When crafting your estate plan, it's vital to consider every aspect of your financial portfolio, including an often-overlooked yet critical component: deferred compensation. These arrangements can significantly influence your overall estate strategy and the financial future of your beneficiaries, making their inclusion in your plan essential.

What Is Deferred Compensation?

Deferred compensation refers to income you earn but choose to receive at a later date, often upon retirement or another triggering event. Common examples include 401(k)s, stock options, and non-qualified deferred compensation (NQDC) plans. While these plans provide immediate tax advantages by deferring taxable income to a later date, they introduce complexities when integrated into estate planning.

Understanding how deferred compensation interacts with your estate is key to ensuring your wishes are carried out effectively and your heirs avoid unnecessary tax burdens.

Tax Implications for Your Estate

Deferred compensation can impact your taxable estate, potentially increasing the estate tax liability for your heirs. For instance, if you hold significant amounts in deferred compensation plans, these assets may be included in your gross estate under federal estate tax laws. As of 2024, the federal estate tax exemption stands at $13.61 million per individual, meaning estates above this threshold may face substantial taxation. Also see "Ways to Deflect Capital Gains Tax: A Guide for California Real Estate Investors and Business Owners."

In California, while the state does not impose an estate tax, federal estate taxes can significantly affect high-value estates. Moreover, distributions from deferred compensation plans like 401(k)s and NQDCs are subject to income taxes when paid out to beneficiaries, adding another layer of tax complexity.

Case Example: Estate of Kollsman

In the landmark case Estate of Kollsman v. Commissioner, 113 T.C. 27 (1999), the court highlighted the importance of proper valuation and inclusion of all taxable assets in an estate. Although the case involved artwork rather than deferred compensation, the principles of accurate valuation and tax inclusion extend to all assets, including deferred compensation plans. Missteps in valuation or planning can lead to unexpected tax liabilities or disputes with the IRS.

The Role of Beneficiary Designations

Deferred compensation plans generally require you to designate a beneficiary who will receive the funds upon your death. Importantly, these designations often take precedence over instructions in your will or trust. If your estate plan and beneficiary designations are not aligned, your deferred compensation may end up in the wrong hands. Also see "Understanding Different Types of Trusts: Making the Right Choice for Your Estate Planning."

For example, if you named an ex-spouse as the beneficiary of a 401(k) years ago and never updated the designation, that individual might still receive the funds despite a subsequent will leaving everything to your children. Regularly reviewing and updating beneficiary designations ensures your assets align with your current wishes.

Statutory Reference: California Probate Code § 5000 reinforces that beneficiary designations on accounts like deferred compensation plans are generally non-probate assets, meaning they bypass the probate process and are distributed directly to the named beneficiaries.

Balancing Deferred Compensation with Retirement Goals

Deferred compensation is an excellent tool for supplementing retirement income, but it's crucial to balance it with other financial goals. Large distributions can impact eligibility for government benefits such as Medi-Cal or increase your Medicare premiums due to higher taxable income.

For example, a $100,000 NQDC payout might push you into a higher income tax bracket, affecting your eligibility for income-based benefits. Planning ahead with strategies such as staggered distributions or Roth conversions can help minimize tax impacts during retirement and ensure your estate plan remains intact.

Using Trusts for Better Management

Trusts can be a powerful tool for managing deferred compensation benefits, particularly in high-net-worth estate plans. A revocable living trust can help streamline the transfer of assets and avoid probate, while specialized irrevocable trusts, like a Beneficiary Designated Asset Trust (BDAT), can provide additional protections. Also see "The Rockefeller Cascade: A Multigenerational Wealth Strategy for Today's California Families." This article explores advanced trust strategies for wealth preservation, offering readers additional context on utilizing trusts in estate planning.

For example:

• Accumulation Trusts: These trusts allow deferred compensation payouts to be reinvested, offering tax deferral and asset protection for heirs.

• Charitable Remainder Trusts (CRTs): By transferring deferred compensation benefits to a CRT, you can support charitable causes while reducing your taxable estate.

Statutory Note: California's strict rules on irrevocable trusts and income taxation (Revenue and Taxation Code § 17742) must be carefully navigated, especially when deferred compensation is involved.

Plan Strategically for Your Beneficiaries

Without proper planning, deferred compensation payouts can lead to disputes or unintended consequences. For instance:

• Distributions may inadvertently push beneficiaries into higher tax brackets.
• Beneficiaries might spend funds irresponsibly without guidance or restrictions in place.
• Heirs with special needs could lose eligibility for government benefits due to lump-sum payouts.

An experienced estate planning attorney can help tailor your plan to account for these issues, ensuring a smooth transfer of deferred compensation benefits.

Let Us Help Secure Your Legacy

Deferred compensation is just one piece of the estate planning puzzle, but its impact can be profound. At the Law Office of James Burns, we specialize in creating customized estate plans that integrate every aspect of your financial life, from trusts and tax strategies to retirement assets and beyond.

With over 24 years of experience and a track record of delivering results for clients across California, we're here to help you achieve peace of mind and protect your legacy. Contact us today at (949) 305-8642 or visit us online at www.jamesburnslaw.com to schedule your consultation.

Take the first step in securing your family's financial future—let's build a comprehensive estate plan that works for you and your loved ones.