CEOs face challenging business decisions every day. But at least once a year, in December, they, along with other corporate executives face a vexing choice that impacts them alone: Whether or not to defer a portion of their compensation. In part because of the higher tax environment we are currently in, the economic impact of this choice can be significant.
Whether to defer or not, salary only, or salary and bonus (which most chief executives receive) is a critical question that federal law requires them to answer every year by Dec. 31. The upcoming deadline covers those payments that will be earned in 2014.
The benefits of deferring can be compelling, including possible tax savings and the opportunity to grow assets at a potentially higher rate of return. However, as with any investment decision, an assessment of liquidity needs, time horizon, and lifestyle choices is critical to making the best decision about whether and when to defer and how to receive distributions when the time comes.
Deferral makes sense if you are comfortable with your level of liquidity and do not expect any large outlays such as a child's college education or a second home purchase. Determining liquidity needs often dovetails with consideration of the length of deferral. In general, the longer you defer the better, because you are postponing your tax liability on that compensation and any growth on those assets. A rule of thumb is to defer for at least eight years, but investment alternatives can alter that time.
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Deferral investment plans may offer choices with higher fixed rates of return that are difficult to match outside the plan. Choices may range from mutual funds to private equity and additional shares of company stock.
The law of compounding makes deferral a good option for many. Consider an executive who receives $100,000 in pre-tax performance-based compensation. By not deferring, he could foresee about $84,000 after 10-years of reinvested after-tax proceeds. If deferred and allowed to grow tax-free for 10 years, the same level of compensation could potentially see closer to $93,000 upon distribution and after taxes are paid, making the value of deferral tangible.
Taking income now can be particularly costly if you live in a high income tax state and city. CEOs considering "retirement migration" to a no-tax or low-tax jurisdiction might wait to take distributions until this time. For example, an executive living in New York City would pay 12.7 percent in city and state taxes on income received in 2013. Or she could elect to receive distributions later, after she has retired and moved to Florida, which has no income tax. It is important to note, however, that for the lower state tax rate to apply, you would have to elect now to receive the distributions in 10 or more annual installments.
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If relocation is not in the cards, deferring income to a later date may still prove effective should state and local taxes have sunset clauses. For example, California recently approved a tax increase for those with income of more than $1 million to 13.3 percent through 2018, after which the top rate will revert back to 10.3 percent, making the case for deferring, if you can, at least until then.
Another attractive reason to defer is if a company will match the income. Some do so only if the executive chooses to invest that deferred income in company stock, so it's important to evaluate how you want to hold those assets and think carefully about the company's financial future.
This leads to another consideration. When you defer compensation, you tie your economic future to the company's. Should the company go bankrupt, you would be treated as an unsecured creditor and would have to try to recoup your deferred compensation along with the company's other creditors.
At the same time an executive decides to defer compensation, he also needs to decide on distribution elections. Do you want it in a lump sum or installments, and when will you begin distributions?
Because regulations around distributions are strict and the ability to make changes limited, deferral elections require careful consideration of future income needs. While you can't receive payments earlier than the deferral date you've chosen, you can choose to receive distributions later than you initially indicated. Choosing to make subsequent deferral elections does leave one open to stringent regulatory conditions, so it is necessary to think well in advance about the potential needs for this money and how it fits into one's overall retirement plan.
The decision to defer compensation can be a key element of a chief executive's overall retirement-planning process. And given the higher tax rates introduced in early 2013, the benefits of allowing assets to grow in a tax-deferred instrument can be compelling. Like any other investment decision, it must take into account income and lifestyle needs, and be part of a holistic tax planning conversation.
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Compensation, regardless in salary only or salary and bonus, is a point of pride and recognition for CEOs who have helped their companies grow and succeed. Making the most of it requires executive-level thought, analysis and planning.
— By Robert Barbetti
Robert Barbetti is head of executive compensation advisory at J.P. Morgan Private Bank, advising clients such as public-company executives on issues related to compensation. J.P. Morgan Private Bank delivers customized wealth-management advice and solutions to wealthy individuals and their families. The Private Bank currently oversees $935 billion in assets.