As an employee, you may have heard of deferred compensation plans but not fully understood what they are and how they work. In this post, we will be discussing all you need to know about deferred compensation plans.
What is Deferred Compensation?
Deferred compensation is a type of retirement savings plan that allows employees to defer or delay a portion of their salary into the future. It’s also known as nonqualified deferred compensation (NQDC) because it doesn’t meet the requirements set by the Employee Retirement Income Security Act (ERISA) for qualified retirement plans such as 401(k)s or pensions.
In other words, it’s an agreement between an employer and employee that allows a portion of the employee’s income (usually bonuses or executive-level salaries) to be held off until some point in the future when it will be paid out as income.
How Does Deferred Compensation Work?
When an employee elects to participate in a deferred compensation plan, they choose how much of their salary they want to defer into the plan. The amount can vary depending on each individual’s preference, but typically employees can defer up to 50% of their annual salary.
The money is then invested by the employer on behalf of the employee and grows tax-free until it is withdrawn at some point in time agreed upon by both parties. Usually, employees can choose when they want to receive their payout from several options like lump-sum payouts or installments over several years.
It should be noted that since these funds are not subject to ERISA regulations; therefore employers have more flexibility in designing them. For example, there are no contribution limits; hence highly compensated executives could potentially save significantly more than those who participate only in traditional qualified retirement accounts like 401(k)s.
What Are The Benefits Of A Deferred Compensation Plan?
There are many benefits associated with deferred compensation plans for both employers and employees alike:
1. Tax-Deferred Growth: One significant benefit for participants in these plans is the tax-deferred growth. This means that any investment gains made within the account are not taxed until funds are withdrawn.
2. Flexibility: Deferred compensation plans offer greater flexibility than traditional retirement plans like 401(k)s or IRAs. Since there are no contribution limits, participants can save more and have more control over how and when they receive their payout.
3. Higher Contributions: The maximum amount an employee can contribute to a 401(k) plan in 2021 is $19,500 (or $26,000 for those aged 50 or older). In contrast, deferred compensation plans have no such limit; hence high earners could defer much higher amounts of income into these accounts.
4. Tailored Plans: Employers have more flexibility in designing these plans depending on their specific needs and business structure.
5. Reduced Taxes: Deferred compensation payouts can be timed as per your convenience once you retire or leave your job; therefore it allows you to reduce taxes payable on income in years when your earnings would otherwise be higher
What Are The Risks Of A Deferred Compensation Plan?
While there are many benefits associated with deferred compensation plans, there are also some risks:
1. Investment Risk: Because deferred compensation funds are invested by employers rather than employees themselves, the employer assumes all investment risk associated with the plan’s returns.
2. Employer Risk: Participants must assume counterparty risk – that is if their employer goes out of business before they receive payment under the arrangement then they may lose everything promised to them under this arrangement;
3.Tax Law Changes : Tax laws change frequently; hence participants should keep a close eye on any changes that might affect tax rates applicable to these types of arrangements;
4.Liquidity Constraints – Once you elect to participate in such arrangements, you cannot change your mind without penalty unless certain conditions apply like death or disability;
Conclusion
Deferred compensation is a flexible way for high-earning employees to save more money for their retirement. However, these plans are not without risks, and participants should carefully consider all the pros and cons before enrolling in any plan. It is always advisable to consult with a financial advisor or tax professional since they can help you navigate this complex topic better.