What Is Deferred Compensation?

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What Is Deferred Compensation?

Let me explain deferred compensation to you directly: it's a financial tool where you, as an employee, can choose to delay receiving part of your salary until a later date, usually retirement. This setup provides tax advantages right away and appears in forms like retirement plans, pensions, and stock options. You need to grasp the differences between qualified and non-qualified types to optimize your savings and handle taxes effectively.

Key Takeaways

Deferred compensation means holding back some of your salary for payment later, often at retirement. It typically delays income taxes until you receive the funds, offering tax relief. You'll encounter qualified plans that follow federal rules and non-qualified ones aimed at high earners. Remember, non-qualified plans risk loss if the company bankrupts, unlike qualified ones. You pay Social Security and Medicare taxes when you defer, but income taxes wait until payout.

Understanding the Mechanics of Deferred Compensation

You might negotiate deferred compensation for its tax perks. Taxes on the income usually get postponed until payout, often at retirement when you could be in a lower tax bracket, reducing your overall burden. Roth 401(k)s differ since you pay taxes upfront, but withdrawals are tax-free, which suits you if you anticipate a higher bracket in retirement.

Exploring Different Types of Deferred Compensation Plans

Deferred compensation splits into qualified and non-qualified categories, each with distinct legal handling and goals.

What Are Qualified Deferred Compensation Plans?

Qualified plans fall under ERISA regulations, including 401(k)s and many 403(b)s. These funds are protected for your benefit alone; creditors can't touch them in bankruptcy. Contributions have legal caps.

Delving Into Non-Qualified Deferred Compensation Plans

Non-qualified plans, or NQDC, are agreements between you and your employer, known as 409(a) or golden handcuffs. They include bonuses, stock arrangements, and SERPs for executives. There's no limit on contributions, and they're offered to key personnel or contractors, unlike qualified plans. Payouts usually happen at retirement, but can occur earlier for events like company ownership changes or emergencies. The company might cancel if you leave under certain conditions. From your view, these reduce taxes and boost savings, especially if you're high-paid and maxed out on 401(k)s. However, funds aren't protected in bankruptcy—creditors can claim them. Companies use these to attract talent by delaying full pay, but it's risky for you.

Important Note on Taxes

You pay Social Security and Medicare taxes on deferred income when you defer it, but income taxes are delayed until you receive the funds.

Comparing Deferred Compensation Plans and 401(k)s

Deferred compensation often supplements a 401(k), offered to select executives who max out their 401(k) contributions. A 401(k) with employer matching is a form of deferred pay, similar to golden parachutes for top employees. But 401(k)s are qualified and regulated federally, while non-qualified plans have less oversight.

Benefits of Choosing Deferred Compensation

Unlike 401(k)s or IRAs, deferred plans have no contribution limits, so you can defer bonuses entirely for retirement. Funds grow tax-free until withdrawn, except in Roth versions where you pay upfront. This lack of limits adds significant value for high earners, providing tax-deferred growth and deductions.

Pros and Cons

Pros: No contribution limits, tax-deferred growth, current tax deduction.
Cons: Balances unprotected in bankruptcy, funds unavailable until retirement, no borrowing option.

Drawbacks and Risks of Deferred Compensation

In these plans, you're essentially lending to your company, so bankruptcy could cost you the money. Funds are locked until retirement, limiting access. Investment options might be restricted, like company stock only. Unlike 401(k)s, you can't roll payouts into an IRA.

Is Deferred Compensation a Good Idea?

Most won't refuse a bonus, which is essentially what this is. But if the base salary feels low and deferral just pads it, especially for younger workers, it might not appeal since payout is far off. For many, a 401(k) suits retirement saving, but high earners might want more deferral beyond limits.

How Is Deferred Compensation Paid Out?

Payouts occur at retirement or after set years, chosen at setup and rarely changeable. Spreading over years is better to avoid jumping tax brackets. Distributions can't roll into qualified plans, so taxes hit that year.

How Does Deferred Compensation Affect Your Taxes?

In non-Roth plans, contributions give a tax deduction that year, with tax-deferred growth until payout. Retiring in a lower bracket or area means you benefit from deferral.

The Bottom Line

NQDC plans let high earners defer more than 401(k) limits, but they're risky without qualified protections. I advise maxing 401(k)s first, checking company stability, and using these for tax and savings advantages cautiously.

What Is Deferred Compensation?

Highlights