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Is a Deferred Compensation Plan Right for You?

Is a Deferred Compensation Plan Right for You?

Deferred compensation plans can be a useful savings tool, especially for participants who want to maximize 401(k) contributions while still having savings to invest. Deferred compensation plans also have many rules and regulations. We've taken the time to analyze everything you need to know about it in this article, including qualified plans versus non-qualified plans, how it works with 401(k) plans, and the pros and cons that come with them.

Beginner's Guide to Deferred Compensation

Benefits and compensation packages sometimes offer an unconditionally deferred compensation plan under Section 409A in addition to the typical 401 (k) options. A deferred compensation plan allows members to defer their income now and withdraw it later, usually during retirement, when their taxable income is more likely to be lower.

Once participants report their income, their employer can track that income through bookkeeping accounts, set aside in a trust, and remain part of the business's general assets or invest the funds. Investment options can include annuities, securities, or insurance arrangements, so it's important to weigh a deferred compensation plan's tax benefits and potential returns against savings alternatives.

Qualified versus Non-qualified Deferred Compensation Plans

There are two types of deferred compensation plans: qualified and non-qualified. Understanding the differences between the two is important to determine which one is best for you and your employees.

A qualifying deferred compensation plan operates per the Employees Retirement Income Security Act (ERISA), which includes the 403(b) and 401(k) plans. They must be non-discriminatory, useful, and equally beneficial for all company employees and include contribution limits. A qualified deferred compensation plan is held in a trust account, making it more secure than its unqualified counterpart.

Non-qualified compensation plans are written agreements between an employee and their employer. A portion of the employee's salary is withheld, invested, and returned to the employee at a later date.

There is no contribution limit for a non-qualified deferred compensation plan, and it is not made available to all employees. Employers can keep deferred funds in company funds, putting them at risk if the company goes bankrupt.

Deferred compensation plan vs. 401 (k)

It's important to compare deferred payments to 401(k) accounts to decide which one is right for you. Deferred compensation plans are usually used to supplement IRA or 401(k) retirement plans because the amount of money that can be deferred in them is considerably higher than the contribution limits for 401(k) and IRA plans.

For 2020, the maximum annual contribution of 401(k) is $ 19,500. Catch-up contributions allow people over 50 to contribute $26,000 or $6,500 per year in optional catch-up elective deferrals.

Do I have to participate in a deferred compensation plan?

There are a few questions employees should consider when deciding to participate in a deferred compensation plan:

  • Consider your current tax level and what your future is likely to be: While no one can predict with certainty what the taxes and categories will be in the future, by deferring income now, employees could now fall into a lower tax bracket.

  • How long do you plan to stay with the employer? Employees with more than 15 years of retirement are at higher risk of threatening the financial stability of their employer. 

  • What are the strengths of the employer? Deferred compensation plans are promissory notes from the employer to the employee. If a business goes bankrupt, these plans are considered unsecured business debt and may result in the total loss of the employee's contribution.

  • What percentage of your total wealth is linked to your employer? In addition to salary, employees can also benefit from stock plans, stock options, or restricted shares, all depending on the company's future. Adding a deferred compensation plan on top of these may involve higher risk than you think is appropriate.

Benefits of deferred compensation plans

Deferred compensation plans have several advantages that employees should consider:

  • Deferred compensation plans offer tax advantages by reducing employee income during the contribution year and raising funds without taxing the profits invested.

  • If the employer offers investment options, employees can invest that money for higher returns.

  • There is no contribution limit for deferred compensation plans, meaning that employees can now defer a large portion of their income to use for retirement.

  • Unlike other retirement savings plans, there are no non-discrimination rules for a deferred executive compensation plan.

Disadvantages of deferred compensation plans

As with any decision, deferred compensation plans have drawbacks that employees should consider:

  • A company's deferred compensation plan is often referred to as "golden handcuffs," which keeps key employees in the company. Depending on the terms of the plan, an employee may end up losing some or all of the deferred cash compensation if he leaves the company prematurely.

  • The decision to participate in a deferred compensation plan must be made before the year in which the compensation is received. This decision, as well as how and when it will be paid, is irrevocable.

  • The deferred compensation of an employee and the investment gains present a risk of loss, depending on the general financial situation of the company.

  • Unlike other employer-sponsored pension plans, employees cannot borrow a deferred compensation plan.

Are deferred compensation plans good?

Employees should consider the following questions when deciding whether a deferred compensation plan is right for them:

  • Are there any investment options with the plan? Is the selection of funds and fees reasonable?

  • Can the employee carry forward the corresponding earnings?

  • Does the plan allow for a flexible withdrawal schedule?

  • Is the employer financially secure and likely to remain so?

  • Will their tax rate be lower in the future when they receive deferred compensation?



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