What is a Deferred Compensation

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Definition:

Deferred compensation is when an employer withholds part of an employee’s pay from their paychecks to set aside for use at a later date.

🤔 Understanding Deferred Compensation

Some employee benefits come in the form of deferred compensation, where an employer withholds part of an employee’s pay for later use. Money taken out for deferred compensation might go toward a pension or retirement plan, deferred savings, or stock options. Deferred compensation plans are often tax-advantaged, meaning the employee does not pay taxes on the income before it comes out of their pay. They usually won’t pay taxes on that income until it comes out of the deferred compensation plan years down the road. There are two different types of deferred compensation plans: qualified and non-qualified. Qualified plans generally have more protections for the employee, but they also have contribution limits. Non-qualified plans have no contribution limits but pose a considerable risk to the employee.

Example

Suppose Linda receives a promotion to a new job as an executive in her company. One of the perks the executives get is access to a non-qualified deferred compensation plan the company organizes. Linda has some money taken out of her paychecks to go toward the plan. Linda likes it because, unlike her 401(k), she can contribute as much as she wants with no limits set by the Internal Revenue Service.

Takeaway

Deferred compensation is like putting away money for a rainy day…

When you participate in a deferred compensation plan, you can have money taken out of your paycheck and put into an account for the future. Then, when a rainy day comes along (the rainy day usually being retirement), you can begin to withdraw the money. The only downside to withdrawing from this rainy day fund is that you’ll usually have to pay income taxes on it when you take the money out.

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How does deferred compensation work?

A deferred compensation plan is one that allows employees to set aside a portion of their income to use at a later date. In most cases, the income taxes are deferred, like the compensation. That means that instead of paying income taxes on the money when you earn it, you pay the taxes when you withdraw it from your deferred compensation plan.

Deferred compensation plans can be a type of investment account. Usually, your employer will offer you the choice of several different investment options, and you can choose which securities or funds to invest your deferred compensation in. That money has the potential to grow depending on the underlying investments, meaning you hopefully end up with t more than you contributed.

Then, once you retire, you can begin to withdraw the money in your deferred compensation plan as income. Unless your plan is a Roth plan (meaning you paid taxes on the money upfront), you will pay taxes on the money as you withdraw it from your plan.

What are the different types of deferred compensation?

There are two main/primary categories that a deferred compensation plan could fall under: qualified plans and non-qualified plans. The two types of plans differ in their features and in the laws that regulate them.

Qualified deferred compensation plans

Qualified deferred compensation plans originated from the Revenue Act of 1978, and are governed by the Employee Retirement Income Security Act (ERISA). ERISA became federal law in 1974. It sets standards for employer-sponsored retirement and health insurance plans.

Qualified deferred compensation plans are the retirement plans that many employers offer to their employees. When an employer offers this type of plan, it is usually available to all full-time employees at the company. The most well-known example of this type of plan is a 401(k) plan.

The federal government sets contribution limits for qualified plans. For example, 401(k) plans have a contribution limit of $19,500 in 2020 for participants under age 50 (though that limit only applies to money the employee contributes, not money the employer contributes).

When you contribute to a qualified deferred compensation plan, you also get to defer the income taxes on those contributions. So when you contribute to a 401(k) plan, you don’t pay income taxes until you take the money out during retirement. However, you still have to pay FICA taxes (a combination of Social Security and Medicare taxes) on the money you defer.

Taxes work a little differently if your 401(k) plan is a Roth 401(k). With a Roth plan, you pay income taxes on the money when you earn it, but then you can withdraw it tax-free during retirement.

Qualified deferred compensation plans offer more security to the employee. Let’s say you and your employer have both been contributing to your 401(k) plan, and then the company goes bankrupt. Creditors come after the company for all of the money they owe. With a qualified plan, the creditors in this scenario can’t touch your money. You can feel safe in knowing that money is yours, regardless of what happens with the company.

Non-qualified deferred compensation plans

Non-qualified deferred compensation plans as they exist today came as a result of the American Jobs Creation Act of 2004, which created Section 409A of the federal tax code. Unlike qualified plans, non-qualified plans are not subject to ERISA regulations.

Non-qualified plans are not available to most employees. Many companies choose to offer them only to their highly-compensated or executive employees. Companies also might offer them to independent contractors. And unlike qualified plans like the 401(k), employees can choose to defer as much of their income as they want into these non-qualified plans. The tax advantages of these non-qualified plans mirror those of qualified plans.

Non-qualified deferred compensation plans are unique in the lack of security in those funds. Remember, the money you put into a qualified plan like a 401(k) is your money, and it’s generally protected even if the company goes bankrupt. But, because they don’t fall under the purview of ERISA, that’s not the case for non-qualified plans. If you have contributed money to a non-qualified plan and your company files for bankruptcy, creditors could potentially claim the money in those non-qualified plans.

Despite the uncertainty with these plans, they can be extremely beneficial to employees who make a lot of money. They may have contributed the most they’re allowed into their 401(k) plan, but still want to put more away for retirement while deferring taxes. Non-qualified plans will enable them to do that.

What are the advantages and disadvantages of a deferred compensation plan?

There are a lot of perks that come with deferred compensation plans. These plans are a way to set aside income for retirement. Regardless of which plan you choose, there is a tax advantage. In most cases, you get the tax benefit at the beginning when you get to invest the money without first paying taxes on it. In the case of Roth plans, you get the tax advantage at the end when you get to withdraw the funds without paying additional taxes . There are conditions that have to be met for all of these plans, so consult your tax advisor for more precise information.

Along with the tax advantages of these plans, you can grow your money exponentially. The money goes into an account that your employer invests in funds and securities. Over many years, that money’s growth compounds, and you can end up with a lot more money than you started with.

Deferred compensation plans may also match a portion of your contributions (‘free money’) to put towards your retirement helping you to accumulate even more of a nest egg. In many cases, an employer might match your contributions up to a particular percent. If you make $100,000 and your employer contributes up to 5% of your income each year, you’re looking at $5,000 per year of free money. Stick around for 20 years and they could have contributed $100,000 to your retirement. And that doesn’t even account for any compounding of potential growth in the plan..

For all the perks they have, deferred compensation plans aren’t without their faults. The biggest disadvantage of the qualified plans is the contribution limit. If you want to save aggressively for retirement, the cap of $19,500 might be much lower than you’d like.

The biggest downside of the non-qualified deferred compensation plans is the chance that you could lose all of the money. If your employer goes bankrupt and creditors come after that money, there’s maybe nothing you can do to stop them. Because of this, it’s best to only take advantage of these non-qualified plans if you feel very secure in your company’s financial future.

The other thing to remember is that deferred compensation plans aren’t the only option for saving for retirement. Individual retirement accounts (IRA) also offer significant tax benefits and give you more control over your investment portfolio. An IRA is an account that, like 401(k) plans, allows you to defer taxes on the money you contribute. There is also a Roth IRA option, which enables you to pay taxes on the money first and then withdraw it tax-free during retirement. However, IRAs only have a contribution limit of $6,000 for 2020 (or $7,000 for those age 50 or older.)

How much should I contribute to deferred compensation?

So how much should you contribute to deferred compensation plans and other retirement accounts?

What some financial experts recommend is contributing at least enough to your 401(k) plan to get your full employer match. Before making any decisions with legal, tax, or accounting ramifications, you should consult the appropriate professionals.

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