When looking at AbbVie’s Deferred Compensation Plan (DCP) and deciding if you should use it, one of the main determinations is going to be tax rates – both now and in retirement.
In general, you are required to report your income on your current tax return. However, the AbbVie DCP allows you to defer the recognition of your income from the current year to a future year.
Fine. Give me two reasons why I should be participating in the DCP.
The first reason to do this is to reduce your current tax burden. As a high earner, you may find yourself in the higher federal and state tax brackets. However, if you anticipate being in a lower tax bracket in the future, such as during retirement, then deferring income to those years can lead to a lower overall tax bill on the deferred amount.
The second reason is to create another stream of income in retirement. Many people go into retirement relying on account withdrawals and Social Security to provide them the income they need. However, at AbbVie, you also have a pension and if you participate in the DCP, you can create multiple streams of income.
Let’s look at an example of how the DCP can work in changing your overall tax situation:
James is single, age 50, lives in Florida, works remotely for AbbVie and earns $500,000 in income from a variety of salary and bonuses. He plans on retiring at 60, so has 10 years to plan how his retirement income will look. He only needs $250,000 to cover his lifestyle, so has $250,000 (before taxes) to decide what to do with.
If he were to recognize all this income on his tax return, his top Federal tax bracket would be 35%. (As he lives in Florida, he doesn’t have to worry about state income tax because it’s 0%). James can defer money to his HSA, and 401(k), but after that, he is still left with close to $200,000 in excess income from his needs. At a 35% tax rate, he’ll be paying $70,000 in taxes to turn around and invest $130,000 where he sees fit.
For examples sake, if he were to defer the whole $200,000, he would avoid paying $70,000 in taxes. If that deferral amount went into the DCP, and he invested it assuming a rate of return of 6%, he’d have a balance of approximately $3,000,000 at age 60 assuming he invested $200,000 a year until he retires. If he withdrew this over a 15-year period, this would be a $200,000/year payout. If that was the only thing he used for his retirement income, the bulk of his income would be in the 24% bracket and below. In this extreme example, and using rough math, James is saving a significant amount of money in taxes.
If this were a real-life example, I wouldn’t suggest deferring the whole amount to the DCP because having all your money in tax-deferred accounts isn’t the best strategy when planning for retirement income.
Here’s how I would design this scenario….
The goal for building a diversified portfolio and retirement income stream is to not defer as much taxes as you can at the beginning. By deferring the maximum amount of taxes at the beginning, you handcuff yourself to tax deferred accounts and the tax brackets when you start to withdraw from them.
When you get into retirement the only way to create your income is to withdraw from these accounts and all these withdrawals are subject to income tax rates. These rates can change throughout time so there's no way of knowing if the rates now are low compared to what they be in the future. Also, having all your money in one type of account it doesn't give you a lot of tax flexibility when you need it.
If I were advising James in the example above, I would have him take his $200,000 and split it almost down the middle I would have him take $135,000 and recognize it as income and have roughly $100,000 to invest in a taxable portfolio once income taxes are paid. The remaining $65,000 I would suggest he put into the AbbVie DCP.
Using the same assumptions as above, if $65,000/year went into the AbbVie DCP for 10 years, with an assumed rate of return of 6% a year, when James retires, he'll have an income stream of $67,000 for 15 years. Using the same assumptions, if we then look at the $100,000 that was invested in a taxable account, that account balance has now risen to approximately $1,5000,000.
This now gives James some flexibility.
If James has an expense that comes up which is over and above his income streams, he can choose where to take money from. He can either choose to take it from his 401(k) or he can choose to use his taxable account – each account withdrawal having different tax consequences. In using his taxable account, if he were to sell positions when withdrawing from the account, that will be subject to capital gains rates which is between zero and 20%. If he were choosing to take it out of his 401(k), it gets layered on top of his AbbVie DCP withdrawals where it's all subject to his marginal tax brackets.
When it comes to using the AbbVie DCP, it's not all about current tax deferrals. You must start planning into the future to determine how much flexibility you need and paying a little bit more in taxes now can actually save a lot of taxes in the long run.
If you're interested in talking about your situation to determine if you should be using the AbbVie Deferred Compensation Plan, let's chat.