Definition:
Deferred compensation is a circumstance in which an employer holds a percentage of a worker’s income in order to keep it away for later use.
The concept of deferred compensation
Deferred compensation funds might be allocated to a pension plan, delayed savings, or stock options. Deferred compensation schemes frequently provide tax benefits, which means that an employee does not pay taxes on income before it is withdrawn from his paycheck. They will often not pay taxes on that income until it is distributed from the deferred compensation plan in a few years.
Deferred compensation plans can operate as a form of investing account. Typically, your company will provide you with a variety of investing alternatives, and you will be able to select which stocks or funds to invest in through deferred compensation.
After you retire, you can begin taking money from your deferred compensation plan as income. If your plan is not a Roth plan (so you have already paid taxes on the money), you will have to pay taxes on the money when you remove it from your plan.
Types of deferred compensation
Deferred compensation programs are classified as either qualified or nonqualified. Qualified plans often provide greater employee protection, but they generally have contribution restrictions. Nonqualified plans have no contribution restrictions but expose the employee to severe risk. The aspects of the two types of plans differ, as do the regulations that govern them.
Qualified Deferred compensation plans
The Employee Retirement Security Act (ERISA) governs qualified deferred compensation plans, which were created by the Income Act of 1978. In 1974, ERISA entered federal law. It establishes the requirements for employer-sponsored pension and health insurance.
Qualified deferred compensation plans are retirement plans provided by numerous firms to their workers. When a corporation offers such a plan, it is generally offered to all full-time employees. The 401(k) plan is the most well-known example of such a plan.
Contribution restrictions for qualified plans are determined by the federal government. For participants under the age of 50, 401(k) plans, for example, have a contribution maximum of $22,500 in 2023. This limitation solely applies to the employee’s contribution, not the employer’s contribution.
When you contribute to a qualified deferred compensation plan, you can delay income tax on those payments. Thus, when you contribute to a 401(k), you don’t pay income tax on the money until you withdraw it in retirement. FICA taxes (a mix of Social Security and Medicare taxes) must still be paid on the money you set away. If your 401(k) plan is a Roth 401(k), taxes operate a bit differently. You pay income tax on the money you make with a Roth plan, but you may withdraw it tax-free after retirement.
Employees have more security with qualified deferred compensation plans. Assume you and your employer both contributed to your 401(k) plan before the firm went bankrupt. Creditors pursue the corporation for all outstanding debts. In this circumstance, lenders cannot access your money provided you have a qualified plan. You may rest easy knowing that the money is yours regardless of what happens to the firm.
Non-qualified deferred compensation plans
The non-qualified deferred compensation plans that exist today are the product of the acceptance of the United States Jobs Creation Act of 2004, which established Section 409A of the Federal Tax Code. Non-qualified plans, unlike qualified plans, are not governed by ERISA.
Most employees do not have access to non-qualified plans. Many businesses choose to limit them to their highest-paid workers. Businesses can also make them available to contract workers. In addition, unlike qualified plans such as 401(k), employees can contribute as much as they desire to these non-qualified plans. The tax advantages of these non-qualified plans match those of qualified plans.
Non-qualified deferred compensation programs are unusual in that they offer no assurances. Remember, the money you put into a qualifying plan, such as a 401(k), is your money, and it’s typically safe even if the firm goes bankrupt. But, because non-qualified plans are not governed by ERISA, this does not apply to them. If you invested in a non-qualified plan and your firm filed for bankruptcy, creditors may seek payment for these non-qualified programs.
Quite apart from the uncertainties surrounding these plans, they may be tremendously beneficial for high-income employees. They may have invested as much as their 401(k) plan allows, but they still want to save more for retirement by deferring taxes. They will be able to make this under non-qualified plans.
Pros & cons of a deferred compensation plan
There are many advantages to deferred compensation plans. These plans are a way to set aside income for retirement. No matter which plan you choose, you will get a tax break. In most cases, you get a tax break at the beginning when you invest money without paying taxes in advance. In the case of Roth plans, you get a tax break at the end when you can withdraw funds without paying additional taxes. Many of these plans have restrictions that must be followed, therefore it is worth consulting a tax adviser for more detailed information.
In addition to the tax advantages of these programs, you have the opportunity to grow your money. The monies are sent to an account in which your company invests in investment options and securities. This money’s growth may accelerate over time, and you may finish up with far more money than you invested.
Despite their numerous benefits, deferred compensation plans are not without downsides. The contribution restriction is the most significant drawback of qualified plans. If you wish to save for retirement actively, the maximum amount of $22,500 in 2023 may be significantly lower than you would expect.
The main downside of non-qualified deferred compensation plans is the possibility of losing all of your money. If your employer declares bankruptcy and creditors come after this money, there may be nothing you can do. As a result, it is recommended to choose these non-qualified plans only if you are confident in your company’s financial future.
Another thing to keep in mind is that deferred compensation plans aren’t the only way to save for retirement. Individual Retirement Accounts (IRAs) provide considerable tax advantages as well as greater control over your investment portfolio. An IRA is a type of account that, like 401(k) plans, allows you to postpone taxes on your contributions. There is also the Roth IRA option, which permits you to pay taxes on the money before withdrawing it tax-free in retirement. Nevertheless, in 2023, the IRA contribution limitation is $6,500 ($7,500 for persons over 50).