In a deferred compensation plan, you earn money today but don't get paid until a later year. Unlike a 401(k) or an IRA, there's no legal restriction on how much you can contribute, though your employer may set a limit. This gives you the freedom to base your contributions on the amount that meets your needs rather than what the law allows.
As long as you invest within your employer's limits, you can invest much or as little money as you want into an deferred compensation plan.
Amount to Contribute
The more you contribute to a deferred-compensation account, the more tax-deferred interest it can earn. The downside is that the more you defer, the less cash you receive. If there's a sudden emergency, deferring too much may leave you in the red.
You have to defer compensation before you earn it, so think carefully about how much income you need in the coming year, including a cushion for emergencies. In rocky economic times, even high-salaried employees may prefer keeping the cash and paying the taxes.
Deferred Compensation Risks
Deferred compensation is a gamble. The federal law that protects 401(k) plans doesn't apply here: If your employer goes bankrupt, the salary and bonuses you defer are just one more asset creditors can seize.
Before deferring compensation, look at your company's financial health. If you have any worries, getting the money now might be safer. Look at your own finances, too. If you have few other retirement assets, consider a safer tax-deferred investment such as putting money in an IRA.
Deferred Compensation Tax Considerations
The more tax you pay, the more money you save when you defer some of your paycheck. If your income is variable – a lot of it is in the form of bonuses or commissions – and you're having a really good year, deferral can protect you from getting thrust into a higher tax bracket. Income tax rates often change, however, as the government tinkers with the tax code. If you expect rates to be higher when you withdraw your money, keeping it and paying the IRS now may be a smarter move.
Consider Your Investment Options
Before making a decision, take a look at how your employer's plan invests your money. If you think you have better investment options in your portfolio, accepting the money now, if it doesn't push you into a high tax bracket, might work out better. Crunch numbers on the investment choices to decide if what you save in taxes makes up for what you'd earn if you pay the taxes and invest the money yourself.