Deferred compensation plans have grown considerably in recent years. Changes in the job market have encouraged employers to look for new ways to retain talented employees by providing appealing benefits. In its simplest terms, deferred compensation is an arrangement between an employer and employee in which a portion of the employee’s income is held and paid out at a later date. There are many different types of deferred compensation plans, such as retirement plans, pensions, and employee stock options. Learn more about deferred compensation plans, their benefits, and why they are often offered to top-tier employees.
Defining Deferred Compensation
Under a deferred compensation plan, employees have the opportunity to place income into a separate savings account where it can sit untaxed until they are ready to withdraw the funds. Once the money is withdrawn, it is then subject to taxes. However, the amount you pay in taxes is typically much less if the payment is deferred until retirement. While there are a number of reasons an employee may choose to participate in a deferred compensation, the main reason is tax benefits. If an employee expects to be in a lower tax bracket when they retire, they can significantly reduce their tax burden by deferring income tax until retirement.
The one exception to this tax rule is the Roth 401k. Under a Roth plan, employees must pay taxes on any income when it is earned. This may be a more preferable choice for employees who expect to be in a higher tax bracket when they retire. Paying income tax upfront ensures that they are not stuck with a significant tax bill at retirement. There are also other considerations to make, such as if the plan is qualified or non-qualified. While deferred compensation typically refers to non-qualified plans, the term technically covers both categories.
Qualified vs. Non-Qualified Plans
Deferred compensation plans are considered either qualified or non-qualified. Qualified plans are usually pension plans that are governed by the Employee Retirement Income Security Act (ERISA), such as 401k, 403b, and 457 plans. These plans are offered to all employees. When contributions are made to employee accounts, the income is taxed. Contributions to qualifying retirement plans are capped by law and set off for the sole benefit of employees, meaning the funds cannot be taken by creditors if a company fails to pay its debts.
Non-qualified deferred compensation plans, also called 409a plans, are typically offered to key employees and executives. There are no limits on non-qualified contributions and employees are given the opportunity to save more for retirement than with a qualified plan. Unlike qualified plans, non-qualified plans are also available to independent contractors. What makes non-qualified deferred compensation plans attractive to certain employers is the ability to hire costly talent without being forced to pay them their full compensation right away. As a portion of income is deferred, employers are able to hold onto the funds until their obligations must be met at a later date.
Benefits of Deferred Compensation
One of the biggest advantages of deferred compensation plans are the tax benefits. With deferred compensation, the income that a person makes in a year is reduced as the funds are placed into an account where it then grows without annual tax. For example, with a 401k all contributions are deducted from an employee’s paycheck before it can be taxed. However, there are certain annual contribution limits. As of 2018, the maximum pre-tax annual contribution is $18,500. These types of deferred plans help reduce the tax burden on employees, therefore reducing the total amount of income taxes paid.
When deferred compensation is offered to employees as a stock option or investment account, the plan has the potential to increase capital gains. Instead of simply receiving the amount of money that you originally contributed, certain deferred compensation plans can be used to increase the account value before retirement. However, deferred compensation plans can also result in a decrease in value. Therefore, it is important to closely monitor your account. When deferred compensation plans are closely monitored, account holders have more control over their investments. Ideally, employees should work towards creating a diversified portfolio to gain the most benefits.
Contact Professional Financial Consultants
For many employees, the ability to access generous benefits is often far more attractive than pay raises and other workplace perks. Employers who wish to find and retain skilled employees often offer deferred compensation plans as part of an appealing benefits plan. Of course, both qualified and non-qualified deferred compensation plans are not right for everyone. To find out if you may be a good candidate for these types of plans, speak with a professional financial consultant. Financial consultants can walk you through the process and educate you on the pros and cons of using deferred compensation plans. For more information or to contact a financial consultant, call IFG.