In the world of competitive employee benefits, a term that often comes up is the ‘Deferred Compensation Plan’. But what exactly does this term mean, and how does it work? In simple terms, a Deferred Compensation Plan is a contractual agreement between an employer and an employee, where the employee voluntarily chooses to have a portion of their income paid out at a later date.
Why would anyone choose to delay their income, you might wonder? There are quite a few reasons for this, which we’ll delve into in the coming sections. This setup can offer significant tax advantages and other financial benefits. It’s a nuanced topic, and like an intricate tapestry, we need to look closely to appreciate its intricacies.
Basics of Deferred Compensation Plans
To understand Deferred Compensation Plans, let’s first break down the phrase itself. ‘Deferred’ refers to something postponed or delayed, and ‘compensation’ is what an employee receives in return for their work—typically salary, but also bonuses, benefits, and more. Therefore, ‘deferred compensation’ refers to some part of an employee’s earnings that is put aside to be paid out later.
There are two broad types of Deferred Compensation Plans:
- Qualified : Qualified plans, such as 401(k)s, are more common and have specific tax advantages, but are subject to numerous rules and restrictions set out by the IRS.
- Non-qualified. Non-qualified plans, on the other hand, are more flexible and customizable, making them a popular choice for high-earning executives who have maxed out their qualified plan contributions.
For instance, imagine being in the shoes of Sarah, a high-earning executive at a major tech company. After contributing the maximum to her 401(k), she decides to participate in her company’s non-qualified deferred compensation plan, allowing her to defer additional income for future use, thereby reducing her present taxable income.
Benefits of Deferred Compensation Plans
Why would an employee, such as our hypothetical Sarah, choose to defer compensation? One primary reason is the potential for significant tax savings. When you defer income, you’re essentially moving it from the present to the future. This income isn’t subject to federal or state income tax until it’s distributed in the future, meaning you can invest and grow this money tax-free in the meantime.
To provide an illustration, let’s say Sarah opts to defer $50,000 of her salary this year. Instead of paying income tax on that amount now, she’s able to invest that full sum into her deferred compensation plan. If she’s in the highest tax bracket (37% as of 2021), this could mean a potential tax savings of $18,500 this year alone.
While the potential tax savings are substantial, deferred compensation plans also provide other financial benefits. For employees nearing retirement, these plans can serve as a form of income smoothing, helping them maintain their lifestyle after their regular income stops. For highly compensated employees, deferred compensation plans can supplement retirement savings beyond what’s possible with only a 401(k) or similar plan.
Table 1: Sarah’s Potential Tax Savings
| Amount Deferred | Tax Bracket | Potential Tax Savings |
|---|---|---|
| $50,000 | 37% | $18,500 |
Please note that while this table shows a simplified calculation, actual tax savings will depend on various factors including individual circumstances and changes in tax law.
How Deferred Compensation Plans Work
Lets see how these plans actually work. Let’s unravel this puzzle together.
- An employee agrees to defer a portion of their income, and this amount is set aside by the employer. The deferred income is invested, often in options chosen by the employee, such as mutual funds or index funds.
- During this period, the employee doesn’t pay income tax on the deferred money, and any investment growth is tax-deferred as well. This allows the employee to potentially build a larger retirement nest egg, much like compounding interest works in our favor over time.
- Once the employee retires or leaves the company, distributions from the deferred compensation plan begin. These distributions are subject to income tax, but the hope is that the employee’s tax rate during retirement will be lower than their tax rate while working, leading to overall tax savings.
However, there is an important detail to remember here. Unlike 401(k) plans, non-qualified deferred compensation plans are not protected from creditors in the event of company bankruptcy. If the company goes under, the deferred compensation could potentially be lost.
Drawbacks and Risks of Deferred Compensation Plans
While we have emphasized the benefits of Deferred Compensation Plans, it is crucial to remember that these plans also carry potential risks and drawbacks.
- As mentioned earlier, non-qualified deferred compensation plans lack the creditor protection enjoyed by qualified plans like the 401(k). In the event of company bankruptcy, deferred compensation might be lost. This is often referred to as creditor risk.
- Once the decision to defer compensation is made, it generally cannot be undone. This lack of flexibility could be a downside if an employee’s financial situation changes unexpectedly.
- Employees face what is known as investment risk. The deferred compensation is typically invested, and like any investment, it could increase or decrease in value.
- There is legislative risk, the possibility that tax laws could change in the future. If tax rates increase significantly by the time the deferred compensation is distributed, the anticipated tax savings could be diminished or even reversed.
Eligibility Criteria for Deferred Compensation Plans
Determining eligibility for Deferred Compensation Plans is important for both employees and employers. So, who can participate in these plans?
For qualified Deferred Compensation Plans like 401(k)s, eligibility is usually widespread, encompassing a large portion of the employee base. The exact requirements may vary from plan to plan and from company to company. Often, employees are required to work for the company for a certain period of time or meet a minimum age before they can contribute to the plan.
However for non-qualified Deferred Compensation Plans. These plans are typically offered to a select group of employees, often top executives or highly compensated individuals within the company. The reasoning behind this selectivity is two fold: Firstly, these employees are most likely to max out contributions to their qualified plans and need additional avenues for retirement savings. Secondly, offering these plans to a select few allows the company to avoid some of the rules and regulations that apply to broad-based plans, providing more flexibility for both the company and the employee.
Qualified Deferred Compensation Plans
Qualified plans are subject to stricter regulations under the Employee Retirement Income Security Act (ERISA), but they also offer unique benefits, namely creditor protection and upfront tax deductions for the employer.
Among the most popular qualified plans are 401(k) plans, which allow employees to contribute a portion of their pre-tax salary to a retirement account. The income is not taxed until it is withdrawn, typically during retirement. There are contribution limits set by the IRS, which as of 2023, is $22,500 annually for those under 50, and $30,000 for those over 50.
In addition, these plans often include an employer match, where the employer also contributes to the employee’s 401(k) up to a certain percentage of the employee’s salary. For example, an employer might match 50% of employee contributions up to 6% of their salary.
Key Differences Between Qualified and Non-Qualified Deferred Compensation Plans
| Criteria | Qualified Deferred Compensation Plans | Non-Qualified Deferred Compensation Plans |
|---|---|---|
| Rules & Regulations | Subject to ERISA, offering creditor protection | Not subject to ERISA, lack creditor protection |
| Contribution Limits | Set by the IRS | No set limit |
| Tax Advantages | Immediate tax advantages for employer and employee | Tax advantages mainly for the employee, realized upon distribution |
| Flexibility | Less flexible due to ERISA regulations | More flexible, can be customized to meet individual needs |
| Target Participants | Ideal for all employees | Mainly targeted towards executives and highly compensated employees |
Examples of non qualified deferred retirement plans
- Excess Benefit Plans: These are plans established to provide benefits to employees who have maxed out their contributions to the company’s qualified plan, often due to the IRS limits on annual contributions to these plans. These are typically offered to higher-income employees.
- Top-Hat Plans or Supplemental Executive Retirement Plans (SERPs): These are plans specifically designed for a select group of “top hat” employees (executives or high earners). They provide supplemental retirement benefits beyond what the qualified plan offers.
- Deferred Compensation Plans for Independent Contractors or 409A Plans: Independent contractors, partners, and directors who aren’t employees can participate in these plans. They’re governed by section 409A of the tax code, which has strict rules about when and how distributions can be made.
- Deferred Bonus or Incentive Plans: These plans allow employees to defer receipt of bonuses or incentive pay to a future year. This can be advantageous if the employee expects to be in a lower tax bracket in the future.
- Stock Options, Restricted Stock, and Phantom Stock Plans: These are types of equity compensation plans. While not technically deferred compensation plans, they can serve a similar purpose by providing future income.
Non-qualified plans are more flexible than qualified plans, allowing for customization based on the needs of the employer and employee. However, they lack some of the protections that ERISA provides, such as safeguards against creditors in case of bankruptcy.
Conclusion
In conclusion, Deferred Compensation Plans are a powerful tool for tax management and retirement planning, but they’re not without potential pitfalls. It’s important to understand the nuances of these plans, and the difference between qualified and non-qualified plans.
Consider your personal tax situation, the financial health of your company, your future financial needs, and any potential changes in tax law. Consult a financial advisor to help navigate these considerations and determine whether a Deferred Compensation Plan is the right strategy for you.
Remember Sarah, our high-earning executive? She didn’t just stumble upon her decision to participate in a Deferred Compensation Plan. It was a calculated decision made after careful evaluation of her current financial status, company’s stability, future financial goals, and potential tax advantages.
In the world of personal finance, knowledge is power. So whether you’re an employee considering a Deferred Compensation Plan, or an employer looking to provide competitive benefits, stay informed, plan strategically, and make decisions that align with your financial goals.