Deferred Compensation Election - Fix it Now Before It's Too Late
Updated: May 5
How high earners can avoid costly tax mistakes this open enrollment season.
Sitting down with a new client, there is always the “a-ha” when we illustrate the real financial consequences of their deferred compensation election.
Timing is everything
Since most enrollment periods are in the Fall, with the holidays pending, it isn’t easy to find time away from family to think about electing something so far away. Miss it, and you’re locked in for another year.
And if that weren’t enough, humans are just bad at thinking about our future selves. Research proves it: when it comes to setting goals for things like deferred comp, we’re our own worst enemy.
Why Goal Setting Makes (or Breaks) Deferred Compensation Elections
Goal setting is critically important to making the correct deferred compensation election.
Research has proven over and over again that most of us don’t do this well at all on our own. We don’t think broadly enough, and we don’t think deeply enough.
In Bond, Carlson, and Keeney (2010) , people missed just shy of 50% of the goals that were important to them when they tried to do it on their own.
In a 2018 Morningstar study, people changed one of their top three goals 73% of the time when they were presented with outside nudges.
That is a horrific batting average, which explains why so many people seek out the advice of a financial planner.
In short, we suck at setting goals.
Now that we know we all have a goal-setting Achilles heel, it is no wonder why so many deferred compensation elections are done poorly. Most people either don’t have a goal or they have the wrong goal when they make the election.
Ralph Keeney, author Effective Decision Making - How to Make Better Decisions Under Uncertainty and Pressure, was on a recent podcast and he said the following about the importance of goal setting:
“Your decisions offer you the only way to purposely influence anything in your life.”
Button line:
The deferred compensation election can profoundly shape your financial future. For 73% of people, the #1 financial goal is “financial independence”—or as I like to call it, making work optional.
Get this decision right, and you might be retiring sooner than you’d planned.
John’s Election Mistakes
Let’s look at a real-life story. My client, whom we will call John, did what everyone does. He contributed enough to get the free match. He was never sure which payment option to select, so he was often influenced by the events at the time of the election.
1. The College Election Mistake
The deferred compensation window opened a week before Thanksgiving. His in-laws were in town.
The conversation about funding college for the boys started over drinks with a not-quite-intrusive and slightly rhetorical question about college savings from his father-in-law. Their kids were 8 and 10.
John started to think that they did not have anything set aside. Between home, mortgage, tuition, there was just not enough space in the cash flow statement to set aside money for college.
The next day he read the company deferred compensation brochure and “college savings” was listed as one of the alternatives. “Why not?”, he said.
Fast forward ten years: Their careers progressed, their income increased as did their tax brackets. The family marginal tax rate grew from 24% to 37% and the in-service college savings deferral was all but lost to the increased tax rate. Lesson, there is almost no planning situation where an in-service election makes sense.
2. The Uncertainty Election Mistake
In another year, the Great Recession was ravaging the financial markets. Many of his friends lost their jobs as companies downsized to protect the mother ship.
The year was 2008, and the wheels had come off the economy. He and his wife were lucky. They were not at risk, but it was too hard to ignore the fear among their friends.
The election window opened, and he just wanted to defer for 5 years to give himself some space.
It was too much to think about retirement when everyone was losing their jobs. It felt more comfortable punting to a future year and then making a new election when things became clearer.
Fast Forward: The same problem as with the college deferral idea is that the distribution would happen when their marginal rate increased, forcing a re-deferral.
The struggle is that the re-deferral is subject to the IRS re-deferral rules, which require employment one year from the date of the election (you can’t leave voluntarily or involuntarily). It must be 5 years after the date of the original election.
If you make the election on August 1 of this year, you must be employed on August 1st of next year for the election to galvanize. And, it must be 5-years after the original election begins. It forces you into a higher tax bill or a 5-year wait, neither of which is optimal. It makes the re-deferral election even more challenging.
Fixing Bad Elections (Before It’s Too Late)
Over the course of his career, John had elected a lump-sum at retirement/separation of service for the majority of his elections.
When we put them into our deferred compensation payout planning tool, the problem became crystal clear. He would be recapturing the majority of his deferrals in one tax year.
As we learned in our previous articles, most corporate employees do not make it to retirement. They either find a new job or are severed involuntarily. Both of which come with additional tax obligations, making the lump sum at retirement very costly from a tax perspective.
We simulate the tax liability in our tax-prep software, but you can do it on your own in TurboTax.
But to change the election, he would have to re-defer until 2035 and that is uncomfortable. It was only after an intensive goal-setting session and planning around future elections that he was comfortable with the change.
Ready To Fix Your Election Before It’s Too Late?
👉 Book a 15-min Deferred Comp Checkup
FAQs:
Why is goal setting key for deferred comp?
It helps avoid short-term decisions that hurt long-term wealth, like paying more taxes than necessary.
What’s the biggest mistake people make?
Choosing lump sums or in-service distributions which often leads to higher taxes later.
How can deferred comp backfire?
Stacking distributions into a single tax year can push you into a higher tax bracket.
Can I change my elections later?
Yes, but it can be very limiting — re-deferral is allowed only under strict IRS rules, with a 5-year delay and you must be employed one year after making the change..
How do I make the smartest choice?
Plan early with tools or an advisor to align deferrals to maximize tax savings and financial independence.
