Choosing Between 401(k) Matching Dollars and Deferred Compensation Tax Savings

Company Matching Dollars refer to the additional money that your company contributes to your 401(k) account. These matching dollars are often referred to as “free money.” While I would not go so far, I agree that many savers need to prioritize maximizing these Company Matching Dollars. But, if you are a High Earning Corporate Executive with access to a Non-Qualified Deferred Compensation Plan, prioritizing the 401(k) Company Match Dollars over contributing more dollars to the Deferred Compensation Plan may cost you significantly more in taxes than the matching dollars you receive.

In this article, I’ll explain:

1.) How your Company Match Dollars are calculated.

2.) Why you are better off prioritizing contributing to the Non-Qualified Deferred Compensation Plan over maximizing the 401(k) Company Match.

3.) Why you should NOT solely rely on Deferred Compensation Calculators - typically on the Plan administrator’s website (e.g. Fidelity) - to provide you the full picture.

The Takeaway

If you just want the key takeaway, here it is: If you are in a marginal tax bracket of 32% or higher, you are likely better off forfeiting some Company Match Dollars in your 401(k) in exchange for the tax savings you generate from deferring income in the Deferred Compensation Plan. For example, if you decide to contribute $100,000 to the Deferred Compensation Plan, your tax savings could be around $10,000 - $15,000 depending on the difference in your tax rate today and when you receive the deferred compensation distribution. On the other hand, assuming your company matches 6% you are only forfeiting $6,000 of Company Match. In sum, the tax savings exceed the company match.

Word of Caution

Before I start, I need to add that the dollars contributed to a Non-Qualified Deferred Compensation Plan are essentially an IOU to your employer. In the case that your employer declares bankruptcy, you become a creditor and it is possible that you lose all the funds you contributed. I would like to say that if you work for a large publicly traded Fortune 500 Company, you do not need to worry too much about credit risk, but then I remember Enron…

Now, let’s use an example to discuss how the 401(k) matching dollars are calculated and when it makes sense to prioritize contributing to the Deferred Compensation Plan.

How Your 401(k) Matching Dollars are Calculated

Your eligible company match is calculated as a percentage of your eligible cash compensation which includes Salary and Cash Bonus, but NOT any equity compensation.

For 401(k) Matching Dollars, the IRS limit for eligible cash compensation is $330,000 (in 2023). This means that if your company matches 6% of your eligible cash compensation in the 401(k), you are eligible for up to $19,800 (6% X $330,000) of Company Match. If you earn less than $330,000 of cash compensation, you would be eligible for 6% of what you earn.

Now, let’s add a wrinkle. If you contribute to a Non-Qualified Deferred Compensation Plan, the amount of the contribution is counted against your eligible cash compensation. Let’s continue the above example and assume that you decided to contribute $100,000 to the Non-Qualified Deferred Compensation Plan. Your eligible cash compensation is now $230,000 ($330,000 - $100,000) and your 401(k) eligible match is now $13,800 ($230,000 X 6%.)

You have left $6,000 on the table because you contributed $100,000 to the Deferred Compensation Plan and lowered Company Match but here is the flip side…

Prioritize Tax Savings over Company Match

Remember that equity compensation is NOT included in calculating your eligible company match, but it IS included in your taxable income. The point is that once equity compensation is accounted for you are likely in at least the 35% marginal tax bracket.

The $100,000 contribution to the Deferred Compensation Plan is not taxed until you receive the distribution in the future. If you plan correctly, you will have a lower tax rate at the time of distribution. If we assume that your current tax rate is 35% and your future tax rate is 22%, the tax savings are $13,000 ($100,000 X the 13% difference in tax rates.) Essentially, you avoid paying 35% on that income today, invest the gross amount for several years, and pay a much lower tax rate on the distribution – which includes your initial contribution plus any investment growth. In this scenario the $13,000 tax savings from the Deferred Compensation Plan exceed the $6,000 of 401(k) Company Match Dollars.

When you are deciding whether to prioritize the Deferred Compensation Plan over the 401(k) Matching Dollars you will want to consider three variables.

What to Consider

1.) You expect your future tax rate to be significantly less than your current tax rate. The most common scenario is that you plan to take the distributions during retirement but before you receive other taxable income such as required minimum distributions from your IRA and Social Security. Your 60s offer a great opportunity to take these distributions without other taxable income that may push you into a higher tax bracket.

2.) Your employer – the sponsor for the Deferred Compensation Plan – is a healthy company with minimal credit risk. Remember, you do not technically earn the income you contribute to the Deferred Compensation Plan until you receive the distribution. In the case that the Company declares bankruptcy, you will become a creditor and potentially lose your contributions.

3.) You want the Deferred Compensation Plan to offer similar investments to the 401(k) Plan. I have seen plans that offer only a limited number of investment options in the Deferred Compensation Plan. In the case these options offer lower returns and/or unattractive investment options, you may want to consider prioritizing the matching dollars.

Maximum Match Calculators

This topic is pretty technical but it answers a frequent question from the type of clients that work with my firm. You need to be careful of the “Maximizing Match Calculators” that are often provided by the Plan’s administrator. For example, if you are a Walmart employee, you have access to the Walmart DCMP calculator resource on the Fidelity site - Walmart DCMP Calculator - but it does not take into account the potential tax savings from contributing more to the Deferred Compensation Plan. It simply tells you if you are maximizing the company match in both the 401(k) Plan and Walmart Deferred Compensation Plan but, again, the potential tax savings should be considered in this decision. If you are facing the decision of whether to maximize your 401(k) match or contribute more to the Deferred Compensation Plan, feel free to schedule a quick call with me here. I’m always happy to get in front of people and help them through an important decision.

Mark Chisenhall, CFA is the founder of Taurus Financial Planning, a wealth management firm specializing in helping high-earning corporate executives reduce taxes, optimize investments, and accelerate retirement.

This publication is for informational purposes only and is not intended as tax, accounting or legal advice as an offer or solicitation of an offer to buy or sell or as an endorsement of any company security fund or other securities or non securities offering.