1)

Married Filing Jointly (Tax Rate Schedule)

When you defer income in the DCP, you will most likely be deferring income currently taxed at the highest marginal rate (37%). At retirement or separation of service, your effective tax rate will likely be much lower unless you start another job. Assuming you don’t have other wages, the DCP payments will be taxed at a lower marginal rate until your income equals your income prior to separation of service. Part of your DCP payment will be taxed at 10%, 12%, 22% and so on versus 37% (plus state income tax if applicable) if you are in the highest tax bracket.   

We had a C-suite client with a meaningful seven-figure DCP plan balance. He had elected the lump-sum option for all his deferrals. The plan permitted him to change from the lump sum to an installment option. Shortly after making the election, he was offered a severance package. If he had not made the change from his lump-sum deferral election, he would have a W-2 plus severance plus a seven-figure lump-sum DCP payment in one tax year. Ouch! It would have been devastating from a tax perspective. Instead, he is now receiving a ten-year payout of his DCP plan, which allows him to preserve his other assets for retirement. The income he deferred at the highest marginal tax bracket is now being taxed at a much lower tax bracket over the next ten years.

Your effective tax rate should decline significantly as you recapture the DCP payments at these lower marginal rates. In addition, the IRS tax brackets are indexed to inflation. If you elect the 10-year installment method and the inflation rate is 5%, the top tax bracket expands from $647,850 to $1,055,279. Each year you delay the income, the expansion of the tax brackets also reduces your effective tax rate. This client is enjoying the benefits of his deferral payments, and he saved a bunch of tax.

How Much Should You Defer?

Now that the reasons for the deferral are explained, how much is enough?  

This depends on how long you plan to work for the company and the current cash-flow needs of your family. Since it’s easier to predict your cash-flow needs, figure out the annual budget for your family and set that as your target DCP payout. 

We have created the following chart to estimate the payout of a hypothetical employee with $1,000,000 in the DCP invested earning 5.5% per year. The payments are not level as they are usually reset annually based on the years remaining.

DCP Distribution Schedule

Even if it does not cover 100% of your cash-flow needs, the DCP payment gives you freedom to accept a job that you love at a lower salary, provide cash flow while you start a business, or provide a safety net for the transition to a new career. It can be the bridge between your separation of service, a new job, or delaying taking Social Security to maximize the value. 

The final decision is the investment election. Because you cannot predict your termination date in corporate America, we err on the side of caution and lean heavily on fixed income. Usually the investment choices mimic the 401(k) plan, not known for having good fixed-income options, but an experienced advisor can help you make an appropriate investment election.

Making the Right Choice

If you’re a successful executive looking to save tax and build an income bridge to retirement, a deferred compensation plan may be the right choice for you. At Holcombe Financial, we have helped many corporate executives navigate their deferred compensation plans, and we can help you weigh the pros and cons. Schedule a no-obligation introductory meeting to see how we can help by calling us at (404) 257-3317 or emailing hello@holcombefinancial.com. 

About Russell

Russell (Rusty) Holcombe is the CEO and strategist at Holcombe Financial, a financial advisory firm serving entrepreneurs and corporate executives and managers. With over 25 years of experience, Rusty spends his days leading Holcombe Financial (a firm his father founded) and providing financial services that help his clients grow and protect their wealth so they can experience financial independence. Rusty is the author of You Should Only Have to Get Rich Once, which has won multiple awards, and created Holcombe Financial’s proprietary financial planning software, which helps clients make smarter financial decisions.
Rusty earned a bachelor’s degree in business administration with a focus in finance and real estate from Southern Methodist University and a master’s degree in taxation from Georgia State University. He is also a CERTIFIED FINANCIAL PLANNER™ professional. In his free time, Rusty and his wife, Regina, tend to their personal farm and grow their own food. You can often find him pursuing his hobby of long-distance running. To learn more about Rusty, connect with him on LinkedIn. You can also watch his latest webinar on investing. 

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(1) https://www.kiplinger.com/taxes/tax-brackets/602222/income-tax-brackets