Getting good compensation for our time and energy is the reason why we get up every day, go to work, and try to pay all of our bills. For me and for the vast majority of us, it’s an endless challenge to get a good paying job (one we actually like) and then to be paid or compensated fairly for what we do and have it be enough to cover the wants and needs of life! To put it simply, it’s a struggle, but what choice do we really have but to do it? Unless your name is Rockefeller or Donald Trump Jr., not much. So we may know about compensation, but what about deferred compensation?
Compensation vs. Deferred Compensation
We understand what compensation is pretty clearly. It can be money, but it can be anything that is valuable and sometimes actually is just that. Vacations, cars, you name it. Now you and I may never see such things as part of our compensation, but some folks see them routinely. Hollywood and entertainment types get that kind of compensation in their contracts for employment and it is possible you may someday get a form of it as well. If you are good…and lucky, that is.
But then there is the case of deferred compensation.
Sometimes you hear about it when it comes to investment income, but deferred compensation is usually and simply a plan in which an employee defers accepting a part of his compensation until a specified future date. For example, at age 55 you are earning $250,000 a year, you might choose to defer $50,000 of your annual compensation per year for the next 10 years until retiring at age 65.
Then, after you retire, you can choose to have that deferred money paid to you over your retirement years—say the next 15 or 20—with some kind of interest attached to it. Why do such a thing? There are some good reasons for it.
Why Consider Deferred Compensation?
Wages are considered deferred if they are received later than their normal payment date. Types of wage payments which may be deferred for most generally include vacation pay, dismissal and severance pay, back pay, bonuses, etc. Is it a good idea for the employer or the employee to consider doing this?
For the Employer
For an employer, deferring income can show a savings of money on the bottom line for right now P&L statements, even free money to use for other purposes that can benefit the business. Payroll and compensation are always the biggest controllable expenses any established business has and deferring compensation and spreading it out over years and years seems like a great way to cut current expense down. In future years, the business may be much more able to afford to pay that compensation out!
For the Employee
For an employee with a good income, a deferred-compensation plan is definitely worth considering. How much to defer is the tougher question to answer and depends on your tolerance for risk and your personal circumstances. Can you manage an income of $200,000 now and defer the other $50,000 for later years? Everyone is different, of course.
For employees who earn enough to place their wages in the top income tax bracket, a deferred compensation plan is a way to contribute more funds toward a retirement or future need. If you make the maximum deferral to your retirement plans using every option available, most people can divert less than $20,000 toward their future needs every year.
How much will that let you enjoy your retirement years? Instead of saving 3%, 4%, or 5% of your annual income, you can save significantly more if your employer permits a Section 409A deferred compensation plan for you.
Pros and Cons of Deferred Compensation
- The IRS allows unlimited contributions to a deferred compensation plan.
- You can postpone your income taxes into the years when you are no longer working and your income levels may be much lower.
- Sometimes employers offer investment options with their deferred compensation plans.
- Deferred income can serve as your primary income during the early years of your retirement and that means you could delay the distribution of your Social Security payments until you reach age 70.
- It is possible to access the cash during a merger or buyout.
- You can still pursue your deferred salary in court even if your deferred compensation plan gets sidetracked because of the poor performance of the company or bankruptcy.
- Your wages are at a substantial risk because that salary you set aside could be forfeited should something happen to the company in future years. Unlike the other retirement accounts, the money is non-qualified and that means it’s tied to the company’s financial wellbeing instead of being 100% yours even though it’s money you have already earned.
- Creditors of the organization would take the first priority in recovering their losses during a bankruptcy. You would only collect after all of the other debts were resolved.
- Once you income is deferred, it cannot be changed.
- Using deferred payment means you must make a decision about your future today and it’s irrevocable.
- You may find there are new tax consequences today and tomorrow if you follow through with this decision.
- You may still have your wages taxed at the highest rate (but your income might fit into a lower tax bracket and allow you to keep more of what you earned even though your overall income at the time you earned it was in the highest tax bracket).
- It’s a disadvantage if your deferred compensation plan requires a lump-sum payment at the time of its distribution.
- It is possible to lose most, if not all, of your salary if you violate the terms of the plan.
- You are not fully vested until you reach the distribution date. If you decide to retire early, quit for a personal reason, or you are fired for just cause, then you could lose a large chunk of your salary.
- If you leave an employer on friendly terms, your deferred compensation plan does not follow you to another job. It’s not portable like an IRA or 401(k) rollover. The funds will stay with the company until your agreed upon distribution date.
- You cannot take out a loan against the money.
The Genius of Bobby Bonilla
Bobby Bonilla is a former Major League Baseball player. He was a good player during his career and played ball from 1986 to 2001. He was a 6-time All-Star between 1988 and 1995 for both the Pittsburgh Pirates and the NY Mets. Because of his skills, he garnered a huge amount of compensation from it, earning over $50 million during that time period.
But more than just being a highly-paid baseball player, Bobby Bonilla is the “poster boy” for salary deferrals!
The “Best Contract Ever”
Not only were Bobby and his agents smart people, he did the smart thing twice!
First, in 1992 at the age of just 28, he signed a record-setting contract that set up deferred payments of $500,000 per year from 2004-2023 when he would be ages 40 to age 60. Because Bonilla was traded to Baltimore midway through the deal, the Orioles and Mets had to split that money. But that was just the tip of the deferred payroll bonanza that Bobby signed up for!
The famous golden event came a little later on when the Mets bought out Bonilla’s $5.9 million salary for the year 2000 when he returned to the Mets in another trade. Yes, that does happen.
The Mets made a deal and used some of the money to add Mike Hampton and made it to the World Series. But the real motivation was to use the savings to invest more money with Bernie Madoff. Oops!
As a result, Bonilla got his compensation spread out another 10 years later, at an 8% interest rate. That switcheroo and contract meant that the Mets will cut a $1.19 million check to Mr. Bonilla every year until the year 2035, when Bonilla will be 72 years old. I am not kidding. He gets paid every year now that amount while he enjoys his retirement which began back in 2001 when he was just 38 years old.
Bobby Bonilla Day
July 1 has become known as “Bobby Bonilla Day” in Major League Baseball, the day when the New York Mets have to cut a check to Bobby Bonilla for his $1.19 million, part of a 25-year deferred payment schedule.
Bonilla is the most famous of many high-profile athletes who signed strange and elaborate contracts with payments shoved far into the future, but the practice goes back decades, which is appropriate, since these payments extend for decades.
Whether it’s smart financial planning, readjustments due to bankruptcies, or a sports owner falling for a Ponzi scheme, there are crazy long contracts and inexplicable deferrals that happen all the time.
Look, you may never get a million dollar compensation package or anywhere even close to it, but you may need to consider some form of deferred compensation for one of the many reasons I have cited here or even some other reason. Deferral of income can at best alter your retirement needs and resources or at least help with your income taxes for this year or a future year if you do it. That year-end bonus might just be better for you if deferred. It’s something to understand and prepare for, isn’t it? Just ask Bobby Bo!