Is It Better To Pay Off My Mortgage Or Invest At Retirement?

When preparing to retire, one question that is on most people’s minds is, “Is it better to pay off my mortgage or invest at retirement?” A common financial goal for many people is to retire debt-free, but most people approaching retirement are still paying off their mortgage.

Before you do anything, it’s important to evaluate your financial situation, available options, and opportunity costs.

Paying off a mortgage early can provide invaluable peace of mind and improve your cash flow. However, you might get a better return on your money by investing in the stock market, your business, or real estate while enjoying tax benefits from your mortgage.

So what’s best? Let’s examine the costs and benefits of paying off your mortgage versus investing at retirement.

Does Paying Off My Mortgage Early Make Sense?

One of the most important factors is to understand where you get the best return on your money. You will want to compare different rates of return and the risks associated with each investment option.

Pay off mortgage or invest

It is also critical to understand the impact of taxes.

Taxes are at the core of every financial decision and need to be accounted for in your analysis.

Getting the Best Return on Your Savings

In the early years of a mortgage, payments are comprised primarily of interest with a little principal. Towards the end of the loan, the opposite is true. Your payments are mostly principal with a little bit of interest.

The reason for this is that towards the end of the loan, the mortgage balance is lower, so a smaller amount of interest is being charged to the mortgage balance.

Thus, any extra principal reduction in the early life of the loan will greatly reduce the overall interest cost, saving money. The higher the interest rate, the more you will save on the life of the loan.

However, for the better part of the last decade, a 30-year mortgage has been in the 3% range. Much lower than than the high-interest rates in the 5-6% range we saw just 15 years ago.

The opposite is true when investing in a diversified portfolio over time. The benefit of compounded interest and growth is significant towards the latter years of the investment. Since 1926 the S & P 500 index has averaged a double-digit return.

Your retirement plan should account for other long-term growth options that can outpace the interest savings of paying off your mortgage early. One example could be to invest in rental property instead of paying off your primary mortgage.

If you’re a business owner, consider what you could achieve by expanding or enhancing your operations. Reinvesting in your business could achieve a much greater return than saving interest on your mortgage.

As you can see, it’s important to think about where your money works best for you. And that’s different for everyone.

The Math: Pay off My Mortgage or Invest

When looking at the numbers, the difference between paying off your mortgage or investing those funds in your investment portfolio can be startling. If you decided to pay off your mortgage rather than invest, you would have paid a high opportunity cost for the feeling of being debt-free.

Historically over longer periods of time (10+ years), you’ll rarely find a time when market interest rates are better than average annual returns from a diversified investment portfolio. 

The table below compares the total interest paid on a 30-year loan to an investment portfolio growing for 30 years. We use a balance of $500,000 in our example. The mortgage rate is 3%, while the growth rate of the investment portfolio is 6%. 

Pay off Mortgage or Invest

The first thing that jumps out is the total comparison of total interest paid on the mortgage vs. total interest earned after 30 years. The total amount of interest paid over the life of the loan is $258,887 while the total return from the investment portfolio is $2,371,746! That is a massive difference in total return.

Of course, the portfolio return is twice that of the mortgage, but these are real numbers based on recent economic and market conditions over the last 10 years. The primary reason for the disparity in the totals is compounding.

Over time, your mortgage balance gets reduced, resulting in you paying less interest. You will notice that interest paid steadily declines every year in the “Interest” column.

However, the payment stays the same. So that means that more of your payment is going to the principal in the later years of the loan as you can see in the “Principal” column.

Also, note the first column titled “Pmt No.” This refers to the monthly payment being made out of 360 total payments (30 years x 12 mos). When you are halfway through the loan at payment number 180, you have paid nearly 71% of the total interest over the entire loan.

This is another reason why it doesn’t make a lot of sense to pay off a mortgage towards the end. You aren’t saving yourself much interest. It can be more beneficial to just continue making payments.

The Benefits of Paying off Your Mortgage at Retirement

It feels good not to owe money, psychologically and emotionally. Many baby boomers share the goal of paying off their mortgage by retirement. Realistically, this doesn’t happen since people move frequently and refinance in their working years.

A Paid Off Mortgage Provides Peace of Mind

Removing what for many people is their largest expense can feel liberating. Your psychological well-being can improve by removing a debt overhang and owning your own home. You will have lower cash needs on a monthly basis, allowing you to spend or invest those dollars elsewhere.

Home equity is also a good source of low-cost debt to tap in order to pay off high-interest debt, like credit cards. It can also be used to help out children, grandchildren or free up capital for all sorts of other reasons.

Another benefit is that lower monthly expenses require a smaller emergency fund. It’s a rule of thumb to have 3-9 months of your monthly expenses in an emergency fund.

Lastly, you remove the financial risk an unexpected life event could pose by impairing your ability to make payments.

No Mortgage Payment Means Lower Retirement Account Withdrawals

You can reduce your withdrawal rate from your retirement savings in the absence of your mortgage payment. This can reduce your tax liability if most of your withdrawals are coming from IRAs and 401k’s. Distributions from these accounts are income taxable.

Since you would use your non-retirement accounts to pay off a mortgage, lower withdrawals can preserve your retirement accounts more. Your average annual return can be higher in the long run by keeping those funds invested over time.

Conversely, you could keep the same withdrawal rate and afford a higher quality of living. If your retirement budget is higher than your pre-retirement budget, that means you will need the extra cash from retirement accounts. A paid-off mortgage will again keep withdrawals more manageable.

Drawbacks of Paying off Your Mortgage at Retirement

As we explained above, the opportunity cost of mortgage interest saved versus interest earned can be quite shocking. We recently discussed this in a recent post titled, “How to Retire Early at 55.”

Paying off Your Mortgage Ties Up Your Money

A mortgage from your bank is a financial partnership. They provide you with capital and you pay interest in return. As long as you keep making mortgage payments, you are the owner of the property and receive all of the appreciation of the home.

So let’s say you decide to fire your banking partner because you don’t want to pay the interest or have a payment. The trade-off is that now the equity of the property is tied up. For you to access your equity, you need to take out a home equity line of credit (HELOC) at an unknown interest rate in the future.

With lower interest rates over the last 10 years, it makes sense to use the interest rates to your advantage and obtain a mortgage. As long as there isn’t a pre-payment penalty, you can always pay it off or refinance it in the future when you have extra money.

Home equity is also a good source of low-cost debt to tap in order to pay off high-interest debt, like credit cards.

Paying off Your Mortgage Can Result in Lost Tax Benefits

When you file your taxes every year, you choose to take a standard deduction or itemize your deductions – whichever amount is greater. The standard deduction for taxpayers that are Married Filing Jointly is $24,000 ($12,000 for single taxpayers) in 2021.

Every year, you add up your itemized deductions with the hope that they are higher than your standard deduction. Expenses that qualify as itemized deductions are broken down into the following categories:

  • Medical and Dental Expenses

    To the extent that they exceed 7.5% of your Adjusted Gross Income (AGI)

  • Taxes You Paid

    Includes State and Local Income Taxes (SALT)

  • Interest You Paid

    Interest/Points you paid on your mortgage and/or vacation home

  • Gifts to Charity

    Charitable gifts made in the current year including carryover disallowed gifts made in previous years

  • Casualty and Theft Losses

    Generally, you may deduct losses caused by a federally declared disaster or by theft

  • Other Itemized Deductions

    You can only claim certain unreimbursed employee expenses if you fall into a qualified category of employment

Since mortgage interest is tax-deductible, losing the interest rate deduction by paying off your mortgage can increase your tax liability. If you purchased a home prior to 2017 and itemize your deductions, interest is deductible on the first $1,000,000 of your mortgage. The Tax Cut and Jobs Act (TCJA) of 2017 reduced this amount to $750,000.

The Act also doubled the standard deduction and reduced the State and Local Taxes (SALT) deduction by imposing a $10,000 limit. This has had a negative impact on residents of states with higher income and property taxes like California and New York.

Let’s take a closer look at Schedule A below to explain how losing your mortgage interest deduction can increase your tax liability.

Schedule A Itemized Deductions and SALT

In our example, although the state income taxes are $46,500 and the real estate taxes are $20,000, the total allowable deductible amount is limited to $10,000. The limitation causes this high-income household to miss out on $56,508 of deductions!

Additionally, you can see the total deductible mortgage interest in the amount of $26,532. The mortgage balance in our example is $1.5 million. That means that this taxpayer actually paid about $53,000 in mortgage interest for the year.

Prior to the TCJA legislation that limited the SALT deduction, there was no limitation. So using our example, prior to 2017, the total itemized deductions would have been $93,040, not $36,532. There is currently a proposal in the Build Back Better legislation to increase the SALT cap.

The bill has passed the House but faces a tougher battle in the Senate. How do you use this information to your benefit? You may have itemized deductions like medical expenses or charitable giving that put you close to the standard deduction amount. 

Mortgage interest could increase your itemized deductions to the point they are now greater than the standard deduction. So it’s an important consideration, especially if the SALT limitation is increased or goes away completely.

Final Thoughts

Like any big financial decision, it is important to weigh the costs and benefits. Financial decisions like this are complex and require a good understanding of all the variables involved.

Use a nuanced approach, giving weight to what matters most to you. Can’t decide whether you want a mortgage or not? A balanced approach is another option. You could pay off part of your mortgage and invest the remainder in whatever split you’re most comfortable with.

Maybe you decide to finance only an amount that would allow all the interest to be deductible for you.

Every decision involves risks that must be measured and managed for any particular path you choose. If you aren’t confident in making these decisions on your own, consult a fee-only financial planner to ensure you don’t leave anything out.

What You Need to Know to Retire Early at 55

Most Americans consider age 65 the normal age of retirement because it was the full retirement age for Social Security Benefits until 1983. But the goal of retiring early has gained widespread popularity in recent years. In this article, we’ll cover what you need to know to retire early at 55.

From formulating a budget to creating tax-efficient retirement income, there are a lot of factors and variables to consider prior to making such an important decision. Making major mistakes will result in lifestyle restrictions or a forced return to the labor force.

Retirement is your reward for a lifetime of hard work and saving money. So let’s talk about how to retire early – and stay retired.

Planning to Retire Early at 55

Knowing exactly how you will spend your time in retirement will be critical to your success. When every day is Saturday there is a high likelihood that you will be spending more money.

Your retirement account withdrawals need to be reasonable to ensure you don’t outlive your savings and investments. Inflation is another obstacle you need to overcome. Your retirement plan needs to account for the higher cost of goods and services in future years.

Thus, having a step-by-step plan to overcome these types of obstacles is necessary. 

How Much Do I Need to Retire Comfortably?

One common goal that everyone has is maximizing their quality of life in retirement. This means spending money confidently, without fear, worry, or anxiety. 

Traveling the world will require more financial resources than playing bridge or having coffee with friends every day. Consider traveling costs to visit your children and gifts to grandchildren. What does your bucket list look like? Make sure to create a good framework detailing all of your retirement goals.

Mapping out your daily, weekly, and monthly lifestyle goals will assist in determining what a comfortable retirement will feel like. Knowing your expenses is the first step in determining your withdrawal rate. Your withdrawal rate is the amount withdrawn divided by the value of your retirement portfolio.

How Will My Expenses Change in Retirement?

Most retirees don’t take time to create a monthly or annual budget. We recommend creating a pre-retirement budget as well as a retirement budget. This will force you to see how expenses will change, line item by line item.

Retiring at 55 can increase your expenses. Health insurance is one of the most important considerations when factoring in higher expenses.

Losing employer-sponsored health coverage is costly until Medicare eligibility kicks in. Paying for health care costs out of your own pocket is unsustainable. For married couples, deciding whether one spouse works longer to retain affordable health coverage is a conversation worth having.

Some families have children entering college when they plan to retire. This can increase expenses dramatically at the same time employment income disappears. Planning for this change in expenses is paramount to a sound financial plan.

Some things are beyond your control. It is important to focus on what you can control now.

What is the Tax Rate on My Retirement Income?

When creating retirement income, how much you get to keep after taxes is what really matters. It’s important to understand how income and capital gains tax rates work. Having a sound financial plan will help you determine how to withdraw the money you need from retirement accounts – while paying the least amount of tax.

Taxable, tax-deferred, and tax-free accounts are the three primary types of accounts you can withdraw from. Withdrawals from tax-deferred accounts like Traditional IRAs increase your ordinary income tax rate. Tax-free withdrawals from Roth IRAs are just that, tax-free.

2021 Ordinary Income and Capital Gain tax rates for Single and Married Filing Jointly Taxpayers

Non-retirement accounts are subject to short-term and long-term capital gains tax rates. Selling an appreciated asset held for less than one year is called a short-term capital gain. Short-term capital gains are taxed at your marginal income tax rate. Assets held for longer than one year are taxed at more favorable long-term capital gain tax rates.

Selling an asset that has gone down in value from when you purchased it results in a capital loss. You can use a capital loss to offset a capital gain. This can be beneficial in reducing your tax liability every year. So just knowing which position to sell in an account can have major tax implications for you.

How Much Money Do I Need to Retire Early at 55?

The key question that every retiree wants to know is how much they can spend in retirement without outliving their nest egg. The challenge with retiring at 55 is that the earliest you can begin Social Security Benefits is age 62.

While many retirees that work for a state or federal government have pensions, the earliest age you can begin benefits can range anywhere from 55 to 65. But drawing your pension at 55 can substantially reduce your benefit.

It may make more sense to rely on retirement account withdrawals and delay your pension start date. These are some of the difficult, yet important decisions that need thorough analysis to ensure that you maximize your income in retirement.

Beyond the Four Percent Rule: How Much Can You Spend in Retirement?

The “four percent rule” states that no more than 4.2% should be withdrawn annually (adjusted for inflation) to ensure you don’t outlive your retirement savings. However, this popular rule of thumb is based on a retirement age of 65. Retiring early at age 55 requires the withdrawal rate to be lower.

It really depends on a number of factors, but you may only be able to draw 2-3% in your 50’s, 4% in your 60’s, and 5% or greater in your 70’s. Having a retirement plan that addresses the timing of your retirement income benefits, retirement account withdrawals, and limits tax liabilities will help optimize your financial decisions.

How Do I Generate Income in Retirement?

The biggest challenge when you retire early at 55 is bridging the income gap until Social Security or Pension eligibility. For married couples, coordinating retirement dates with their spouse is important. Extending group health insurance coverage helps reduce expenses until Medicare eligibility. Another option is part-time work or consulting, depending on your goals and skills.

Many retirees pursue entrepreneurial passions they never had a chance to realize during their working years. A lifetime hobby or passion can now have space to blossom into a business and provide supplemental retirement income.

Real estate investors should evaluate their real estate portfolios as they approach retirement. The goal is to invest/retain properties that produce higher income in retirement.

Social Security Benefit Reductions for Early Retirement

Social Security eligibility begins when you reach age 62. But drawing benefits early will reduce your payouts by 20-30%. Delaying retirement benefits to age 70 can increase benefits by as much as 30%!

If you work while receiving benefits prior to reaching your full retirement age, the Social Security Administration will reduce your benefits depending on how much employment income you earn. For example, at full retirement age, they deduct $1 in benefits for every $3 you earn above $50,520. This matters if you plan to work again in one form or another. If you do, it might pay to delay Social Security even if you retire early.

You also want to ensure that you have worked for 40 quarters (10 years) to become eligible for Social Security Benefits. If you are short, it makes a lot of sense to postpone your early retirement at 55 and consider a later age.

How Do I Avoid an Early Withdrawal Penalty from my 401K or IRA?

Retirement accounts have early withdrawal penalties that are prohibitive by design. The intention of having tax-free and tax-deferred growth is to help Americans save more effectively for retirement. By nature, this helps alleviate reliance on programs such as Social Security.

Rules on retirement accounts restrict withdrawals for non-retirement-related purposes. However, there are some exceptions and strategies that can be extremely valuable for early retirees.

Roth IRA Taxes and Penalties

Retirement Account Early Withdrawal Penalties – The 59 ½ Rule

Withdrawals from retirement accounts are subject to a 10% withdrawal penalty prior to reaching age 59 and 1/2. This penalty is taken out of the distribution amount prior to assessing the amount of the taxable distribution.

Eligible withdrawals prior to age 59 1/2 are limited to the following exceptions:

  • First-time home purchases
  • Educational expenses
  • Birth or adoption related expenses
  • Disability
  • Death
  • Medical expenses

Remember that distributions from all tax-deferred accounts like IRA’s and 401K’s are taxed at ordinary income tax rates.

Using the Rule of 55 to take Early 401K Withdrawals

A great strategy for accessing money from retirement accounts when you retire at 55 is the Rule of 55. If you are laid off or retire early at 55, the IRS waives the 10% penalty for early distributions from 401k or 403b plans. For public service employees, the rule applies in the calendar year they reach age 50.

The IRS Rule of 55

Not all employer-sponsored retirement plans support the rule of 55 and some plans require that proceeds be taken in a lump sum.

It is advised that you check with your plan provider prior to making this important decision.

It’s also worth mentioning that the rule of 55 does not apply to old 401ks from previous employers or IRA accounts. It only applies to 401k or 403b plans with your current employer.

Can I Avoid Penalties for Early IRA Withdrawals?

Another strategy to avoid penalties for early retirement distributions is Rule 72(t). This rule allows penalty-free withdrawals from retirement accounts, with some caveats. Individuals must take five “substantially equal periodic payments” (SEPP).

The amount varies upon life expectancy calculations. The IRS has three approved methods of calculation. You must also adhere to the SEPP schedule for a minimum of five years or until the age of 59 1/2. Rule 72(t) applies to IRAs as well as 401k and 403b plans.

Are Roth IRA Distributions Subject to the Early Withdrawal Penalty?

You can always withdraw contributions from a Roth IRA with no penalty at any age. At age 59½, you can withdraw both contributions and earnings with no penalty, provided your Roth IRA has been open for at least five tax years.

This five-year rule governing Roth IRAs applies to three scenarios:

  • You withdraw earnings from your Roth IRA.
  • Convert a Traditional IRA to a Roth IRA.
  • Inherit a Roth IRA

Roth IRAs offer more accessibility than other retirement accounts, but also provide tax-free growth. It’s better to use them as a last resort if possible.

How to Invest When Retiring Early at 55

The asset allocation of your portfolio should become more conservative as you near retirement. This rationale is based upon time horizons. You can withstand volatility and recover from loss when you have a longer time horizon.

When you reach retirement you need your portfolio to provide retirement income. This means that you need some safety in your portfolio to fund these income needs.

Investing Safely for Early Retirement

Fixed income (bonds) are considered to be a “safer” asset class than stocks. Fixed income plays a major role in diversification and wealth preservation.

Historically, bonds have an inverse relationship with stocks. During market downturns when most stocks decrease in value, investment-grade bonds increase in value. This makes them ideal positions to liquidate if stocks are down to provide the income needed in retirement.

In addition to being a hedge against stock declines, bonds pay higher interest than cash. One mistake that some retirees make is having large cash positions in retirement. Cash historically does not keep pace with inflation and is a poor way to invest in the long-term.

Should I Still Invest in Stocks if I Retire Early at 55?

The average retirement represents a long time horizon anywhere from 20-30 years. But if you want to retire at 55, you need to plan for a timeframe of 40 years. This longer time frame is sufficient to absorb risk while participating in upside growth. Think of the stocks in your portfolio as the money you will spend 10 to 20 years down the road.

A well-diversified portfolio should include stocks from a number of different asset classes. You want to have exposure to small, medium, and large companies. Your portfolio should also hold international stocks in addition to U.S. stocks. Holding different types of asset classes in your portfolio spreads the risk around.

Important Strategies for your Retirement Investment Portfolio

Asset location (different from asset allocation) involves determining which accounts to house assets. For example, Roth IRAs provide tax-free distributions making them ideal for high-risk/return asset classes. You want to position low-risk/low-return asset classes in accounts with the highest tax rates like Traditional IRAs.

Rebalancing your portfolio is an important investment management strategy that should be performed consistently. Stock returns outpace bond returns in the long run. If you don’t rebalance your portfolio, the percentage of stocks in your portfolio will continue to increase, making it riskier than you originally intended.

Tax-loss harvesting is another technique to reduce your taxable income. In taxable accounts, selling an asset at a loss and purchasing another will create a realized loss. These losses can then be used to offset gains in the current year or carried forward indefinitely.

What Else to Consider Before You Retire Early at 55

As we have discussed, there are a number of things to contemplate when deciding to retire early. Forming a retirement budget, minimizing taxes, and navigating the complexity of retirement account rules are primary considerations.

Since everyone’s situation is different, there will always be unique situations that require more difficult decisions to be made. Now let’s take a look at some of these situations and some unforeseen risks that could throw a wrench in your plans.

Paying Off Your Mortgage Early vs. Investing: Which Is Best?

Many baby boomers make it a goal to be debt-free by the time they retire at 55. While that may feel like a great decision psychologically, it isn’t necessarily the best financial decision. Leveraging “good debt” like mortgages can really help you out financially. Over the last 20 years, mortgage rates have hovered around 3-4%.

From 1926-2020, the average return of portfolio invested 60% in stocks and 40% in bonds averages over 9% per year. It’s easy to see why utilizing a mortgage and letting your money grow in your investment portfolio is a good long-term strategy. Having a mortgage may make you feel uncomfortable, but changing your perspective about carrying debt can make all the difference in retirement.

Pay off mortgage or invest in stocks?

Mortgages aren’t the only type of liability retirees have to deal with upon retirement. Some retirees also have children entering college at the same time they retire. In the absence of a 529 plan or college fund, this added expense can cause a significant strain on cash flows. These decisions are integral to your success if you want to retire at 55.

The Five Most Common Retirement Risks You Should Know

There are five main risks every prospective retiree should plan for prior to retirement. Neglecting these risks could inhibit you from your goal to retire early at 55.

Market Risk

A decline in asset values similar to the Great Recession of 2008 is a good example of market risk. At the same time, you can’t be too conservative in retirement. Having a well-diversified portfolio that takes into account your retirement income needs is key.

Longevity and Mortality Risk

The risk of outliving your assets is what every retiree fears. Another risk related to longevity is premature death. This can impact your spouse and any other dependants in your household.

These risks can dictate whether to purchase/retain any life insurance policies. They may also assist you in making decisions like when to take Social Security benefits and pensions.

Health Risk

More trips to the doctor should be accounted for in retirement. We already discussed the higher cost of purchasing your own healthcare before you become eligible for Medicare. But you also have to account for more frequent doctor visits, co-pays, and deductibles.

Health risks increase as you grow older so make sure this is planned for in your retirement expenses. These costs should be higher in your budget until Medicare eligibility at age 65.

Event Risk

There are some events that could have low odds of occurring, but you still want to be prepared in case they do. A long-term care event such as Alzheimer’s could require round-the-clock care for years. Self-insuring this risk is cost-prohibitive for most people. Regular health insurance will not provide coverage against this event.

Relying on an inheritance without 100% certainty could be another example. An earthquake in California could devastate most retirees as only 13% of California homeowners have earthquake insurance.

We can’t predict what curveballs life will throw next. At the very least, you will want to know how certain types of these events will impact you financially.

Tax and Policy Risk

One thing that will be consistent during your retirement is frequent legislative changes. Changes to retirement account rules and the tax code can change year to year. One example is the Tax Cuts and Jobs Reconciliation Act (TCJA) bill that was passed in 2018. In 2020, we saw the SECURE and CARES Acts passed, which had a dramatic impact on retirement distribution rules.

Making sure you have a short and long-term tax plan may be the most important factor in maximizing retirement income. Once a plan is in place, it’s important to keep on top of the policy and tax changes every year and adjust your retirement plan accordingly.

Should I Hire a Financial Advisor or Do it Myself?

We covered a lot up to this point and you should have a pretty good idea of what it takes to retire early at 55. But here’s the million-dollar question:

Do I have the expertise to understand, implement, and monitor every facet of my finances in retirement – and do I really want to?

When making this decision, be honest with yourself and think about the repercussions of making mistakes. Keep in mind that the long time horizon in retirement compounds any mistakes you make. A large amount of personal finance knowledge and expertise is needed, which can increase your margin for error.

Will you really spend the time to keep up on changes to the economic, legislative, and tax landscapes? Is this something you are really interested in doing? If the answer is no, then it probably makes sense to consult with a few financial planners. At the very least, you will be able to get a good sense of the planning work that’s needed after speaking with them.

A Certified Financial Planner™ (CFP®) can help you custom tailor a comprehensive plan that helps you accomplish all of your goals. Above all, a CFP® will provide invaluable peace of mind when things change. Remember that your retirement plan will need to be adjusted on an ongoing basis.

It pays to have an experienced guide on the most important journey of your life.

Final Thoughts on Retiring Early at 55

Early retirement at age 55 is an idea that continues to grow in popularity. Ultimately, it means accumulating enough financial resources to live off for another 5-10 years. A successful early retirement plan hinges upon organization and preparation and is the blueprint to accomplishing your goals.

Making adjustments to your plan on a year-to-year basis is equally as important as formulating a good initial plan. There will be constant change and unpredictability with a number of things that are out of your control. How you react to these changes will play a big part in successfully retiring early at 55.

Nonqualified Deferred Compensation Plans

A deferred compensation plan is a retirement plan that allows employees to defer some of their compensation to a later date. Common types you may already be familiar with are 401(k) and 403(b) plans. If you are a key employee, however, your employer may offer one or more nonqualified deferred compensation plans (NQDC’s).

NQDC plans are governed by section 409A of the U.S. tax code and differ from most other employer-sponsored retirement plans. Whether or not you should participate in an NQDC requires some careful consideration. In this article, we explain nonqualified deferred compensation plans and whether one is right for you.

What are Deferred Compensation Plans?

First, it’s important to understand the differences between qualified and nonqualified deferred compensation plans. The Employee Retirement Income Security Act (ERISA) governs qualified plans. This legislation sets standards for health and retirement plans offered by employers to protect employees.

An NQDC plan is exempt from ERISA law’s strict rules, making them more flexible and customizable for employees. The primary purpose is to attract and retain highly compensated key employees and executives.

Qualified Deferred Compensation Plans

ERISA law ensures that qualified plans have minimum standards for vesting, eligibility, benefit accrual, funding, and the overall administration of plans. It also guarantees certain benefits for participants through the Pension Benefit Guaranty Corporation (PBGC).

Participants in a qualified plan are also subject to strict parameters that govern the plan. Required minimum distributions, annual contribution limits, and penalties for early withdrawal apply in most scenarios. The complex rules of qualified plans position the employer as a fiduciary on behalf of the plan participants.

The table below lists other common characteristics along with the different types of qualified plans.

Common types and characteristics of qualified plans

The single most important trait of qualified plans is that employee and vested employer contributions are assets belonging to the participant. This is the significant distinguishing characteristic between qualified and nonqualified deferred compensation plans.

Nonqualified Deferred Compensation Plans

A nonqualified deferred compensation plan or 409A plan, allows participants to defer some of their compensation into the future. For key employees and executives, this can be a very attractive benefit. Top-heavy and non-discrimination requirements limit key employees’ participation in qualified plans.

Additionally, highly compensated employees are subject to annual contribution limits of only $19,500 in a qualified plan. The ability to defer larger amounts of compensation into a nonqualified plan is a very attractive benefit to high-income earners.

Like most endeavors involving money, these plans do not come without risk. The compensation you defer into future years is considered an asset of the employer. This means that your NQDC plan would be at substantial risk if the company you work for becomes financially unstable.

The Benefits of Nonqualified Deferred Compensation Plans

As we just mentioned, the primary reason to participate in an NQDC is to minimize tax liabilities. Reducing compensation in the current year helps keep you out of higher marginal tax brackets.

And taking distributions in retirement years when tax rates are lower is the objective with retirement planning.

A Great Tool to Retain and Attract Key Employees

Employers want to attract and retain highly skilled executive talent. A nonqualified deferred compensation plan can be a key component of an executive benefits package. Even when the company has a qualified plan in place like a 401(k), an executive’s contribution amount faces more hurdles.

Percent of Fortune 1000 companies that provide non-qualified deferred compensation plans to key employees

The annual contribution limit for employee deferrals to a qualified deferred compensation plan is $19,500 in 2021.

There are rules in place to prevent a plan from benefiting higher-income employees over rank and file employees.

These rules limit contributions of high-income earning employees to a lesser amount.

The qualified annual contribution limit of $19,500 is less than ideal for top earners. NQDC plans don’t have contribution limits, allowing employees the option to defer a large percentage of their salary.

For example, let’s say you accept a job offer that pays a salary of $450,000. Even without any other household income, this would place you in a 32% federal marginal tax bracket.

In reviewing your benefits package, you find out that you can defer $100,000 of your salary every year. This would save you $32,000 of tax liability!

Tax-advantaged Compound Growth

There are different types of nonqualified deferred compensation plans offering various investment options (more on that later). Most plans offer stocks, bonds, and mutual funds. This can provide substantial long-term growth in addition to tax savings.

Let’s look at an example of how powerful compound tax-deferred growth is in accumulating wealth. Following our previous example, let’s assume an employee in a 32% marginal tax bracket defers $100,000 into their NQDC. The tax savings in year one would be $32,000.

Assuming the plan’s investments grow at a rate of 7% over 10 years, the $32,000 grows into $62,949! So instead of paying $32,000 to the IRS, you created nearly $100,000 of additional wealth in retirement.

Spreading Income Tax Liability into Retirement Years

Once retirement begins, household income usually decreases, which means that tax liabilities decrease as well. So it’s extremely important to have a good idea of what your income tax situation looks like upon retirement.

Coordinating distributions with other sources of retirement income is crucial for achieving tax efficiency. Deciding when to take Social Security and pension benefits should be coordinated with scheduled distributions.

The same goes for coordinating retirement dates with your spouse and accounting for Required Minimum Distributions (RMD’s). Most of us are in the highest tax brackets in our working years. So deferring taxable income to your retirement years can make a ton of sense.

The Risks of Nonqualified Deferred Compensation Plans

Funds are Assets of the Employer

Unlike ERISA plans, salary deferrals into an NQDC plan are not assets of the employee, but assets of the company. In a nutshell, your deferrals become a promissory note between you (the borrower) and your company (the lender).

Since your deferrals are assets of the company, should they become financially insolvent, your funds would be at risk. This is by far the most important consideration when choosing how much to defer into your deferred compensation NQDC plan.

There May Be Limitations of Investment Options

Aside from stock option plans, most nonqualified deferred compensation plans will have an approved list of mutual funds to choose from. This mutual fund lineup is often the same as in the company’s qualified plan like a 401k.

In the case of a stock option plan, your deferrals purchase stock in the company. This creates additional risk if your company encounters financial trouble. Even if they remain solvent, a concentrated position in the company stock could experience large declines.

Distribution Options are Limited

The year prior to deferring money into your plan, you need to decide when distributions will begin. Plans can offer a lump sum or multi-year payout options, but 5-10 years is a common election. Distributions don’t start until a triggering event occurs. There are six triggering events:

  1. A fixed date
  2. Separation from service (usually retirement)
  3. A change in ownership of control of the company
  4. Disability
  5. Death
  6. An unforeseen emergency

Distributions are difficult to change once selected and require a five-year waiting period if allowed at all.

How Nonqualified Deferred Compensation Plans Work

In some cases, the triggers for deferred comp distribution are beyond your control. For example, death or disability will force you (or your heirs) to take distributions.

Choosing a fixed date can be useful when anticipating future income needs as well. A good example is having a child enter college around the same time you retire. Scheduling distributions when the child begins school can alleviate pressure to draw funds from other sources.

No Loans in Nonqualified Deferred Compensation Plans

If you really needed to access money from your 401(k) plan, many plans offer loans. This is not the case with an NQDC plan. Section 409A of the U.S. tax code governs these plans, subjecting withdrawals only to the six triggering events above.

This means that you should consider deferrals into the plan to be irreversible. So making sure you don’t overcontribute to the plan is important. It’s helpful to create a budget including annual income tax liability to avoid an income shortfall at end of the year.

Is a Nonqualified Deferred Compensation Plan Right for Me?

Do I Need Another Retirement Savings Account?

The first place to maximize retirement contributions is qualified plans like 401k’s and IRA’s. But few options reduce taxes and provide tax-deferred growth like an NQDC. Also, there aren’t any other types of deferred compensation plans with unlimited contribution limits.

Thus the biggest advantage of deferred compensation plans is a tax-advantaged way to save annual income surplus.

How Financially Secure is the Company I Work For?

Again, since NQDC plans are assets of the employer, the financial strength of your employer is of paramount importance. Your company needs to be around in the long run for you to receive distributions from the plan. The longer you are away from your triggering event, the more risk you carry.

Concentration risk

Another consideration you want to make is how much of your wealth you tie to your employer. Do you already have other types of nonqualified deferred compensation plans? Do you already own a high concentration in company stock?

Too much concentration can be dangerous, as we saw with big companies like Chrysler in 2008 and Hertz in 2020. Having a significant amount of your wealth AND income tied to your employer can be extremely risky. If you feel comfortable with a high concentration of company stock, there are ways to obtain third-party insurance.

Key Considerations in Participating to a NQDC Plan

How Will My Tax Rate Change in the Future?

Tax savings are amongst the primary benefits of a nonqualified plan. It’s important to weigh your future income needs and tax liability when electing to participate in your plan. Accounting for all your sources of income such as Social Security and RMD’s is vital upon retirement.

Remember that your contributions are invested into a portfolio with an expected rate of return. If you are ten years away from retirement, you should estimate your contributions’ value in year ten.

This is because all distributions are income taxable. You must be careful not to defer too much and create a future tax problem. It’s recommended to consult with a financial planner or tax advisor before you make your elections since they can’t be changed.

What are My Distribution Options?

We have discussed how important it is to coordinate your NQDC distributions with your other retirement income sources. The big challenge is choosing the distribution schedule at the same time as the deferral election.

Let’s go through an example of how this works. It’s September and you receive your enrollment package to make your deferral for the following year. Your salary is $300,000 and you anticipate your bonus will be $100,000 next year.

You can defer up to 50% of your salary and 100% of your bonus. You decide to defer 33% of salary and 100% of bonus to your retirement date 10 years down the road. Your distribution options are to take a lump sum or payment over 10 years.

You must decide on which distribution to take, even though it won’t start for 10 years. To make a good decision, you will need to coordinate distributions with your future income sources. This takes some serious financial planning.

The final step is to choose how your deferral will be invested. The performance of the investments you choose will determine what the final amount will be upon retirement. As you can see, there are a lot of variables to consider when making this decision.

Key Takewaways

Nonqualified deferred compensation NQDC plans are a great tool for both employers and employees. Employers have added ways to enhance benefits packages for employees. And employees have another way to save in addition to their qualified retirement plan.

Employees need to weigh the benefits, risks, and whether an NQDC fits into their financial plan. They are a great way to reduce taxes and boost tax-deferred growth for retirement. But remember that the funds in these plans belong to the employer until the employee actually receives them.

These plans are very complex and should be discussed with your financial advisor prior to participating.