Financial Crisis Exposes Problems With Some Deferred Compensation Plans

Many of our higher-paid readers may be offered savings plans through their employer that allow tax-deferred contributions in excess of the annual limits on 401(k) contributions. (In 2010, the most you can invest in a 401(k) plan is $16,500 -- $22,000 if you're age 50 or older). These plans go by various names; the most common are 401(k) mirror plans, 401(k) spillover plans, 401(k) excess plans, and deferred compensation plans. But the recent meltdown exposed a critical problem with these plans. Let me explain.

These plans look and feel like standard 401(k) plans. Your contributions are automatically withdrawn through payroll deduction or from an annual bonus, you defer paying income taxes on your contributions, you might be offered a menu of investment options, and you pay income taxes when you withdraw your money, presumably many years in the future. However, there's a crucial difference. Your 401(k) accounts are invested in a trust fund that's protected from creditors in the event of your employer's bankruptcy, while the assets in deferred compensation plans are not protected from your employer's creditors.

Some of these plans might appear to have protection with devices called rabbi trusts or corporate-owned life insurance; these are complex mechanisms that are too involved to explain here. But don't be fooled! Even with these protections, your savings will go to creditors in the event of your employer's bankruptcy. For this reason, I'd be very wary of voluntarily participating in these plans.

I personally know several people who lost substantial sums of money in their deferred compensation plans when their company went bankrupt during the recent financial crisis. They did, however, keep their 401(k) accounts. These people worked for large, well-known companies where only a few years ago, it was unthinkable that their company could go bankrupt.

Rather than putting money into these plans, it might be a better idea to take the income tax hit today, so you don't need to worry about the continued viability of your employer for long periods of time. And if you think income taxes will rise in the future, deferring paying taxes to a later date may not make sense.

What can you do if you're currently participating in such a plan? Most likely, you can simply stop making voluntary contributions under the terms of the plan. It's a different story regarding your current accounts, though. With most plans, your money is locked up and you can't withdraw from your account for many years. Some plans, however, allow withdrawals with a "haircut." For example, you might get paid 90 percent of your account balance and forfeit 10 percent. In this case, you have a tough decision: whether to take a haircut now or risk getting scalped later!

There are also a few special considerations regarding your decision to participate in these types of plans. Some employers offer matching contributions, just like in your 401(k) plan. Now you're faced with a dilemma; by declining to participate, you might leave money on the table. In this case, you might invest in the plan and then closely monitor the financial health of your company. If such a plan has a haircut feature, then the amount of the haircut might be less than the match. This presents a stronger case for participating in the plan.

Another possibility is that participation isn't voluntary. For instance, your employer might automatically invest incentive compensation amounts in these plans. If you have no choice, then your only option is to closely watch the financial health of your company. If you have substantial sums of money invested and you believe your company might go bankrupt, you might want to explore your payout options if you terminate employment.

It's important to keep in mind a basic principle of retirement investing. The only ways to invest through your employer in a tax-deferred manner and be protected in the event of your employer's bankruptcy are with a 401(k) plan or a 403(b) plan, if you work for a non-profit, and with health savings accounts (HSAs) for future medical expenses. There's just no way around this basic principle.

These plans are one example of getting overly focused on a single goal -- reducing current income taxes -- while losing sight of the big picture, which is building safe financial resources for a retirement that can be many years in the future.

Image from iStockphoto contributor trigga