A deferred compensation plan withholds a portion of an employee's pay until a specified date, usually retirement. The lump sum owed to an employee in this type of plan is paid out on that date. Examples of deferred compensation plans include pensions, retirement plans and employee stock options.
Deferred compensation plans can be qualifying or non-qualifying. A qualifying compensation plan complies with the Employee Retirement Income Security Act (ERISA). Qualifying plans include 401(k)s, 403(b)s and 501(c)(3)s.
A non-qualifying compensation plan is a written agreement between an employer and an employee in which part of the employee's compensation is withheld by the company, invested, and then given to the employee at some point in the future. Benefits of a deferred compensation plan include tax savings, the realization of capital gains and preretirement distributions.
A deferred compensation plan reduces income in the year a person puts money into the plan and allows that money to grow without annual tax being assessed on the invested earnings. In the case of a 401(k), the most common deferred compensation plan, contributions are deducted from an employee's paycheck before taxation, and are limited to a maximum pretax annual contribution, which is $18,500 as of 2018.
These deferred plans only require the payment of tax when the participant actually receives the cash. This means that in the case of a 401(k), participants can withdraw funds penalty-free after the age of 55. While taxes need to be paid on the withdrawn funds, these plans give the benefit of tax deferral, meaning withdrawals are made during a period when participants are in a comparatively lower income tax bracket.
These types of plans also reduce the current year tax burden on employees. When a person contributes to a deferred compensation plan, the amount contributed over the year reduces taxable income for that year, therefore reducing the total income taxes paid. Then, when the funds are withdrawn, savings are realized through the spread in the retirement tax bracket and the tax bracket in the year the money was earned.
Deferred compensation, when offered as an investment account or stock option, has the potential to increase capital gains over time. Rather than simply receiving the amount that was initially deferred, a 401(k) and other deferred compensation plans can increase in value before retirement. On the other hand, deferred compensation plans can also decrease in value, and should be monitored closely.
While investments are not actively managed by participants, people do have control over how their deferred compensation accounts are invested, choosing from options preselected by an employer. A typical plan includes a wide range of these options, from more conservative stable value funds and certificates of deposit (CDs), to more aggressive bond and stock funds. It is possible to create a diversified portfolio from various funds, select a simple target-date or target-risk fund or rely on specific investment advice.
Some deferred compensation plans allow people to schedule distributions based on a specific date, also known as an in-service distribution. This added flexibility is one of the largest benefits of a deferred compensation plan. It offers a tax-advantaged way to save for a child’s education, a new house or other long-term goals.
It is possible to withdraw funds early from most deferred compensation plans for specific life events such as buying a new home. These withdrawals are treated as being tax-free and are not subject to early withdrawal penalties.
In-service distributions can also help people partially mitigate the risk of companies defaulting on obligations. Some deferred compensation plans are completely managed by employers or have large allocations of company stock in the plans. If people are not comfortable leaving deferred compensation in the hands of their employers, preretirement distributions allow them to protect their money by spending it on current necessities rather than waiting until retirement.