Understanding the Microsoft Deferred Compensation Plan
The Microsoft Deferred Compensation Plan (DCP) lets eligible employees defer a portion of their income until a future year. This deferral will reduce your taxable income for the current year, which can save you thousands of dollars in taxes. Here’s what you need to know.
Key Takeaways
The Microsoft DCP allows high-earning employees to defer a portion of their salary and bonuses, reducing taxable income for the current year.
Deferred funds are invested, offering tax-deferred growth that can boost long-term wealth if investments perform well.
Salary deferrals can be made during November and bonus deferrals in May. Decisions are locked in for the year after each window closes.
The DCP is ideal for those with high incomes who can strategically manage cash flow and anticipate lower future tax brackets.
What Is the Microsoft Deferred Compensation Plan?
The Microsoft Deferred Compensation Plan (DCP) allows high-earning employees to delay some of their salary or bonuses until later. If you are eligible for the Microsoft DCP, you can defer two primary types of income:
Salary: You can defer up to 75% of your base salary.
Bonuses: You can defer up to 100% of your annual cash bonus.
The deferred funds are then invested as you choose, similar to a 401(k). If your investments pay off, the funds will grow until you are ready to withdraw them, usually during retirement. The funds are taxed as ordinary income at withdrawal.
How It Works
Here’s a step-by-step rundown of how the Microsoft DCP functions:
Determine eligibility: Verify that you meet the criteria to participate. Only Microsoft employees at Level 67 or higher can enroll in the DCP.
Plan your deferrals: Decide how much of your salary and/or bonus you want to defer.
Choose investments: Once you've determined your deferral amounts, select from 24 investment choices. These options mirror those available in the Microsoft 401(k) plan, including various stocks and bonds. The deferred funds are not directly invested in these choices but are tracked by Microsoft, which guarantees the performance of the selected benchmarks.
Choose your withdrawal schedule: When enrolling, you must select how and when to receive your deferred income. You can choose between:
Lump sum: Receive all deferred funds at once when you leave the company or reach a specified date.
Installments: Spread distributions over 5, 10, or 15 years. This choice impacts your tax burden, so careful planning is essential.
Receive distributions: Once the elected distribution period begins, you will start receiving payouts based on your chosen schedule. Distributions are considered taxable income in the year they are received, so careful timing can help optimize tax impacts.
Eligibility
To be eligible for the Microsoft DCP, you must be a Level 67 employee or higher. This typically includes senior-level positions such as directors, senior directors, and other executive roles. The DCP is specifically tailored for high-earning professionals who wish to defer a portion of their compensation to future years.
Enrollment
Enrollment in the Microsoft DCP occurs during two key windows each year:
The enrollment period for salary deferrals is November 1 to November 30. Any deferral elected during this period will apply to your salary for the following year, beginning in January.
The enrollment period for bonus deferrals is May 1 to May 31. This will apply to bonuses received in the following year, specifically in September.
Once the enrollment windows close, your deferral choices are locked in for that year. You can adjust how you allocate your investments, but you can’t change how much you defer until the next enrollment window.
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Tax Benefits of Deferred Compensation
Deferring income through the Microsoft DCP can provide significant tax advantages. Here’s how.
Reducing Taxable Income
By deferring part of your salary or bonus to a future year, you reduce your taxable income for the current year. This can result in immediate tax savings, especially if you’re in a high tax bracket. The lower taxable income may place you in a lower marginal tax bracket, reducing your federal and state tax bills.
Paying Taxes at a Lower Rate
By using the Microsoft DCP, you can choose when you want to receive the deferred compensation. Most employees opt to receive distributions after retirement, when their income is lower than during their peak earning years. This means the distributions may be taxed at a lower rate than if you accepted them now.
State Tax Considerations
Some states tax the income of residents, while others do not. If you retire in a state with no income tax, such as Washington, Florida, or Texas, you will not have to pay state taxes when you withdraw your deferred funds.
Tax-Deferred Growth
The DCP allows you to invest your deferred funds. They will then grow tax-deferred until you are ready to withdraw them. This means you can increase your wealth over time through compound interest with no immediate tax impact.
Estate Planning Benefits
Deferring compensation can also play a role in estate planning. If you don’t withdraw the entire deferred amount during your lifetime, the remaining funds may be passed to heirs. Properly structured, this can offer tax advantages to your beneficiaries, especially if they are in lower tax brackets.
Potential Risks and Considerations
While the Microsoft DCP offers significant tax and financial planning advantages, there are notable risks and considerations to keep in mind. (Though these downsides can be mitigated — more on that below.)
Credit Risk
Deferred compensation is an unsecured liability of Microsoft. This means that, unlike a 401(k) plan, which is protected by federal law (ERISA) and held in a separate trust, DCP funds are part of Microsoft’s general assets. If Microsoft were to face financial instability or declare bankruptcy, the deferred funds would be at risk since they are subject to the claims of creditors. Essentially, by participating in the DCP, you become an unsecured creditor of the company.
Locked-In Deferral Decisions
Unlike 401(k) contributions, which can be adjusted throughout the year, DCP elections are final once the enrollment window closes. Once you decide how much of your salary or bonus to defer, that decision is irrevocable for the year. This lack of flexibility means you must accurately forecast your cash flow needs and financial goals well in advance.
Investment Risk
Although the DCP offers a variety of investment options, the funds are not directly invested. Instead, Microsoft tracks the performance of your selected investment choices internally. This can expose participants to both market risk (through the selected investments) and company risk (if Microsoft’s financial condition changes).
Cash Flow Management
Deferring income means it won't be available for your immediate use, which can strain your cash flow. This can be particularly challenging if unexpected expenses arise, especially if a significant portion of your compensation is deferred.
PRO TIP: Given that deferring a significant portion of your salary could strain cash flow, consider selling your Microsoft restricted stock units (RSUs) as they vest to cover living expenses. This can provide liquidity without tapping into deferred funds, especially if those RSUs form a large portion of your compensation.
Tax Timing Risks
While deferring income can result in significant tax savings, poor timing of withdrawals can negate these benefits. If you receive large distributions in a single year, it could push you into a higher tax bracket, increasing your overall tax burden. And if tax rates rise, deferred income could be subject to higher taxes than anticipated.
State Tax Implications
State tax rules can change based on your location during distribution years. For example, if you defer income while working in a state with no income tax (like Washington) but move to a state with a high-income tax before withdrawing, you could face unexpected state taxes.
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Tips for Maximizing Your Microsoft Deferred Compensation Plan Benefits
To get the most out of the Microsoft DCP, you’ll want to plan ahead. Here are key tips to maximize your DCP benefits.
Plan Your Cash Flow Needs Carefully
Before deciding how much to defer, evaluate your cash flow needs for the upcoming year. Deferring a large portion of your salary or bonus can create cash shortages if you don't have other sources of income. Ensure that you maintain sufficient liquidity for day-to-day expenses, emergencies, and unexpected costs.
Maximize Other Tax-Advantaged Accounts First
Before committing substantial amounts to the DCP, prioritize contributions to other tax-advantaged accounts like your 401(k), health savings account (HSA), and Roth IRA. These accounts offer additional tax benefits and protections that the DCP does not, such as employer matching on 401(k) contributions or tax-free growth on Roth IRA withdrawals.
Choose the Right Investments
The DCP offers a variety of investment options that mirror Microsoft’s 401(k) selections. The right choice depends on your timeline and risk tolerance. For shorter-term goals, consider more conservative investments to preserve capital. For long-term goals, take advantage of higher-risk options with greater growth potential. And remember: diversifying your portfolio is the best way to protect yourself from market volatility.
Monitor and Adjust Investments Over Time
Although your deferral decisions are locked in annually, you can adjust your investment choices within the DCP at any time. Regularly monitor your portfolio to ensure it aligns with your risk tolerance, financial goals, and market conditions.
Spread Distributions Out
One of the core benefits of the DCP is controlling when your income is taxed. While the Microsoft DCP has a lump sum option, it’s usually better to spread your payments out over multiple years. This will avoid a tax spike from a single lump sum payout. For instance, taking installments over 5, 10, or 15 years helps smooth out tax liability and reduces the risk of a hefty tax bill in any single year.
Work with a Fiduciary Financial Advisor
Navigating the Microsoft DCP requires a comprehensive plan. A fiduciary financial advisor can give you the insights you need to make informed decisions and make the most of your deferred compensation strategy. Because fiduciary advisors are legally obligated to act in your best interests and disclose any potential conflicts, you can rest easy knowing your finances are in trustworthy hands.
Microsoft Deferred Compensation Plan vs. 401(k): What's the Difference?
The Microsoft DCP and Microsoft 401(k) both offer a way to defer a portion of your salary and invest it for long-term growth. However, there are some distinct differences.
Contribution limits: The DCP allows for higher deferrals — up to 75% of salary and 100% of bonuses, with no cap on contributions. 401(k) contributions are capped annually by the IRS, limiting the amount that can be deferred each year.
Contribution window: DCP contributions are only allowed during specific windows each year. After that, decisions are locked until the next window. The 401(k) offers more flexibility, allowing changes throughout the year, up to IRS annual limits.
Investment protection: DCP funds are not directly invested by Microsoft, but rather tracked. This makes them an unsecured liability of the company. 401(k) funds are protected by ERISA, safeguarding them from creditors even in bankruptcy.
Employer match: The Microsoft DCP has no employer match feature. The 401(k) has a 50% employer match for all employee contributions up to the IRS limit.
Required minimum distributions (RMDs): The DCP does not require mandatory withdrawals, allowing more control over when to access funds. In contrast, traditional 401(k) accounts require RMDs starting at age 73.
Penalty exceptions: The DCP has no early withdrawal feature. Once you set a distribution schedule, it can’t be changed. The 401(k), on the other hand, allows early withdrawals, though there may be a penalty. (This penalty is waived for certain needs, such as a first-time home purchase or educational expenses.)
Loan availability: The 401(k) allows participants to take out loans against their balance, up to certain limits. The DCP does not have a loan feature, making it less flexible if you need to access funds in an emergency.
Both the Microsoft DCP and 401(k) are great options for high-earnings hoping to save more for retirement. However, they are not equally suited for every employee or financial plan. Your fiduciary financial advisor can help you make the best choices for your unique situation.
PRO TIP: Microsoft matches 50% of all employee 401(k) contributions up to the IRS limit. Fully fund your 401(k) before deferring any funds to the DCP, which does not include an employer match.
Get Help from TrueWealth!
The Microsoft Deferred Compensation Plan is a powerful tool for high-earning employees to defer income, optimize tax savings, and invest for long-term growth. However, the complexities and potential downsides of this plan can make it risky. It’s always better to have a little help from the pros.
At TrueWealth, we're here to help you make the right decisions. Our team of fiduciary financial advisors will help you build a retirement strategy that aligns with your goals. Schedule a free consultation today, and we’ll be happy to answer all your questions.
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FAQs
What is the Microsoft Deferred Compensation Plan?
The Microsoft Deferred Compensation Plan (DCP) is a benefit for eligible employees (Level 67 and above) that allows them to defer a portion of their income (like salary and bonuses) to a future year. This strategy can help employees reduce taxable income in high-earning years, potentially lowering their tax liability when the income is eventually received, often in retirement.
Is the Deferred Compensation Plan a good idea?
The DCP can be a smart strategy for high-income earners who expect to be in a lower tax bracket after retiring. However, it requires careful planning due to limited flexibility with withdrawal schedules and the risk associated with Microsoft’s financial stability. A fiduciary financial advisor can help you understand the risks and benefits in your case.
Can I change my distribution schedule once it's set?
Once you've selected a distribution schedule, changes are limited. You can push your chosen date back, but it must be extended by at least five years, and will you need to make this decision at least 12 months before the original payout date.
When can I withdraw money from my Microsoft Deferred Compensation Plan?
Withdrawals from the DCP can only occur based on the distribution schedule you set when you deferred the income. Options include a lump sum payment or regular installments over 5, 10, or 15 years. Changes to this schedule are possible but limited.
Are there any penalties for withdrawing funds early from the DCP?
Unlike a 401(k), there are no early withdrawal penalties for the DCP, but you cannot access the funds outside of the pre-determined payout schedule unless you've extended the distribution. It's crucial to plan your deferrals carefully to match your anticipated financial needs.
What happens to my deferred compensation if I leave Microsoft?
If you leave Microsoft, your deferred funds will be distributed according to your chosen schedule. If you didn't select a specific distribution method, you will receive the full amount as a lump sum payment when you leave the company. This could have significant tax implications, making it important to set up a favorable distribution schedule from the start.
Can I lose my deferred compensation at Microsoft?
Yes, the DCP funds are an unsecured liability, meaning they are not protected under federal ERISA laws like a 401(k). If Microsoft faces financial trouble or bankruptcy, there is a risk of losing deferred compensation. It’s advisable to diversify your overall portfolio to mitigate this potential risk.
What happens to my deferred funds if I pass away before all distributions are complete?
In the event of death, any remaining deferred compensation is typically paid out to your beneficiaries. The specifics can vary depending on when the deferrals were made. Pre-2014 deferrals may be paid within one month, while post-2014 deferrals may take up to six months to distribute.
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