If you work in tech or founded a company, you have probably heard about deferred compensation plans. On the surface, they can seem like a smart way to postpone income and reduce your current tax bill. You may even hear colleagues talking about how it helps them build retirement savings or smooth out tax brackets in high-income years.
But before you tick that box on your enrollment form, it is important to understand the downsides. Deferred compensation plans are very different from qualified plans like a 401(k). They come with unique risks and rules that can create problems down the road if they are not carefully evaluated. At KB Financial Advisors, we help tech professionals and founders look past the shiny tax benefit and make decisions that fit their full financial picture.
Here are five solid reasons your deferred compensation plan could be a bad idea.
1. Your Deferred Compensation Is Not Guaranteed
One of the biggest misconceptions about deferred compensation is that it is like a retirement savings account you own. It is not. Most deferred compensation plans are unfunded promises from your employer. The money remains part of the company’s general assets and is not set aside in its own secure account. If your employer runs into financial trouble or files for bankruptcy, you could lose some or all of your deferred income. In bankruptcy cases, deferred compensation amounts may be treated like any other debt owed to creditors. This makes your deferred pay much riskier than funds in a 401(k) or IRA, which are protected under federal law.
What you can do
Ask whether your plan’s money sits in a protective trust, and research the financial stability of your company before deferring large amounts of compensation.
2. You May Forfeit Your Deferred Pay If You Leave Your Job
Another risk that often gets overlooked is forfeiture. Many plans include strict vesting schedules or conditions that must be met before you actually earn the deferred funds. If you leave the company voluntarily or are terminated before vesting, you could lose the promised amounts. Some plans are even referred to as “golden handcuffs” because they tie key employees to the company simply to preserve the deferred income.
What you can do
Carefully review your plan’s vesting and forfeiture rules. If your career path might take you elsewhere in the next few years, think twice before locking a large piece of your compensation into a plan with strict conditions.
3. You Might Not Be Able To Access The Money When You Want It
Deferred compensation is not liquid. Once you make a deferral election, the funds are generally unavailable until the distribution date you chose, which could be many years in the future. Some plans allow distribution only after specific events, like retirement or separation from service. There is no early withdrawal option like you might have with other retirement vehicles.
This lack of liquidity can be a problem if you need funds for an emergency, a home purchase, or a startup investment. If you need to access money sooner than planned, you may have no option but to wait or incur significant penalties.
What you can do
Make sure you have adequate liquid savings outside of your deferred compensation before you commit. Treat deferred comp as money you cannot touch until your distribution date.
4. Your Tax Decisions Are Irreversible And Complex
One of the main reasons people choose deferred compensation is to reduce their current tax bill by recognizing income in a future year. In many plans, these elections are irrevocable once the tax year begins. That means you must predict your income, tax bracket, and life needs years in advance.
This is hard for anyone, and especially for tech professionals whose compensation can vary widely year to year due to bonuses, equity vesting, or liquidity events. Getting the timing wrong can result in a higher tax bill than you would have had otherwise.
What you can do
Use tax projection tools or work with a CPA before you elect deferred compensation. Run scenarios for different distribution years so you understand the potential outcomes.
5. You Could Trigger Severe IRS Penalties If Rules Are Violated
Deferred compensation plans are governed by complex tax rules, especially Internal Revenue Code Section 409A. These rules specify how deferral elections must be made, when distributions are allowed, and what constitutes compliance. If a plan fails to meet these requirements or if elections are made incorrectly, the consequences can include immediate taxation of all deferred amounts, interest, and an additional 20% penalty tax.
In other words, a simple mistake can convert what you thought was tax-deferred income into ordinary taxable income plus significant penalties.
What you can do
Before making decisions, consult a financial or tax advisor with experience in deferred compensation. They can help ensure your elections and distribution timeline satisfy IRC 409A requirements.
Also read: 5 Reasons Your Deferred Compensation Plan is a Good Idea
Speak With A Financial Advisor Who Understand Deferred Compensation
Deferred compensation plans can look appealing at first glance. The idea of postponing income and reducing your current taxes sounds smart, especially when you are focused on growth and long-term goals. But these plans come with real risks that deserve careful consideration. Unlike a 401(k), your deferred amounts are unsecured, potentially inaccessible when you need them, and subject to complex tax rules with severe penalties for mistakes.
Before deciding, it is worth stepping back and looking at the full picture of your financial situation, including liquidity, career path, tax projections, and diversification. At KB Financial Advisors, we guide many of our clients through this decision. A thoughtful review can help you decide whether deferring compensation actually supports your goals or simply creates new risks.
If you have questions about how deferred compensation fits into your financial plan or want help evaluating your options, schedule a call with our advisors. We can walk through your specific situation and help you make confident choices.
