LAST REVIEWED Dec 13 2019 8 MIN READ
By The Human Interest Team
Deferred compensation plans can be a useful savings tool, especially for participants looking to maximize 401(k) contributions while still having savings available for investment. Deferred compensation plans also come with lots of rules and regulations. We break it all down here, including qualified vs. non-qualified plans, how they work together with 401(k) plans, and the advantages and disadvantages that come with them.
A Beginner’s Guide to Deferred Compensation
Benefit and compensation packages for top-level executives and employees sometimes offer a Section 409A non-qualified deferred compensation plan, in addition, to typical 401(k) options. A deferred compensation plan allows participants to defer income now and withdraw it later on, typically during retirement, when their taxable income most likely will be lower.
Once participants defer their income, their employer can either keep track of this income via bookkeeping accounts, set aside in a Rabbi Trust and remain part of the company’s general assets, or invest the funds. Investing options can include annuities, securities, or insurance arrangements, so it’s important to evaluate tax benefits and potential returns of a deferred compensation plan vs. alternative saving avenues.
Qualified vs. Non-qualified Deferred Compensation Plans
There are two types of deferred compensation plans: qualified and non-qualified. Understanding the differences between the two is important when determining which is right for you and your employees.
A qualified deferred compensation plan acts in accordance with the Employee Retirement Income Security Act (ERISA), which includes 403(b) and 401(k) plans. They must be nondiscriminatory, available to and benefiting all company employees equally, and include contribution limits. A qualified deferred compensation plan is held in a trust account, making it more secure than its non-qualified counterpart.
Non-qualified compensation plans are written agreements between an employee and their employer where a portion of an employee’s compensation is withheld, invested, and then returned to the employee sometime in the future.
There are no contribution limits for a non-qualified deferred compensation plan, and they are not required to be made available to all employees. Employers can keep deferred funds as part of the company’s funds, putting them at risk if the company were to go bankrupt.
Deferred Compensation Plan vs 401(k)
Comparing deferred compensation vs 401(k) accounts is important when deciding which one is best for you. Deferred compensation plans are often used to supplement IRA or 401(k) retirement plans since the amount of money allowed to be deferred into them is significantly greater than contribution limits for 401(k) and IRA plans.
For 2020, the maximum annual 401(k) contribution is $19,500. Catch-up contributions allow individuals aged 50 years or older to contribute $26,000 annually, or $6,500 in catch-up elective deferrals.
Should You Participate in a Deferred Compensation Plan?
There are a few questions employees should consider when deciding to participate in a deferred compensation plan:
What is the strength of the employer? Deferred compensation plans are IOUs from the employer to the employee. If a company goes bankrupt, these plans are considered unsecured company debt and may result in a total loss of the employee’s contribution.
How much of your total wealth is connected with your employer? In addition to salary, employees may also have stock purchase plans, stock options, or restricted stock units, all of which depend on the future of the business. Adding a deferred compensation plan on top of these may result in more risk than you feel is appropriate.
How long do you plan on staying with the employer? Employees who are more than 15 years away from retiring are at more risk of something threatening the financial stability of the employer. For example, who would have guessed ten years ago that GE would be facing the financial difficulties they are now?
Consider your current tax bracket and what it’s likely to be in the future. While no one can completely predict what tax brackets and rates will be in the future, by deferring income now, employees may be able to place themselves in a lower tax bracket now.
Benefits of Deferred Compensation Plans
There are several benefits to deferred compensation plans employees should consider:
There are no contribution limits for deferred compensation plans, meaning employees can defer a great deal of income now to use during retirement.
If the employer offers investment options, employees might be able to invest that money for increased earnings.
Unlike other retirement savings plans, there are no nondiscrimination rules for an executive deferred compensation plan.
Deferred compensation plans offer tax benefits as they reduce an employee’s income for the contribution year and allow funds to grow without invested earnings being taxed.
Disadvantages of Deferred Compensation Plans
As with any decision, there are also disadvantages to deferred compensation plans that employees should consider:
A company deferred compensation plan is often referred to as “golden handcuffs,” keeping key employees with the company. Depending on the terms of the plan, an employee may end up forfeiting all or part of their deferred cash compensation if they depart from the company early.
An employee’s deferred compensation, along with any investment earnings are at risk of forfeiture depending on the overall financial health of the business.
The decision to participate in a deferred compensation plan must be made before the year that compensation is earned. That decision, along with how and when it is to be paid out, is irrevocable.
Unlike other employer-sponsored retirement plans, employees aren’t able to take loans out against a deferred compensation plan.
Are Deferred Compensation Plans Good?
Employees should think about the following questions when deciding if a deferred compensation plan is right for them:
Is the employer financially secure and likely to remain so?
Will their tax rate be less in the future when they receive deferred compensation?
Can the employee afford to defer the income in question?
Are there investment options with the plan? Are the selection of funds and fees reasonable?
Does the plan allow for a flexible withdrawal schedule?
Have questions about how a deferred compensation plan can help supplement 401(k) retirement plans for your small and medium business employees? Complete this online form and have a Human Interest representative contact you.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.