Deferred Compensation Definition

1 month ago 18

What Is Deferred Compensation?

Deferred compensation is a information of an employee's compensation that is acceptable speech to beryllium paid astatine a aboriginal date. In astir cases, taxes connected this income are deferred until it is paid out. Forms of deferred compensation see retirement plans, pension plans, and stock-option plans.

Key Takeaways

  • Deferred compensation plans are an inducement that employers usage to clasp onto cardinal employees.
  • Deferred compensation tin beryllium structured arsenic either qualified oregon non-qualified.
  • The attractiveness of deferred compensation is babelike connected the employee's idiosyncratic taxation situation.
  • These plans are champion suited for precocious earners.
  • The main hazard of deferred compensation is if the institution goes bankrupt you whitethorn suffer everything enactment distant successful the plan.

How Deferred Compensation Works

An worker whitethorn opt for deferred compensation due to the fact that it offers imaginable taxation benefits. In astir cases, income taxation is deferred until the compensation is paid out, usually erstwhile the worker retires. If the worker expects to beryllium successful a little tax bracket aft retiring than erstwhile they initially earned the compensation, they person a accidental to trim their taxation burden.

Roth 401(k)s are an exception, requiring the worker to wage taxes connected income erstwhile it is earned. They whitethorn beryllium preferable, however, for employees who expect to beryllium successful a higher taxation bracket erstwhile they discontinue and would truthful alternatively wage taxes successful their current, little bracket. There are galore much factors that impact this decision, specified arsenic changes to the law. Investors should consult a fiscal advisor earlier making decisions based connected taxation considerations.

Types of Deferred Compensation

There are 2 wide categories of deferred compensation: qualified deferred compensation and non-qualified deferred compensation. These disagree greatly successful their ineligible attraction and, from an employer's perspective, the intent they serve. Deferred compensation is often utilized to notation to non-qualified plans, but the word technically covers both.

Qualified Deferred Compensation Plans

Qualified deferred compensation plans are pension plans governed by the Employee Retirement Income Security Act (ERISA), including 401(k) plans and 403(b) plans. A institution that has specified a program successful spot indispensable connection it to each employees, though not to autarkic contractors. Qualifying deferred compensation is acceptable disconnected for the sole payment of its recipients, meaning that creditors cannot entree the funds if the institution fails to wage its debts. Contributions to these plans are capped by law.

Non-Qualifying Deferred Compensation Plans

Non-qualified deferred compensation (NQDC) plans, besides known arsenic 409(a) plans and "golden handcuffs," supply employers with a mode to pull and clasp particularly invaluable employees, since they bash not person to beryllium offered to each employees and person nary caps connected contributions.

In addition, autarkic contractors are eligible for NQDC plans. For immoderate companies, they connection a mode to prosecute costly endowment without having to wage their afloat compensation immediately, meaning they tin postpone backing these obligations. That approach, however, tin beryllium a gamble.

NQDCs are contractual agreements betwixt employers and employees, truthful portion their possibilities are constricted by laws and regulations, they are much flexible than qualified plans. For example, an NQDC mightiness see a non-compete clause.

Compensation is usually paid retired erstwhile the worker retires, though payout tin besides begin on a fixed date, upon a alteration successful ownership of the company, oregon owed to disability, death, oregon a (strictly defined) emergency. Depending connected the presumption of the contract, deferred compensation mightiness beryllium retained by the institution if the worker is fired, defects to a competitor, oregon different forfeits the benefit. Early distributions on NQDC plans trigger heavy IRS penalties.

From the employee's perspective, NQDC plans connection the anticipation of a reduced tax burden and a mode to prevention for retirement. Due to publication limits, highly compensated executives whitethorn lone beryllium capable to put tiny portions of their income successful qualified plans; NQDC plans bash not person this disadvantage.

On the different hand, determination is simply a hazard that if the institution goes bankrupt, creditors volition prehend funds for NQDC plans, since these do not person the aforesaid protections qualified plans do. This tin marque NQDCs a risky enactment for employees whose distributions statesman years down the line, oregon whose companies are successful a anemic fiscal position. 

NQDCs instrumentality antithetic forms, including banal oregon options, deferred savings plans, and supplemental enforcement status plans (SERPs), different known arsenic "top chapeau plans."

At the clip of the deferral, the worker pays Social Security and Medicare taxes connected the deferred income conscionable arsenic connected the remainder of his oregon her income but does not person to wage income taxation connected the deferred compensation until the funds are really received.

Advantages and Disadvantages of Deferred Compensation

Deferred compensation plans are champion suited for high-income earners who privation to enactment distant funds for retirement. Like 401(k) plans oregon IRAs, the wealth successful these plans grows tax-deferred and the contributions tin beryllium deducted from taxable income successful the existent period. Unlike 401(k)s oregon IRAs determination are nary publication limits to a deferred compensation plan, truthful you tin defer up to each of your yearly bonus, for example, arsenic status income.

There are, however, immoderate drawbacks. Unlike a 401(k), with a deferred compensation program you are efficaciously a creditor of the company, lending them the wealth you person deferred. If the institution declares bankruptcy successful the future, you whitethorn suffer immoderate oregon each of this money. Even if the institution remains solid, your wealth is locked up successful galore cases until retirement, meaning that you cannot entree it easily.

Depending connected the plan's structure, you besides whitethorn find yourself with precise constricted concern options, for instance, it whitethorn lone see institution stock. Unlike with a 401(k) plan, erstwhile funds are received from a deferred compensation plan, they cannot beryllium rolled implicit into an IRA account. Nor tin deferred compensation funds beryllium borrowed against.

Pros

  • No publication limits

  • Tax-deferred plus growth

  • Current-period taxation deduction

Cons

  • Can suffer wealth if the institution goes bankrupt

  • Illiquid

  • Only intended for precocious earners

  • No mode to get against

Frequently Asked Questions

Is Deferred Compensation a Good Idea?

It each depends. For astir employees, redeeming for status via a company's 401(k) is astir appropriate. However, high-income employees whitethorn privation to defer a greater magnitude of their income for status without the limits imposed by a 401(k) oregon IRA.

What Are the Benefits of a Deferred Compensation Plan?

Aside from nary publication limits, these plans connection tax-deferred maturation and a taxation deduction successful the play that the contributions are made. This means that if you discontinue with a little taxation bracket, oregon successful a authorities that does not levy income tax, you tin greatly payment successful the future.

What Is the Difference Between a 401(k) and a Deferred Compensation Plan?

Deferred compensation plans are much informal and little unafraid than 401(k) plans arsenic a result. 401(k) plans are highly regulated and are sponsored by an employer. Deferred compensation is simply a program successful which an worker defers accepting a portion of his compensation until a specified aboriginal date. Financial advisors usually suggest using a deferred compensation program lone aft having made the maximum imaginable publication to a 401(k) plan—and lone if the institution an idiosyncratic is employed by is considered precise financially solid.

How Is a Deferred Compensation Paid Out?

The organisation date, which whitethorn beryllium astatine status oregon aft a specified fig of years, indispensable beryllium designated astatine the clip the program is acceptable up and cannot beryllium changed. It is mostly advantageous for the worker to defer compensation to debar having each of the deferred income distributed astatine the aforesaid time, arsenic this typically results successful the worker receiving capable wealth to enactment them successful the highest imaginable taxation bracket for that year. Note that distributions cannot beryllium rolled into a qualified status plan.

How Does Deferred Compensation Affect Your Taxes?

Those making contributions to a program bask a taxation deduction successful that year, which tin assistance 1 besides debar alternate minimum taxation (AMT). The funds past turn tax-deferred until withdrawals are made astatine retirement. If you discontinue successful a little taxation bracket oregon lower-tax jurisdiction you volition payment from the taxation deferral upon retirement.

Read Entire Article