If a business wants to hire and retain top-performing employees, it needs to offer substantial benefits. While options like healthcare and paid time off are enticing, nothing is quite as appealing as tax breaks. High-earning workers typically want to save as much money on taxes as possible while maintaining investment opportunities.
Fortunately, that’s accomplished through deferred compensation plans. These plans can come in many forms and offer specific advantages (and potential disadvantages). This article will dive into how these plans work and why they can be so attractive.
What is a Deferred Compensation Plan?
As the name suggests, this type of plan postpones compensation until a later date. While you may get paid bi-weekly or monthly with a standard paycheck, deferred compensation builds in a separate account until you’re able to access it.
The most common example of a deferred compensation plan is a 401k. As an employee, you can contribute to your retirement account instead of receiving the money immediately. Over time, the account grows until you can start withdrawing it penalty-free at age 59 1/2.
While a 401k is the most prevalent version of deferred compensation, it’s not the only option. Other examples can include pensions, stock options, and other retirement savings accounts (i.e., IRAs). These plans can also either be qualified or non-qualified. Let’s break down both types.
Qualified Deferred Compensation Plans
For a plan to be considered “qualified,” it must abide by the Employee Retirement Income Security Act (ERISA). This legal doctrine sets regulations for these plans and protects the funds contained within.
Because qualified programs have to follow legal restrictions, they may not be as enticing for high earners. However, since the government protects them, individuals can’t lose their funds either.
The primary elements of a qualified deferred compensation plan include:
- Must be available to all employees, excluding independent contractors.
- The IRS sets contribution limits. In 2021, the maximum allowance is $19,500 for those under 50 and $26,000 per year for those 50 or older.
- Employees cannot withdraw funds before turning 59 1/2 without paying a penalty. Some situations may allow for unpenalized withdrawals, though.
- All assets are protected from creditors, so even if the company goes bankrupt, the accounts remain solvent.
- Plans require account holders to take required minimum distributions during retirement. Only Roth-type accounts are exempt from this rule.
Non-Qualified Deferred Compensation Plans (NQDC)
Another term for these compensation plans is “golden handcuffs.” The phrase stems from the fact that the company uses a lucrative package to keep high-value employees for the long term. So, even though you’re “handcuffed” to the job, they’re made of gold, and you get to keep them when you leave.
Non-qualified deferred compensation plans don’t have to adhere to the rules set forth by ERISA. This means that companies can customize the package to a specific individual or employee class (i.e., executives).
There are no contribution limits, and not all employees have to get access. Independent contractors can participate in non-qualified plans, making them an ideal choice for businesses who want top talent without paying them upfront.
The only potential downside to a non-qualified package is that the government does not protect it. So, if the company does go bankrupt, those funds can be seized by creditors.
Not only that, but because the plan exists within a specific business, you can’t roll it into an IRA if you lose your job. That said, most NQDC plans do have shorter time frames, meaning that you don’t necessarily have to wait until retirement to access your money.
Some examples of NQDC plans can include:
- Stock Options
- Deferred Savings Plans
- Supplemental Executive Retirement Plan (SERP)
For the uninitiated, SERPs work similarly to a 401k without as much IRS oversight or restrictions. These plans come with a set contract that lays out specific qualifications and requirements that you have to meet. Assuming that you meet those rules, you can withdraw from the SERP after you retire.
Instead of contributing your own money to this plan, it’s fully funded by the company. Typically, a SERP comes in the form of a life insurance policy that pays annuities during retirement.
One distinct disadvantage of SERPs is that you can’t receive immediate tax benefits as you can with a 401k. When you contribute to a qualified retirement plan, you get to defer those taxes since it will lower your total income.
Since SERPs are funded by the company, you can’t claim any tax deferral. That said, since you’ll be withdrawing money from the account during retirement, you should be at a lower tax rate anyway.
Benefits of a Deferred Compensation Plan
Because deferred compensation plans are designed to attract top employees, they come with a slew of benefits. Here are some excellent reasons to participate in one of these packages.
Depending on the type of plan you use, you can save on your tax burden twice. First, when you contribute money to a retirement account, and second when you withdraw it during retirement. Here’s a breakdown of how that works:
As we mentioned, the current maximum contribution for a 401k in 2021 is $19,500. Let’s say you put the whole amount into your account. In this case, you can lower your adjusted gross income (AGI) by $19,500, meaning that you don’t have to pay taxes on it.
In a best-case scenario, that deduction will push you into a lower tax bracket so that you can save on the rest of your earnings for the year.
Since 401k plans are tax-deferred, you won’t pay anything to the government until you withdraw the money. When you’re retired, your income level should be (in theory) lower than it is right now, meaning that you’ll be in a lower tax bracket (as long as they remain the same)t. So, you didn’t have to pay taxes immediately, and you wind up paying less money overall.
If you participate in a Roth IRA or 401k, the situation is a bit different. Roth plans don’t allow you to defer taxes, meaning that you have to pay them no matter how much you contribute. Contribution limits are also much smaller than they are for a 401k, and they come with income restrictions.
That said, since you paid the taxes on your funds already, you don’t have to pay them when you withdraw. So, during retirement, you can take money out tax-free. Best of all, you can earn money since the account is tied to the stock market. As long as you don’t withdraw capital gains before age 59 1/2, you still don’t have to pay any taxes.
Although most deferred compensation plans are built for retirement, not all of them make you wait that long. For example, your company may set a time limit of 10 years with a non-qualified package.
In this case, you can save money for specific needs, such as buying a new house or paying for your kid’s college tuition. Best of all, some qualified packages still allow you to do this without incurring penalties. However, there are more restrictions, so you’ll need to pay attention to those before pulling money out.
Keep in mind that you will have to pay taxes on these withdrawals. So, if you remove $200,000 to help pay for a new home, that money will get tacked onto your adjusted gross income and put you into a higher tax bracket.
Your employer determines your salary, so your standard compensation doesn’t change. However, deferred compensation plans work differently. In most cases, these packages act as investment accounts, meaning that you can earn more money over time.
For example, let’s say that you contribute $10,000 per year to a deferred compensation plan for 10 years. If you took that money as regular income, you’d only have $100,000. However, with a deferred plan, you could earn some interest and growth.
Let’s say that your account made an average of four percent per year. After the first year, you’d have an extra $400, then another $816, and so on. That’s money that you wouldn’t receive otherwise.
Another example is if the company provides stock options. If the company does well and its stock price goes up, you could earn more money. Imagine working for a brand like Apple or Google in their early days and receiving stock options. Today, that’d be worth a lot.
Contact NextGen Wealth Today
It’s crucial to make the right decisions for your money. Whether you’re contributing to a deferred compensation plan, investing in stocks, or planning for retirement, it helps to have professionals on your side. NextGen Wealth can help you make the best money moves so that you’re always one step ahead. Contact us today to see what we can do for you.