Microsoft’s deferred compensation program can be a great way to produce massive tax savings for eligible employees (level 67 and above). The program allows you to defer a portion of your salary/bonus into the future. The deferred compensation can grow over time and gives employees flexibility over timing their income. Shifting income to future years where expected taxable income will be lower results in large tax savings for highly compensated employees.
Here’s how the plan works:
Deferral Amounts
Employees in the plan can defer up to 75% of their salary and 100% of their bonus. New hires can defer up to 90% of their signing bonus. Once the enrollment period ends deferral choices cannot be changed.
Enrollment Windows
- November- Salary deferral elections for the following year are made
- May – Bonus deferral elections for the following fiscal year are made. Because the actual bonus deferral isn’t taken until September following the fiscal year, nearly a year and a half will pass before the deferral is made for this election
- New hire signing bonus deferral elections must be made before the employment start date
Investment Selection
- Like its 401(K) plan, Microsoft has a lineup of investment funds that employees can choose from
- Unlike a 401(K) plan, your money won’t actually be invested in the fund. Microsoft will credit your deferred compensation as if it were being invested in that fund. But no segregated account with investments or assets exists
Distribution Schedule
- Lump Sum- At retirement or a specified date. Generally not the optimal choice for minimizing taxes
- Annual Installments- Annual payments spread over 3-15 years. Payments may begin at retirement/termination or at a specified date
Changing Distribution Schedule
Distribution schedules are not easy to change. Early distributions are not allowed except in cases of extreme hardship or death. You are allowed to push back the distribution so long as it’s a delay of at least 5 years. The election to delay must be made at least 12 months in advance of the initial scheduled distribution.
Tax Planning
There is a huge planning opportunity provided by the deferred compensation program. Let’s take a look at a simplified example to see how beneficial this program can be.
Hypothetical Scenario:
- Salary- $225K
- Bonus: $75K
- RSU’s: $300K
- Total Comp: $600K
- Tax Filing Status: Married Filing Jointly
With no deferred compensation, the above hypothetical employee will be in the 35% marginal tax bracket in 2022. How can we save that employee money? Let’s pretend the employee forecasts $75K of income their first year of retirement. If the employee shifted $100K of their income from 2022 to that first retirement year they would generate $13K in tax savings!
Here’s an illustration of this example:
In this extremely simplified scenario, $100K of income shifts from the 35% tax bracket to a future year where the tax bracket would be 22% based on the current tax code. That means $13K of potential tax savings are generated! Overall tax savings can become very significant when you’re deferring income from multiple high earning years and deferring that to lower future tax years.
Risks of Deferred Compensation
- Participating in a deferred compensation program makes you an unsecured creditor of your employer. Unlike a 401(K) where you own a segregated account which has many legal protections, your deferred compensation is essentially an accounting entry on Microsoft’s books.
- Fortunately, Microsoft is in a strong financial position and their debt is currently AAA rated – placing them amongst the strongest companies in the nation in terms of financial strength.
- Uncertainty in tax code- If tax rates were significantly lower for high earners in the future then the effectiveness of this strategy could be diminished
- Investment Returns- Your deferred compensation will be tied to your investment choices and is therefore subject to market risk
Planning Considerations
There are a lot of variables that go into determining the optimal way to utilize your deferred compensation program. The first consideration is your current cash flow. How much of your salary or bonus do you need to fund your current living expenses and lifestyle? If you can live off vested RSUs, then you may have a lot of flexibility in deferring your salary and bonus.
Once you’ve determined that you can afford a large deferral, then you get into projecting your future income. Will your RSUs continue to vest after you retire? Do you have other sources of income? How about your spouse’s income? RMD’s from retirement accounts?
Mapping out your current vs future taxable income helps you find differences which can be exploited to generate tax savings.
Of course even the best planning cannot give you a crystal clear picture of the future. Growth rates of your deferred compensation will depend on the market performance of the funds you choose. Tax rates are subject to the whims of congress. Nevertheless, with tens of thousands of potential savings I think the deferred compensation program is a very powerful planning tool for those who can take advantage of it.
If you want help coming up with a strategy for your deferred compensation, schedule a complimentary call today.
Scott Caufield, CFA, CPA