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Investment Advice & Risk

Navigating Retirement With an Excess Benefit Plan

Pennies
May 08, 2018

May 08, 2018

8:21 AM America/Chicago

Millions of Americans make contributions to a company-sponsored retirement plan, like a 401(k), a  Roth 401k or a 403(b) plan, to help them prepare for their retirement. However, these plans have yearly contribution limits imposed by the IRS. For that reason, some high-income professionals will take advantage of an employer’s excess benefit plan if they want to keep putting away money beyond this cap.  

For the most part, contributing to an excess benefit plan — also known as non-qualified deferred compensation plan — isn’t much different than contributing to something like a 401(k). When it comes to receiving those funds, however, things work a bit differently. An excess benefit plan can be a powerful savings vehicle, and potentially has tax benefits. It’s important to understand exactly how that money can make it back to you, and how you may be able to get the most out of it.

Let’s take a look at some of the key considerations you should take when managing an excess benefit plan.

Understanding an Excess Benefit Plan

For any company-sponsored retirement plan, there are IRS limits on how much an individual can contribute each year. Once you hit that limit, you no longer have a tax-deferred place to save for retirement.

That’s where an excess benefit plan can help. It’s a company-sponsored, tax-deferred plan that enables employees to continue saving by deferring the compensation that doesn’t “fit” into their 401(k), IRA or other retirement plan. This pay is owed to the employee later on, typically at or during retirement.

What makes this different than a 401(k), a Roth 401k or a 403(b) is that an excess benefit plan is controlled by the employing company and the funds within it are owed to the employee. So, while money in your IRA or 401(k) belongs to you from the start, funds in your excess benefit plan won’t until they are distributed. This has implications for managing your retirement.

Chart Out Your Future

How you decide to receive the funds in your excess benefit plan will depend on how you plan to live your life and your own financial horizon. Plans for a new home, paying for college, loan payments, and charitable commitments are just a few important things to consider. It’s not easy planning many years in advance, so talk to your financial advisor if you need help making sense of your long-term timeline.

Whatever your plans may be, the question to ask yourself is whether your expenses will go up or down during retirement, as this impacts a critical aspect in how you handle your excess benefit plan — your income tax.

Income Tax & Installments

When you receive funds from an excess benefit plan, they are taxed according to your income tax rate at that moment. For retirees, this is attractive: By allowing an individual to defer compensation until later on in their life, they can receive their pay when they are at a lower income tax rate, thus requiring them to pay less tax than they would have before.

Individuals seeking this outcome will choose to receive their funds in installments, to be distributed to them on a yearly, quarterly or weekly schedule, depending on their needs. Spacing out distributions over a longer time can produce the largest benefits, but only if an individual can lower the amount of taxable income they have throughout retirement. There are many ways to shrink this number, from changing your spending habits to making charitable donations. Talk to your financial advisor to explore your options.

Lastly, it’s important to note that excess benefit plans come with the benefit of tax-deferred compounding. This allows your funds to potentially grow with the market tax-deferred — an added incentive to leave money in the fund.

Taking a Lump Sum

Instead of receiving funds through scheduled distributions, individuals with an excess benefit plan can opt for a lump sum, typically received at retirement. For those who take this route, their funds will be taxed at their current income tax rate. In some situations, this could result in a larger tax bill than if the funds were distributed in installments over time.

So why would you decide to go with a lump sum? One reason an employee may choose this option is if they were not confident leaving their deferred compensation with their former employer.

As we mentioned earlier, excess benefit plans are under the control of the company that employs the individual, to be distributed back at a later date. If the company goes bankrupt or can’t pay these funds, you might lose some or all of the compensation you deferred.

For this reason, concerns over company health or longevity may motivate an employee to take their funds, suffer the immediate tax impact, and apply them to more stable retirement or investment efforts.

Get Informed

There is no ‘right way’ to receive your excess benefits. At the end of the day, you have to make the choice that makes the most sense for you. It’s important to do this carefully. Some choices can’t be undone once they’re made, and can affect your retirement significantly. Make sure you have the advice you need to make an informed decision.

It’s at financial crossroads like these that having a retirement specialist by your side can be a valuable resource. Here at Baird Retirement Management, our team has been helping oil, gas, and chemical professionals turn planning into healthy retirements. We’re ready to work for you.

 *Baird does not offer tax or legal advice. Robert W. Baird & Co. Incorporated

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