The Most Common (and Costly) Mistake on Deferred Compensation Plans

Deferred Compensation Plans - such as the Walmart DCMP - are the most powerful tool available to executives seeking to reduce their tax bill. By deferring income during high-earning years and taking distributions in lower-income years (such as retirement or a second career), many executives can unlock tax savings worth hundreds of thousands of dollars.

But to maximize the benefit, you need to get two decisions right:

1. How much to contribute to the Plan each year

2. When you receive the distributions (and pay taxes)

   
   

While most executives focus on the contribution decision, the distribution schedule is often overlooked. Unless both are working in tandem, the strategy can backfire—leading to unexpectedly high tax bills and missed savings.

In this case study, you’ll see how John, an Executive at a Fortune 100 Company, made a common mistake—and how a small change helped him rectify this mistake saving him over $250,000 in taxes!

John’s Situation

John is a Vice President at a large retailer. For years, he has deferred 100% of his Annual Bonus and a portion of his salary to his Company's Deferred Compensation Plan. Each year, he enjoys calculating how much the tax-deductible contribution reduces his tax bill for that year.

He has accumulated $1 million in his Deferred Compensation Plan and plans to continue contributing to the Plan until his retirement in five years.

Looking for a second set of eyes to validate and help prepare for the biggest financial decision of his life, John hires a flat-fee financial planner—someone who charges an hourly rate and offers objective guidance without requiring him to move his investments, pay a fee based on the size of his investments, or sit through sales pitches for commission-based products.

Together, they uncover a serious issue:

❌John’s entire Deferred Compensation balance is scheduled to pay out as a Lump Sum in the same year he retires.

That means his payout of $1M plus 5 years of additional contributions will be stacked on top of other taxable income including a partial year of salary and his final equity vesting.

All of it taxed in a single year—creating a massive tax spike. 📉💸

Once salary and equity compensation are accounted for, the deferred comp payout would be taxed at a rate of at least 35% resulting in a tax liability of almost $800,000 - just from the Deferred Comp payout.

For simplicity and to isolate the tax savings, a 0% growth rate is assumed. 2024 MFJ tax table.

The Mistake: Lump Sum Distribution

This is one of the most common and costly mistakes with Deferred Compensation Plans—defaulting to a Lump Sum Distribution the year of retirement.

Why? Because many executives make this election years in advance, without thinking about how the distributions will be taxed in the future. Additionally, the Lump Sum option is often the default method for many Plans.

And once the distribution elections are made, they are typically irrevocable, but fortunately, there’s a fix for John!

The Fix: The 5+1 Rule

John’s financial planner introduces him to the 5+1 Rule, which allows him to modify his distribution schedule—but there is a catch. The rule requires John to meet two criteria:

• Delay the payouts by at least 5 additional years, and

• Request the change at least 12 months before separating from the company.

  
  

Since John still has five years to go until retirement, he has an opportunity to rectify the mistake.

The Plan: Build a Smoother, Tax-Efficient Distribution Schedule

Here’s what they do:

• Together, John and the Planner call the Plan Administrator (e.g. Fidelity) and verbally request a "Change Election."

• They elect to delay the lump sum payout and instead receive annual installments over 10 years, beginning in Year 6 after retirement.

• Over the next five years, John continues contributing to the plan. Each year’s new contribution is set to pay out in Years 1–5 of retirement.

  
  

This strategy provides:

✅ Smoother, more predictable cash flow across the first 15 years of retirement.

✅ A much lower effective tax rate on distributions.

✅ Longer tax deferral allowing John to keep more dollars invested for longer.

💰Estimated tax savings: $260,000

For simplicity and to isolate the tax savings, a growth rate of 0% is assumed. Assume no other taxable income. 2025 MFJ tax table.

Note: For this example, we assumed a 0% growth rate on the contributions to illustrate the value solely from tax savings. In reality, deferring taxes allows the participant to earn a return on future tax liabilities resulting in wealth creation above and beyond just these tax savings!

Avoiding the Most Common Deferred Compensation Mistake

Most executives think the tax savings of Deferred Compensation Plans happen at the time of contribution. But the decision must be coupled with a tax-efficient distribution strategy.

✅ Contributions: Defer income that would be taxed at high rate - 32% or higher.

✅ Distributions: Manage distribution payouts so they meet funding needs but also stay in a lower tax bracket - 24% or less.

✅ 5+1 Rule: If needed, exercise the 5+1 Rule to smooth out the distributions over multiple years to maintain lower tax rates.

If you’re participating in a Non-Qualified Deferred Compensation Plan - like the Walmart DCMP - it’s worth reviewing your elections. For those participating in the Walmart DCMP, Fidelity offers a statement showing your current distribution schedule

A few small changes to your Deferred Compensation strategy can potentially save you $100,000s in taxes - this translates to more financial freedom to live the life you want!

Interested in Working with Us? Let's Talk

Thanks for reading,

Mark Chisenhall, CFA, MBA

Financial Advisor | Founder of Taurus Financial Planning

Taurus Financial Planning is a Fee-Only Wealth Management firm based in Bentonville, AR. The firm offers comprehensive financial planning, tax planning and investment management to corporate executives across the country.

Taurus Financial Planning is a Registered Investment Advisor with the State of Arkansas. This information is provided as a guide to assist you in your financial planning. The specific examples are provided for illustration purposes only and are not representative of specific investments or guarantees of future returns. Please consult with a professional for specific questions regarding your particular situation. If there is any error or inconsistency between this document and the official company plan documents, your company plan documents will govern.

This publication is for informational purposes only and is not intended as tax, accounting or legal advice or 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. This publication should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made by the Author, in the future, will be profitable or equal the performance noted in this publication.