Business, Legal & Accounting Glossary
An arrangement in which a portion of an employee’s income is paid out at a date after which that income is actually earned. Examples of deferred compensation include pensions, retirement plans, and stock options. The primary benefit of most deferred compensation is the deferral of tax.
Deferred compensation is the portion of an employee’s income that is paid out at a date later than when the income was actually earned. Broadly, there are two types of deferred compensation plans: qualified and non-qualified. Non-qualified deferred compensation plans include salary reduction arrangements, bonus deferral plans, supplemental executive retirement plans, and excess benefit plans. Non-qualified deferred compensation plans are not eligible for the tax deferral benefits associated with qualified deferred compensation plans. The benefits of non-qualified deferred compensation plans include aligning employees’ incomes with company growth and adding an incentive for employees to stay with a company. Qualified deferred compensation plans include pensions and retirement plans and are eligible for tax deferral benefits. The primary benefit of qualified deferred compensation plans is to allow employees to defer some of their income (as well as the taxes on that income) until retirement.
Deferred compensation is a portion of an employee’s pay that is set aside for later payment. In most cases, taxes on this income are postponed until it is delivered. Retirement plans, pension plans, and stock-option plans are all examples of deferred compensation.
Employees may choose deferred compensation because it may provide tax benefits. Most income taxes are postponed until the compensation is paid out, which is usually when the employee retires. If the employee anticipates being in a lower tax bracket after retirement than when they earned the compensation, they may be able to reduce their tax burden.
Roth 401(k)s are an exception, requiring employees to pay taxes on earnings when they are earned. However, they may be preferable for employees who expect to be in a higher tax bracket when they retire and would prefer to pay taxes in their current, lower bracket. There are numerous other factors influencing this decision, such as changes in the law. Before making tax-related decisions, investors should consult with a financial advisor.
Deferred compensation is divided into two types: qualified deferred compensation and non-qualified deferred compensation. These differ greatly in their legal treatment and, from the perspective of an employer, the purpose they serve. Although the term “deferred compensation” is frequently used to refer to non-qualified plans, it technically refers to both.
Qualified deferred compensation plans, which include 401(k) and 403(b) plans, are pension plans governed by the Employee Retirement Income Security Act (ERISA). A company that has such a plan must make it available to all employees, but not to independent contractors. Qualifying deferred compensation is set aside solely for the benefit of the recipients, which means that creditors will not be able to access the funds if the company fails to pay its debts. Contributions to these plans are legally limited.
Non-qualified deferred compensation (NQDC) plans, also known as 409(a) plans and “golden handcuffs,” offer employers a way to attract and retain particularly valuable employees because they are not required to be offered to all employees and have no contribution caps.
In addition, NQDC plans are available to independent contractors. They provide a way for some businesses to hire expensive talent without having to pay their full compensation right away, allowing them to postpone funding these obligations. This approach, however, can be risky.
NQDCs are contractual agreements between employers and employees, and while their options are constrained by laws and regulations, they are more adaptable than qualified plans. A non-compete clause, for example, could be included in a NQDC.
Compensation is typically paid out when an employee retires, but it can also begin on a set date, upon a change in company ownership, or due to disability, death, or a (strictly defined) emergency. Deferred compensation may be retained by the company if the employee is fired, defected to a competitor, or otherwise forfeits the benefit, depending on the terms of the contract. Early distributions from NQDC plans are subject to steep IRS penalties.
From the employee’s perspective, NQDC plans provide the opportunity for a lower tax burden as well as a way to save for retirement. Because of contribution limits, highly compensated executives may only be able to invest a small portion of their income in qualified plans; NQDC plans do not suffer from this limitation.
On the other hand, if the company goes bankrupt, creditors may seize funds for NQDC plans, which do not have the same protections as qualified plans. This can make NQDCs a risky investment for employees whose distributions begin years later or whose companies are in financial distress.
Stock or options, deferred savings plans, and supplemental executive retirement plans (SERPs), also known as “top hat plans,” are all examples of NQDCs.
Deferred compensation plans are ideal for high-income earners who want to save for retirement. The money in these plans, like 401(k) plans or IRAs, grows tax-deferred, and contributions can be deducted from taxable income in the current period. A deferred compensation plan, unlike a 401(k) or an IRA, has no contribution limits, so you can save up to your entire annual bonus as retirement income.
However, there are some disadvantages. Unlike a 401(k), you are effectively a creditor of the company with a deferred compensation plan, lending them the money you have deferred. You may lose some or all of this money if the company declares bankruptcy in the future. Even if the company remains stable, your money is often locked up until retirement, making it difficult to access.
Depending on the structure of the plan, you may also find yourself with very limited investment options, such as company stock. When funds are received from a deferred compensation plan, they cannot be rolled over into an IRA account, unlike a 401(k) plan. Deferred compensation funds cannot be borrowed against.
I opted for deferred compensation when I decided to put some of each of my paychecks into a Roth IRA every month.
I did not want any deferred compensation because in the past I had never gotten it at all and that made me mad.
You may need to offer some deferred compensation if you will not be able to pay an employee until the profits come in.
It’s all up to you. Saving for retirement through a company’s 401(k) is the best option for most employees. High-income employees, on the other hand, may want to save a larger portion of their income for retirement without the restrictions imposed by a 401(k) or IRA.
Apart from the fact that there are no contribution limits, these plans provide tax-deferred growth and a tax deduction in the year the contributions are made. This means that retiring in a lower tax bracket or in a state without an income tax will benefit you greatly in the future.
Deferred compensation plans are less formal and secure than 401(k) plans. A 401(k) plan is a type of retirement savings plan that is heavily regulated and sponsored by an employer. Deferred compensation is a plan in which an employee postpones accepting a portion of their salary until a later date. Financial advisors usually recommend using a deferred compensation plan only after contributing the maximum amount to a 401(k) plan—and only if the company where an individual works is considered to be financially sound.
The distribution date, which can be at retirement or after a set number of years, must be specified when the plan is established and cannot be changed. It is generally advantageous for an employee to defer compensation in order to avoid having all of the deferred income distributed at the same time, as this typically results in the employee receiving enough money to put them in the highest tax bracket for the year. Distributions from a qualified retirement plan cannot be rolled into another qualified retirement plan.
Contributions to a Deferred Compensation plan are tax-deductible in the year they are made, which can help you avoid the alternative minimum tax (AMT). The funds will then grow tax-free until they are withdrawn at retirement. You will benefit from the tax deferral if you retire in a lower tax bracket or in a lower-tax jurisdiction.
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This glossary post was last updated: 25th January, 2022 | 0 Views.