How Deferred Compensation Works: Help Grow Your Wealth

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Author: Adam Curry, Vice President and Senior Wealth Strategist, Fifth Third Private Bank

In December 2023, the Los Angeles Dodgers signed Shohei Ohtani to a 10–year, $700 million deal with $680 million deferred 10 years¹, sparking conversation around deferred compensation. While occasionally used in Major League Baseball², a nonqualified deferred compensation (NQDC) plan is no stranger to the corporate sector.

For many highly compensated executives, last year’s tax liability will leave them looking for tax mitigation strategies. Considering a NQDC plan as part of a comprehensive wealth strategy can provide significant tax savings and a source of income in retirement.

What is a NQDC plan?

A NQDC plan can come in a variety of forms. A common NQDC plan structure is deferral of a highly compensated executive’s salary and/or bonus, and employer contributions with payout at a future date.

Often, the payout operates as retirement income for an executive and is subject to federal income taxes and potential state income taxes³. The retirement income is not subject to the Federal Insurance Contributions Act (Social Security and Medicare) withholding as those taxes apply at the time of deferral or contribution.

How it works

Generally speaking, when an executive decides to use a NQDC plan, he or she elects the percentage of his or her future salary or bonus to be deferred with a corresponding payout election (lump sum or installments). Once a deferral election is made, the deferral amount cannot be changed for a plan year. However, a payout schedule can be changed as long as it fits within the IRS rules.

Planning for income needs

Working with a wealth strategy team, you can map out projected income (salary, bonus and vested and exercisable stock options) and determine answers to the following questions:

• How much cash flow is needed for my lifestyle?
• What can be deferred to provide a tax benefit?

NQDC plans can help mitigate high tax years by deferring future income. For example, contributing to a NQDC plan may allow an executive to exercise his or her options at a high value and negate the tax burden through the deferral of income (salary or bonus).

Retirement income from NQDC plans can also fill in the gap years from retirement (say age 65) to when the retiree reaches his or her required retirement beginning date (typically age 73 or 75). This is the time when qualified retirement accounts (e.g., 401(k), IRA, etc.) have a forced payout.

For retirees who will be moving to or living in a state that has no state income tax, a distribution election of 10 years or more can potentially save state income taxes. This is because the retiree’s residence or domicile is used when retirement payments are made instead of the state where the deferred income was earned.

Key considerations

Here are a few key considerations when reflecting on if a NQDC plan is right for you:

• Cash flow – Are you able to defer compensation without impacting your current lifestyle? Projecting future cash f low is important. Other income and assets should be available to cover future cash flow needs.
• Taxes – Is there a tax advantage gained by delaying payout until a later date? Predicting your future federal and state income taxes is necessary to determine if forgoing compensation will be beneficial.
• Risks – How is the employing company positioned? The future payout is an unsecured promise. If the company were to go bankrupt, the executive is a general creditor.

Case study

William ("Will") Brewer, a professional baseball player, signs a $500 million contract for 10 years with a California team. With endorsements and other income, he and his wealth planning team determine 90% of his contract should be deferred, with a 10-year payout schedule. In retirement, Will anticipates residing in a state that has no state income tax. Moreover, team solvency is not a concern given anticipated revenue streams/media contracts. The anticipated state tax savings totals $64.8 million over the lifetime of the contract.

Playing years: $5 million per year for 10 years.
Retirement income: $45 million per year.
$450 million (deferred income) x 14.4% (California Projected Tax Rate) = $64.8 million

Illustration for informational purposes only and does not depict actual planning strategies or results.

For more information, contact your Fifth Third Private Bank advisor.

Notes:

¹Ronald Blum, Ohtani’s Dodgers contract has $680 million deferred, lowering tax value to $46 million annually.
²Bobby Bonilla, Manny Ramirez, Max Scherzer and Ken Griffey Jr. are several other players who elected to defer a portion of their contracts.
³ If an executive moves to a state that has no state income tax and the payout period is 10 years or more, then the executive may be able to avoid the state taxes where the compensation was earned. However, if the payout is less than 10 years, then taxes are owed to the state where compensation was earned.