It may be an understatement to say that employees want to get paid. But not everyone wants all of their pay right away. Some employees, especially those planning a retirement nest egg, would rather receive a portion of their income at a later date. This voluntary practice is commonly known as deferred compensation.
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What is a deferred compensation plan and how does it work?
Deferred compensation allows employees to defer payment of an agreed-upon portion of their earned income to a future date, usually retirement. In many cases, the taxes owed on the income are also deferred. Further specifics, such as contribution limits and distribution timing, depend on the type of deferred compensation plan offered.
Types of deferred compensation plans
Employers interested in offering deferred compensation as a recruitment and engagement tactic generally may choose from either qualified or nonqualified plans.
Qualified deferred compensation plans
Traditional individual retirement accounts (IRAs) and 401(k)s are examples of qualified deferred compensation. With these plans, employees contribute pretax dollars via payroll deductions to their retirement savings account. The total contributions cannot exceed the prescribed IRS annual limit.
Various investment options allow an employee’s savings to grow over time. When they reach retirement age, employees may draw from their account, though they must pay tax on the income as it is withdrawn.
Nonqualified deferred compensation plans
Nonqualified deferred compensation plans are typically reserved for highly paid employees and executives. They and their employer must contractually agree to the terms of the deferral, including the amount deferred and the distribution timing. The latter can be an arbitrary date or triggered by an event, such as retirement, death or personal emergencies. Contracts may also have certain requirements or exclusions, such as forfeiture if the employee leaves to join a competitor.
Similar to many qualified deferred compensation plans, nonqualified plans generally defer pretax dollars. The employee pays tax on the income at the time of distribution.
Benefits of nonqualified deferred compensation
Unlike qualified deferred compensation plans, nonqualified plans can be offered exclusively to certain employees, i.e., executives. This provision gives employers greater flexibility. And because the compensation is deferred to a later date, employers may experience improved cash flow in the near term.
Nonqualified deferred compensation plans are beneficial for employees as well. The IRS does not cap the amount that can be contributed each year, maximizing the savings potential. Deferring compensation may also place high earners in a lower tax bracket.
Disadvantages of nonqualified deferred compensation
Despite the aforementioned benefits, employees should carefully weigh the risks before agreeing to participate in a nonqualified deferred compensation plan. The Employee Retirement Income Security Act (ERISA) does not protect these types of plans, which means participants can lose their entire balance if their employer goes bankrupt. Nonqualified deferred compensation plans also typically have limited investment opportunities. In some cases, employees may only be able to invest their money in company stock.
Nonqualified deferred compensation vs. 401(k)
Here’s how nonqualified deferred compensation plans stack up against one of the more common qualified plans, 401(k):
|Contributions made pretax||Yes||Yes|
|Annual contribution limits||No||Yes|
|Multiple investments available||No||Yes|
|All employees equally eligible||No||Yes|
|Rollover to IRA available||No||Yes|
Frequently asked questions about deferred compensation
What are the benefits of deferred compensation plans?
Deferred compensation plans help employees save for the future and become retirement-ready. If the plan uses pretax contributions, it can also help lower taxable income.
What is the difference between a 401(k) and a nonqualified deferred compensation plan?
There are many differences between a 401(k) and a nonqualified deferred compensation plan. Some of the primary distinctions are as follows:
- 401(k) has annual contribution limits; nonqualified plans do not.
- ERISA protects assets in a 401(k), whereas funds in a nonqualified plan may be lost if the company declares bankruptcy.
- 401(k) enrollment must be available equally to all employees. Nonqualified compensation can be offered to select employees, such as senior executives.
How is deferred compensation paid out?
Employees who enroll in a qualified deferred compensation program generally may only withdraw from the account when they reach retirement age. Withdrawing before that date is possible, but unless the participant has a financial hardship or other qualifying circumstance, penalties incur.
Distribution from a nonqualified compensation plan is determined via a contractual agreement between the employer and the employee. In many cases, payout begins at retirement, but arbitrary dates may be chosen. Once the contract is finalized, however, the distribution timeline cannot change.
How does deferred compensation affect your taxes?
Pretax contributions to a deferred compensation plan lower an individual’s taxable income. But because plan participants must pay tax on the income as it is withdrawn, employees may want to consider which tax bracket they expect to be in at retirement age. Roth IRAs, which use post-tax contributions, might be a better option for retirees in high-income tax brackets.
This article is intended to be used as a starting point in analyzing deferred compensation and is not a comprehensive resource requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.