The Complete Guide to Deferred Compensation Plans

What is a Deferred Compensation Plan?

Picture nearing retirement, a stress-free future on the horizon, but then you're hit with the reality of taxes eating into your savings. It's a common worry, so how can you save effectively without losing a huge proportion of your savings to taxes? The simple answer is a deferred compensation plan.

A deferred compensation plan is a savvy financial strategy for anyone looking to manage their income taxes smartly. It's a financial arrangement in which you, as an employee, opt to have a portion of earnings set aside. These earnings can then be paid at a later date, usually at retirement.

This is a key strategy in smart retirement planning which allows you to defer taxes on your income until it's distributed.

Why is this beneficial? By deferring compensation, you're postponing when you pay taxes and potentially the amount of taxes paid. Because deferred compensation plans usually mean receiving this income during retirement, when you could be in a lower tax bracket, the income taxes due could be less than what you currently have to pay.

Basically, it's a strategic move to maximize your earnings and reduce your tax burdens.

Who are deferred compensation plans for?

Deferred compensation plans are particularly attractive for high-income earners. This is because most high earners are in a tax bracket that takes a significant percentage of their earnings. But they're pretty much great for anyone looking to enhance their retirement savings while managing their current tax liabilities with less stress.

Types of Deferred Compensation Plans: 457b and NQDC

Deferred compensation plans work differently depending on your employment scenario. The two main types are 457b plans and Non-Qualified Deferred Compensation (NQDC) plans. Take a look at the differences between the two, so you can see which one works better for your financial goals.

457b plans

These are mainly for government and certain non-profit employees, in addition to being quite unique. They share lots of similarities with 401(k) plans but stand out because of their flexible withdrawal rules. Here's what makes these plans appealing:

• Pre-tax contributions: Contributions are made from your pre-tax income, which reduces your taxable income.
• No early withdrawal penalties: Unlike 401(k) plans, 457b plans allow you to make withdrawals upon leaving the employer without the 10% penalty. Do bear in mind that normal income taxes will still apply.
• Contribution limits: These plans have generous contribution limits, which can translate to substantial retirement savings.

These plans are great for eligible employees who want to save for retirement while enjoying immediate tax benefits.

Non-Qualified Deferred Compensation (NQDC)

NQDC plans are more widely accessible and are offered by private-sector employers. They're a very flexible way for employees, especially those who earn a lot, to defer income. Its key features include:

• Deferred income: You can defer a portion of your salary, bonuses, or other compensation to a later date, which is typically the date of retirement. This reduces current taxable income.
• Investment growth: The deferred money can be invested, growing tax-deferred until it's withdrawn.
• Tailored to individual needs: NQDC plans offer customizable deferral and payout options that can be aligned with your own strategies and preferences.

It's important to note that NQDC plans usually come with their own set of risks (which we'll touch on soon) since they aren't protected like 401(k) and 457b plans.

Advantages of Deferred Compensation Plans: Why You Should Consider Them

Companies often introduce deferred compensation plans to keep employees motivated and to help with their financial planning. However, there are a lot more advantages that include:

Tax deferral

One of the major benefits of deferred compensation plans is the ability to defer taxes. To reiterate, the money you contribute to these plans isn't taxed until it's withdrawn. This could mean being on the receiving end of significant tax savings, especially if you're in a lower retirement tax bracket compared to your working years. What could this mean? A much comfier retirement.

Tax-efficient savings growth

Since the funds in this plan grow tax-deferred, they can gain interest over time without the annual tax drag. This potential for higher growth compared to taxable investments is what makes these plans attractive for gaining long-term savings.

Reduction in current taxable income

Contributing to deferred compensation plans means seeing a reduction in your current taxable income. This is the reason why lots of high-earners want to immediately lower their tax bill.

Retirement savings boost

These plans offer an extra route to save for retirement, which can be highly beneficial for those who have reached their contribution limits in other retirement accounts like 401(k)s or IRAs.

Potential for employer match

In some cases, much like the 401(k), employers may match a portion of your contributions, which can increase your retirement savings quite significantly.

Customizable withdrawal options

Deferred compensation plans have a variety of options when it comes to receiving payments. This means you can align your withdrawal strategy with your retirement and tax planning needs.

Higher contribution limits

More often than not, these plans come with higher contribution limits than traditional retirement accounts. This feature is very advantageous for those who earn a lot, as it lets them defer a significant amount of their income.

Additional financial incentives

When it comes to employee financial incentives, profit sharing is another avenue. Platforms like ShareWillow offer innovative solutions for profit sharing, which can synergize employee efforts and company success. This approach can complement deferred compensation plans, giving employees a comprehensive financial incentive package.

Be sure to check out our guide on 401(k) profit sharing plans.

Understanding the Risks and Limitations

Although deferred compensation plans work well for many, it's still important to understand the risks and limitations. These factors can impact your retirement income and total income taxes. Here's a breakdown of the key risks...

Risk of loss due to employer bankruptcy

In non-qualified deferred compensation plans, assets aren't insulated from the employer's creditors. If your employer faces bankruptcy or serious financial issues, the funds you've accumulated in your compensation plan could be at risk. This lack of protection is a lot different compared to that of 401(k) plans.

Lack of early access and penalties

Deferred compensation plans are designed for long-term savings, and because of this, they come with strict rules on early withdrawals. If you need to access these funds before the specified date, you could face penalties and immediate taxation.

This makes the money in these plans less liquid and accessible compared to other investment options, like a regular savings account.

Limited investment choices

Another limitation is the potentially narrow range of investment options. Unlike other retirement plans, like 401(k)s or IRAs, deferred compensation plans typically have a more limited selection. This constraint may affect your ability to diversify your investments to fit into your financial strategy.

Future tax rate uncertainty

A lot of people opt for deferred compensation plans because of the tax deferral aspect. But, they still come with the uncertainty of future tax rates. So, there's a possibility that you could be in a higher tax bracket come retirement, especially because of how unpredictable tax laws can be.

This uncertainty can lead to higher tax liabilities than you initially expected and affect the net value of your retirement income.

Legal Aspects of Deferred Compensation Plans

Both employers and employees need to understand the legal aspects of deferred compensation plans. These plans are governed by specific tax laws and regulations to ensure fairness and compliance.

Compliance with IRC Section 409A

Deferred compensation plans are subject to the Internal Revenue Code Section 409A. This is a regulation that sets strict guidelines on deferrals and distributions. Following these rules is important as failure to do so could result in immediate taxation, penalties, and interest charges.

Plan documentation and communication

Proper documentation is a legal requirement for deferred compensation plans. The documents need to clearly outline the plan rules, including the timing of deferrals and distribution. Also, employers are obligated to communicate these details to eligible employees. Transparency ensures employees are fully aware of the plan's workings and their rights within it.

Fiduciary responsibilities and reporting requirements

With a qualified plan, employers have fiduciary responsibilities under the Employee Retirement Income Security Act (ERISA). This means that they're in charge of managing and protecting the plan's assets. These plans are also subject to reporting and disclosure requirements.

Anti-discrimination rules for qualified plans

To promote fairness, qualified plans must adhere to anti-discrimination rules. These rules ensure that the plans don't disproportionately favor employees who earn more over those who earn less. This is important for maintaining the integrity of the plan.

Seeking legal or tax advice

Given how complex these regulations are, it's recommended that employers and employees seek legal or tax advice from qualified professionals. A tax advisor can give guidance on how participating in these plans could affect individual tax obligations, like Medicare taxes.

How to Offer a Deferred Compensation Plan as an Employer

Here's a step-by-step guide on how to offer a deferred compensation plan:

1. Set up a plan

The process begins when an employer decides to offer a deferred compensation plan. This is usually part of the negotiation phase before finalizing employment terms. It involves creating a plan that aligns with the company's financial capabilities and objectives while offering attractive benefits to staff.

2. Decide on the deferral amount

Once the plan is in place, participating employees need to decide how much of their future salary they want to defer. Plans typically have guidelines on the minimum and maximum percentages that can be deferred. This means that employees can then customize their deferral amount according to their goals.

3. Choice of investments

Employers should try to provide a variety of investment options for deferred income. This gives employees the power to align their deferred funds with their risk tolerance and investment preferences. Having a range of options can greatly influence the growth potential of the deferred amount.

4. Growth phase

During this phase, the deferred amount is invested according to the chosen investment options. This money grows tax-deferred, which can potentially increase the investment value over time, without the immediate burden of having to pay taxes on gains.

5. Distribution phase

When retirement or the specified date for distribution is reached, the accumulated funds are paid to the employee. This can be in the form of a lump sum owed or periodic payments over time. The distribution method should be decided on in advance and clearly outlined in the plan.

6. Tax implications

It's vital to understand the tax implications at the distribution phase, as the distributed amount is subject to taxation, like ordinary income. Employers should inform employees about these tax implications. They should also help them plan for any tax liabilities associated with their deferred compensation plan.

FAQs

What is the difference between a 401k and a deferred compensation plan?

A 401(k) is a retirement savings plan where the account is established and contribution limits are set by the IRS. A deferred compensation plan often has higher contribution limits and more investment options.

How much money should I put in a deferred compensation plan?

This depends solely on your financial goals, current income needs, and tax situation. Try to balance immediate financial requirements with long-term retirement planning.