Being smart about saving for retirement will ensure a strong financial future. Yet as many people have found out recently, some retirement savings vehicles have turned into money traps for the unwary.
When most people think about saving for retirement, the first things they think of are either employer-sponsored retirement plans like 401(k)s, or IRAs. Both offer great tax benefits that let many savers take immediate tax deductions for contributions, or in some cases establish tax-free accounts that avoid income tax for the life of the account. Combined, these accounts would let you put aside as much as $21,500 -- or $28,000 for those 50 or older -- for retirement in 2009.
Going beyond the obvious
But what if you earn a lot of money and want to save more than that? Depending on where you work, you may have another option, known as a deferred-compensation plan.
Deferred compensation comes in a number of different forms. Companies like Microsoft (NASDAQ:MSFT), Starbucks (NASDAQ:SBUX), and Southwest Airlines (NYSE:LUV) give many employees access to stock-option plans that often qualify as deferred compensation.
But other types of deferred-compensation arrangements let highly paid employees choose to set aside cash from their paychecks and put it into a special account, sheltering it from immediate taxation. Moreover, the limits on contributions to 401(k)s and IRAs don't apply to these deferred compensation plans, allowing eligible employees to shelter much more than they otherwise would be able to.
The downsides
As good as deferred compensation plans sound, there's a catch that's hitting people especially hard right now. When you save money in a 401(k) plan, your employer puts it into a separate account that's protected from the employer's creditors. That means that if your employer becomes insolvent or declares bankruptcy, creditors of the business can't get at that money -- it's protected by federal law and belongs to you, without being vulnerable to any claims against your employer.
In contrast, though, deferred-compensation plans don't have that same protection. So if your employer goes out of business, you could lose that money -- even though you legitimately earned it. In a bankruptcy, you don't get preferential status; you're just a general creditor, and higher-priority claims can bump you out of line and leave you with nothing. That's what former Washington Mutual employees are facing, as they argue with acquirer JPMorgan Chase (NYSE:JPM) about whether the surviving bank must honor deferred-compensation arrangements.
Looking at the consequences
Those disadvantages have many people thinking about bailing out from deferred compensation plans. Bob Lutz, CEO of General Motors (NYSE:GM), recently sold all his company shares from his deferred-compensation account. But some plans come with added strings. For instance, at Citigroup (NYSE:C), directors and executives must keep 75% of the shares they acquire as long as they continue to serve.
Moreover, because the requirements of deferred compensation plans aren't as stringently regulated as 401(k) plans, unusual situations often arise. For example, AIG (NYSE:AIG) is involved in a battle with its former chairman over whether hundreds of millions of AIG shares are pledged to employees, or belong to a charity.
A study cited by The Wall Street Journal confirms that many employees are concluding that deferred compensation plans aren't worth the risk. Although part of the downturn is likely due to falling compensation, creditor protection is clearly an important factor as well.
Think twice
If you have access to a deferred compensation plan, consider several things before you decide to participate. First, estimate the taxes you'd pay without the plan, and think about whether you believe your future tax rate will be lower. With the possibility of tax hikes coming soon, there's a good chance you'd be better off just paying tax now.
Even if you think your taxes will be lower in the future, then make a guess about your company's financial health. It's much better to pay tax and get your money than to sacrifice everything just to try to avoid taxes. If there's any doubt that your employer will make it through these tough times, don't take a chance.
For more on making smart retirement moves:
- The biggest threat ever to your retirement.
- The monster that will eat your retirement.
- Where millionaires are turning for help.
