Deferred Compensation Plan And How To Use It

A Deferred Compensation Plan is an arrangement in which an employee agrees to receive a portion of their income at a future date, typically during retirement, rather than when the compensation is earned. The primary benefit of deferred compensation is the tax deferral, as the income is not taxed until it is paid out, which is often in a lower tax bracket during retirement.

There are two main types of deferred compensation plans: 1. Qualified Deferred Compensation Plans (such as 401(k) plans) 2. Non-Qualified Deferred Compensation (NQDC) Plans

Key Features of Deferred Compensation Plans

1. Tax Deferral: Employees delay receiving income, pushing the tax burden into future years when they may be in a lower tax bracket.
2. Employer-Sponsored: These plans are typically offered by employers and can be a key part of executive compensation packages or long-term savings strategies.
3. Customization: Non-qualified plans, in particular, can be highly customizable and are often used by high-earning employees who exceed contribution limits of qualified plans like 401(k)s.
4. Risk: In a non-qualified deferred compensation plan, employees take on the risk of not being paid if the employer becomes insolvent, as the deferred income is considered part of the employer’s general assets.

How Deferred Compensation Plans Work

1. Contributions

• Employees elect to defer a portion of their salary or bonuses into the plan.
• In the case of qualified plans like a 401(k), the IRS limits the amount that can be deferred.
• For non-qualified plans, there is no specific contribution limit, making it appealing for high-income individuals.

2. Tax Deferral

• Taxes on deferred income are postponed until the employee receives the payment, usually in retirement.
• Since many people are in lower tax brackets post-retirement, this often results in significant tax savings.

3. Distribution

• Employees typically receive deferred compensation upon reaching a certain age, retirement, or another triggering event (e.g., termination of employment).
• Distributions can be taken as a lump sum or over time in installments.

4. Investment of Deferred Funds

• The deferred compensation may be invested in various investment vehicles, such as mutual funds or company stock, depending on the plan's structure.
• Any growth on the deferred amount is not taxed until the money is withdrawn.

Qualified vs. Non-Qualified Deferred Compensation Plans

| Feature | Qualified Plans (e.g., 401(k)) | Non-Qualified Deferred Compensation (NQDC) | |---------------------------------------|----------------------------------------------------------------|--------------------------------------------------------| | IRS Contribution Limits | Yes (e.g., $23,000/year for 401(k) in 2024, with catch-up contributions) | No contribution limits | | Eligibility | Open to all employees | Typically reserved for executives and high-income earners | | Tax Deferral | Income tax deferred; no taxes until retirement or distribution | Same tax deferral, but funds are part of company assets and carry insolvency risk | | ERISA Protections | Yes, regulated and protected | No; subject to company solvency risks | | Vesting Schedule | Typically applies | Highly customizable; company may set vesting schedules | | Creditor Protection | Assets are protected in a trust | No; assets remain part of employer’s assets |

Who Should Use Deferred Compensation Plans?

1. High-Income Earners
2. Individuals in high tax brackets who anticipate being in a lower tax bracket in retirement can benefit by deferring income.

3. Non-qualified plans are especially attractive because they allow unlimited deferrals, unlike 401(k)s, which have annual contribution limits.

4. Executives and Key Employees

5. Companies often use deferred compensation plans to attract and retain top talent by offering a tax-advantaged way to defer bonuses, salary, or stock options.

6. Executives who have maxed out contributions to other retirement accounts (401(k), IRA) can defer additional income into non-qualified plans.

7. Individuals Approaching Retirement

8. Deferring income closer to retirement when tax brackets may be lower makes sense for individuals in peak earning years.

9. Those Seeking Tax Optimization

10. Deferred compensation can serve as a tax planning tool, particularly for individuals looking to reduce their current-year taxable income.

When Does it Make Sense to Use Deferred Compensation Plans?

1. High-Earning Years:

2. If an individual is in their highest-earning years, deferring compensation to a time when they expect to be in a lower tax bracket can result in substantial tax savings.

3. Post-Retirement Income Planning:

4. Deferring income until after retirement allows an individual to stretch their income over many years, smoothing out their tax burden.

5. Maximizing Retirement Savings:

6. After hitting the IRS limits for 401(k) or other qualified retirement plans, a non-qualified plan allows for additional tax-deferred savings.

7. Tax Deferral for Bonuses or Stock Options:

8. Executives or employees who receive large bonuses or stock options can defer a portion of those windfalls to avoid significant taxation in a single year.

How to Implement a Deferred Compensation Plan

1. Employer’s Role

• Employers must decide whether to offer qualified or non-qualified plans. Non-qualified plans are usually reserved for executives and key employees.
• The employer and employee will negotiate the terms, such as how much income to defer, how long to defer it, and the payout structure (lump sum vs. installments).
• In the case of NQDC, the deferred compensation remains on the company's balance sheet, meaning the company is responsible for paying out at the agreed-upon time.

2. Employee Elections

• Employees must elect how much of their salary or bonus to defer and when they wish to receive it. Elections are typically made in the year before the income is earned.
• They may also choose how their deferred income is invested, depending on the options provided by the employer.

3. Vesting and Distribution Schedule

• The plan may have a vesting period, meaning the employee must stay with the company for a certain number of years to receive the full deferred amount.
• Once vested, the distribution schedule may allow for flexibility, with some plans offering lump-sum payments and others spreading payments over several years.

4. Investment Choices and Management

• In a non-qualified plan, the deferred compensation can be invested in various investment vehicles. However, the investments are technically part of the company’s assets, which exposes them to company solvency risks.
• Employees should consider the financial health of their employer when participating in an NQDC plan.

5. Plan Administration

• A qualified deferred compensation plan like a 401(k) requires adherence to strict IRS rules and reporting, while a non-qualified plan is more flexible but must be carefully managed to comply with deferred compensation rules under Section 409A of the Internal Revenue Code.
• Failure to comply with Section 409A rules can result in severe tax penalties for the employee.

Pros and Cons of Deferred Compensation Plans

Pros: - Tax Deferral: Income is not taxed until distributed, potentially in a lower tax bracket. - Investment Growth: Deferred compensation can grow tax-deferred, enhancing long-term savings. - No Contribution Limits: Non-qualified plans allow for unlimited deferrals, which can be especially valuable for high-income earners. - Customizable Distribution: Employees can plan payouts to optimize tax efficiency (lump sum or installments).

Cons: - Risk of Loss: In non-qualified plans, deferred compensation remains part of the employer's general assets and can be lost if the company goes bankrupt. - No ERISA Protections: Non-qualified plans are not subject to the same protections as 401(k) plans. - Complexity: Structuring non-qualified deferred compensation plans involves complex rules, particularly around IRS Section 409A, which could result in penalties if not properly followed. - Limited Access: Funds are generally locked until retirement or a specified event, limiting liquidity for employees.

When Does It Not Make Sense?

1. If You Expect to Be in a Higher Tax Bracket Later:

2. Deferring income may not make sense if you expect your tax rate to increase, either due to higher earnings in retirement or potential changes in tax laws.

3. Company Solvency Risk:

4. If you have doubts about your employer’s financial stability, the risk of losing deferred compensation in a non-qualified plan is a significant concern.