To Defer or Not to Defer? A Financial Planner's take on the Zurich Executive Savings Plan.
The Zurich Executive Savings Plan is a non-qualified deferred compensation plan for eligible employees of Zurich Insurance Company. Here I share my insights on the plan from my experience in advising Zurich Insurance officers.
To defer on to defer, that is the question. It's decision time for eligible participants of the Zurich Executive Savings Plan (ESP). The ESP is a savings plan offered to a select group of management and other highly compensated individuals. Each year, eligible participants can defer a portion of their compensation be paid out at a future date. Since the deadline to make the election is fast approaching, it is important eligible participants understand the plan.
A client retiring in a state with no income taxes may regret not thinking through the State Source Tax.
What is it?
The Zurich Executive Savings Plan (ESP) is a non-qualified deferred compensation plan. Participants defer a portion of their eligible compensation and can receive payment at a future date. The deferred compensation is excluded from gross income in the year deferred, so there is no federal or state income tax owed, however, FICA taxes are still paid. The money inside the ESP is invested in a select group of mutual funds that mirror the mutual funds in the 401(k) savings plan. There are no taxes on the mutual fund earnings while the funds are inside the plan. At the time of withdrawal, the entire withdrawal is taxed as ordinary federal and if applicable state income tax. ESP money is not eligible for an IRA rollover.
Why Participate in the ESP?
Saving on current year income taxes is the main advantage. If you can afford to defer a portion of your bonus, deferring will mean less taxable income for that year. This is especially helpful if you have other sums of money coming due - stock vesting or other income. Deferring income may help prevent bracket creep - preventing other sources of income from getting taxed in a higher tax bracket.
Another advantage is tax-deferral. Any interest, dividends, and capital gains are tax-deferred within the plan, which can help the account grow. Plus, if eligible, there is a company match or base contribution.
Why Not Participate in the ESP?
In my opinion, there are three major risks to participating in the ESP:
1. Liquidity One major disadvantage is money deferred is not readily available. Though there is a provision for an “unforeseen emergency withdrawal” the ESP is not an ATM. Participants should make sure they have a readily available emergency fund.
2. Deferring to a higher tax bracket If you deferred your salary into a higher tax bracket, then what was the point? Ideally, you want to defer income to a lower tax bracket. However, current federal income tax rates are schedule to sunset at the end of 2025 and revert to the laws back in 2017, which may not be favorable. Deferring income to a higher tax bracket is not ideal.
3. Unsecured Creditor Funds in the ESP can be used to satisfy a creditor in the event of bankruptcy. This unsecured creditor provision is common with non-qualified deferred compensation plans. When Kodak filed for bankruptcy in 2012, executives received only 4-5% of their deferred salaries, and delivery was not in cash but in stock. The promise to pay you in the future is just that, a promise - money deferred is not guaranteed to be received.
Lump-Sum or Annual Installments? How to decide on a distribution election
There are two choices on how to receive the income in the future: 1. A single lump-sum payment or 2. Quarterly installment payments paid over five or ten years. Keep in mind, the distribution election is made when you first enroll in the plan, and it is irrevocable. Once the withdraw election is made you cannot change it for any subsequent contribution - it is the same election for every contribution thereafter.
Here are what I see as the advantages and disadvantages of both options:
Lump-sum | Periodic Payments |
| Potentially less exposure to company risk - Since the withdrawal is made all at once, there may be less exposure to a company bankruptcy as compared to the periodic payment option which subjects you to company risk for longer. The lump-sum may be a better choice if you are concerned about the company's health. | Greater exposure to company risk - Since payments are made over a series of years, the participant must wait longer to realize their full payment, exposing them to the risk of a company default for longer. |
| Income Tax Heavy: A lump-sum payment can inflate your income taxes significantly in a single year. This is especially a problem if tax rates increase in the future or if you have other sources of income paying out in the same year such as a severance payment or stock vesting. | Taxes spread out more evenly: Annual installments can mean less income and less income taxes than a single lump-sum since the tax liability is spread out over many more years. Ideally, the installment payments are paid in retirement where you may be in a lower tax bracket. |
| State Taxes: A lump-sum is taxed in the state where the money is earned, not the state you reside in at time of withdraw. For example, if you work in a high-tax state, but retire in a low-tax state, the state taxes are levied by the high-tax state, where the income was earned, even if you live in a low-tax state at time of withdraw, an obvious disadvantage to the lump-sum. Please consult with a qualified tax-advisor for more information. | State Taxes: If spread out over a period of 10 years, state taxes are paid in the state you reside in at the time of payment, not the state in which you earned the income. This is especially important if you plan to move to a lower tax state in retirement. We refer to this as the State Source Tax. |
Other Alternatives?
Before you defer, it's important to think about the best use of your money. There may be other alternatives to the ESP that make more sense, especially if you are not eligible for a match or company contribution. Some clients, instead of deferring, use the money to pay down a mortgage, top-off a 529 college savings account, or invest in a regular brokerage account. One option I like is to save in an investment brokerage account which employs an aggressive tax-loss harvesting strategy. This is a great way to control the taxes on an account. Plus, you maintain control over the timing of withdrawals, unlike the ESP which could lock up your money for several years. Working with a comprehensive financial planner can help you evaluate the alternatives.
Strategies
If participating in the ESP, here are additional planning tips:
- Consider high-yielding investments in the ESP since the earnings are tax-deferred
- If the distribution is a lump-sum, considering bunching charitable contributions in the year the lump-sum is paid via a Donor Advised Fund.
- Consider the Periodic Payments distribution option to avoid the State Source Tax if applicable
- If you do not plan on staying with the company for an extended time, the benefits of the ESP and tax-deferral may be small
Parting Thoughts
The decision to defer or not to defer into the Zurich Executive Savings Plan is not a decision to take lightly. The distribution option - lump-sum or periodic payments - is an irrevocable choice and can have long lasting implications. A client retiring in a state with no income taxes may regret not thinking through the State Source Tax. If a participant defers too much into the plan, they may be over-exposed to the company, especially if he or she has significant company stock. Like most decisions executives make, there are pros and cons to this one. If you need help or a second opinion, please let me know.
Disclaimer: This information is based on third party sources and, although believed to be reliable, this information has not been verified by Summit Financial. This material is not complete and is subject to change without notice. Refer to your plan documentation for complete information.
