Deferred Compensation Plans

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on July 11, 2023

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What Are Deferred Compensation Plans?

Deferred compensation plans are voluntary arrangements between employees and employers that allow employees to defer a portion of their income to be paid at a later date, typically after retirement.

These plans can provide tax advantages and supplement other retirement savings vehicles.

The primary purpose of deferred compensation plans is to help employees save for retirement by setting aside a portion of their income on a tax-deferred basis. Benefits of these plans include potential tax savings, increased retirement income, and financial planning flexibility.

There are two main types of deferred compensation plans: nonqualified deferred compensation (NQDC) plans and qualified deferred compensation plans. Each type has its own features, advantages, and tax implications.

Nonqualified Deferred Compensation (NQDC) Plans

Overview of NQDC Plans

Eligibility and Participation

NQDC plans are typically offered to highly compensated employees and key executives. Participation is usually determined by the employer and may be based on factors such as job title, salary, or length of service.

Key Features and Advantages

NQDC plans allow participants to defer a portion of their income without being subject to the contribution limits and nondiscrimination rules that apply to qualified plans. This provides greater flexibility in terms of contribution amounts and plan design.

Types of NQDC Plans

Elective Deferral Plans

Elective deferral plans allow employees to voluntarily defer a portion of their salary, bonuses, or other compensation. The deferred amounts are usually invested on the employee's behalf and grow tax-deferred until distribution.

Supplemental Executive Retirement Plans (SERPs)

SERPs are employer-sponsored plans that provide supplemental retirement benefits to select employees. Employers typically contribute to these plans on behalf of the employee, and the benefits are often based on a percentage of the employee's salary.

Tax Implications of NQDC Plans

Income Tax Treatment

Deferred amounts in an NQDC plan are not subject to income tax until they are distributed to the employee. Distributions are generally taxed as ordinary income at the employee's current tax rate at the time of distribution.

Social Security and Medicare Tax Treatment

NQDC plan contributions and earnings are subject to Social Security and Medicare taxes at the time the compensation is deferred, not when the amounts are distributed.

Qualified Deferred Compensation Plans

Overview of Qualified Plans

Eligibility and Participation

Qualified deferred compensation plans are subject to specific rules and regulations under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. These plans are typically available to a broader range of employees, and participation is often voluntary.

Key Features and Advantages

Qualified plans offer tax advantages, such as tax-deferred growth and the possibility of tax-deductible contributions. Additionally, these plans are subject to contribution limits and nondiscrimination rules, ensuring that benefits are provided equitably to all eligible employees.

Types of Qualified Plans

401(k) Plans

401(k) plans are employer-sponsored retirement savings plans that allow employees to contribute a portion of their salary on a pre-tax or after-tax basis. Employers may also provide matching contributions.

403(b) Plans

403(b) plans are similar to 401(k) plans but are designed for employees of tax-exempt organizations, such as schools and nonprofit organizations.

457(b) Plans

457(b) plans are deferred compensation plans for employees of state and local governments and certain tax-exempt organizations. These plans allow participants to defer a portion of their salary and enjoy tax-deferred growth on their investments.

Tax Implications of Qualified Plans

Income Tax Treatment

Contributions to qualified plans are generally tax-deductible, and investment earnings grow tax-deferred until distributed. Distributions are typically taxed as ordinary income at the employee's current tax rate at the time of distribution.

Social Security and Medicare Tax Treatment

Contributions to qualified plans are subject to Social Security taxes and Medicare taxes at the time the compensation is deferred. However, investment earnings within the plan are not subject to these taxes.

Choosing the Right Deferred Compensation Plan

Assessing Individual Financial Goals

When selecting a deferred compensation plan, it's essential to consider your financial goals, desired retirement age, and overall retirement savings strategy.

Evaluating Employer-Sponsored Plans

Review the features, advantages, and tax implications of any employer-sponsored deferred compensation plans available to you. Compare these plans to other retirement savings vehicles to determine which option best aligns with your financial goals.

Understanding Tax Implications and Consequences

Consider the tax implications of each deferred compensation plan, including income tax, Social Security, and Medicare tax treatment. Consult with a tax professional to determine the most tax-efficient strategy for your specific situation.

Consulting With Financial Professionals

Seek the advice of a financial advisor or retirement planning professional to help you choose the most appropriate deferred compensation plan and develop a comprehensive retirement savings strategy.

Choosing the Right Deferred Compensation Plan

Risks and Considerations of Deferred Compensation Plans

Company Financial Stability

For NQDC plans, it's crucial to consider the financial stability of your employer, as these plans are not protected by ERISA or insured by the Pension Benefit Guaranty Corporation (PBGC). If your employer experiences financial difficulties, your deferred compensation may be at risk.

Investment Risk

Both qualified and nonqualified deferred compensation plans may involve investment risk. It's essential to understand and manage the investments within your plan to minimize potential losses and maximize growth potential.

Tax Law Changes

Tax laws are subject to change, which could impact the tax treatment of deferred compensation plans. Staying informed about potential changes can help you adjust your strategy and maintain the most tax-efficient approach.

Limited Access to Funds

Deferred compensation plans generally have strict rules regarding access to funds before retirement, often imposing penalties or taxes for early withdrawals. Be aware of these limitations when planning your overall financial strategy.

Strategies for Maximizing Deferred Compensation Plan Benefits

Diversifying Investments Within Plans

To minimize investment risk and optimize potential returns, diversify your investments within your deferred compensation plan. This may involve investing in a mix of asset classes, such as stocks, bonds, and real estate.

Balancing Contributions With Other Financial Goals

While maximizing contributions to deferred compensation plans can provide tax advantages and boost retirement savings, it's essential to balance these contributions with other financial goals, such as saving for a home, funding education, or paying off debt.

Monitoring Plan Performance and Adjusting as Needed

Regularly review and evaluate the performance of your deferred compensation plan investments. Make adjustments as needed to ensure your plan remains aligned with your financial goals and risk tolerance.

Coordinating With Other Retirement Savings Vehicles

Consider coordinating your deferred compensation plan contributions with other retirement savings vehicles, such as individual retirement accounts (IRAs) or employer-sponsored pension plans. This integrated approach can help you optimize your retirement savings strategy.

Strategies for Maximizing Deferred Compensation Plan Benefits

Conclusion

Deferred compensation plans offer valuable benefits, such as tax advantages, increased retirement income, and financial planning flexibility. Both nonqualified and qualified deferred compensation plans can play a crucial role in a comprehensive retirement savings strategy.

To make the most of your deferred compensation plan, it's essential to understand the plan's features, advantages, and tax implications. Regularly monitor and manage your plan to ensure it remains aligned with your financial goals and risk tolerance.

Consulting with financial professionals, such as financial advisors or tax experts, can provide valuable guidance in selecting and managing your deferred compensation plan.

These professionals can help you develop a comprehensive retirement savings strategy tailored to your unique financial goals and circumstances.

By understanding and actively managing your deferred compensation plan, you can maximize its benefits and enjoy a more secure and comfortable retirement.

Deferred Compensation Plans FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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