A deferred compensation plan is a contractual agreement between an employee and an employer that allows the worker to delay a portion of their salary or bonus until a future date, such as retirement.
Taxes on those earnings are deferred, allowing you to reduce your taxable income at the time of the deferral. But these earnings would still be taxed at the time they are distributed to you.
Still, this could result in tax benefits if you believe you’ll be in a lower tax bracket at the time of the distribution.
This is why many plans provide you with the funds at retirement, when you may find yourself in a lower tax bracket.
You may take your distribution in a lump sum, or you could stretch out the payments over multiple years to spread out your taxable income.
Each year, you may decide whether to participate in the plan and how much to defer.
Deferred Compensation Plan Basics
There are two main types of deferred compensation plans. Qualified deferred compensation plans include traditional 401(k)s and IRAs. You fund these plans with pre-tax dollars, and earnings are tax-deferred.But when most people discuss deferred compensation plans, they’re really talking about nonqualified deferred compensation (NQDC) plans.
Unlike traditional 401(k)s and IRAs, NQDCs have no annual contribution limits. However, your employer may place caps on how much you may defer each year.
Some NQDC plans allow you to place your compensation in a variety of investment options, similar to a 401(k) plan menu. However, some companies are more strict and limit your investment options to company stock.
And unlike 401(k) plans, which are generally open to a large pool of employees, NQDC plans are typically limited to highly compensated individuals such as company executives.
So if used correctly, an NQDC plan can place executives in lower tax brackets and help them boost their retirement savings or fund a major future expense.
Deferred Compensation Plan Disadvantages
Unlike 401(k) and 403(b) plans, NQDC plans are not protected by the Employee Retirement Income Security Act (ERISA). This means you could lose your entire balance if the company goes bankrupt.Some financial advisers recommend you focus on maxing out other retirement plans such as a 401(k) and IRA, and then contribute to an NQDC plan only as much as you can afford to lose.
And while there are basic rules behind NQDC plans, each company’s plan is different. Some may have major restrictions such as forfeiture in the event you leave the company and go to work for a competitor.
So these may be best for executives who plan to stick with the firm for the long haul and climb the corporate ladder internally.
And although many companies may allow you to defer compensation until a date of your choice, that decision, once you make it, is final. It’s nearly impossible to change the distribution timeline.
Plus, it’s important to note that you’d still owe Social Security and Medicare taxes on deferred income at the time of deferral.
Furthermore, nobody can predict future tax rates. So if tax rates are notably higher at the time of the distribution, this may reduce or negate the plan’s tax benefits.
The Bottom Line
Deferred compensation plans, and NQDC plans in particular, can provide high-income company executives with major tax benefits.But you must carefully consider the pros and cons of these complex plans. Without ERISA protection, you may lose all your deferred compensation should your company go bankrupt. And in some cases, investment options are highly limited. And some companies place strict restrictions on these plans.
And because it’s ultimately an investment vehicle, you may need to adjust your asset allocation over time to align with your financial situation, investment goals, and market conditions. This is why it’s best to review and approach an NQDC plan with a qualified financial and tax adviser.
