When we hear the word compensation, most people tend to think of salaries and wages. But that's not the only form of compensation that employees have available to them. In fact, compensation comes in many forms. It can also include tips, profit-sharing, vacation pay, healthcare coverage, and deferred compensation plans.
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, 401(k) retirement plans, and employee stock options.
- Deferred compensation plans allow employees to withhold a certain amount of their salaries or wages for a specific purpose.
- Deferred compensation plans can be qualified or non-qualified.
- Qualified plans fall under the Employee Retirement Income Security Act and include 401(k)s and 403(b)s.
- Non-qualified plans are usually written and regulated by the employer
- There may be contribution limits, tax benefits, rules about withdrawals, penalties, and other regulations depending on the plan.
Qualified vs. Non-Qualified Deferred Compensation Plans
Deferred compensation plans generally come in two different forms: qualified and non-qualified. Although there are similarities, there are also distinct differences between these two types of deferred compensation plans.
- A qualified deferred compensation plan complies with the Employee Retirement Income Security Act (ERISA) and includes 401(k) and 403(b) plans. They are required to have contribution limits and be nondiscriminatory, open to any employee of the company, and beneficial to all. They are also more secure, being held in a trust account.
- A non-qualified 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.
Non-qualified plans don’t have contribution limits and can be targeted to specific employees, such as top executives. The employer may keep the deferred money as part of the business’s funds, meaning that the money is at risk in the event of bankruptcy.
It's important to note that money from a qualified plan can be rolled over into an individual retirement account (IRA) or other tax-advantaged retirement savings vehicle. Money from a non-qualified plan, though, cannot be rolled over into another plan. Be sure to check the plan rules that apply to you with your plan's administrators and consult a tax advisor before taking any in-service withdrawals.
Benefits of a deferred compensation plan, whether qualified or not, include tax savings, the realization of capital gains, and pre-retirement distributions.
There may be limits to the amount of money employees can set aside for their deferred contribution plans. These are referred to as Internal Revenue Service (IRS)-recognized plans, such as 401(k)s and 403(b)s. These limits are established by the IRS and adjusted annually for inflation. The annual contribution limit for employees for these plans is:
- $20,500 for 2022
- $22,500 for 2023
The IRS allows older individuals to make additional contributions to their plans. You can make a catch-up contribution of $6,500 in 2022 and $7,500 in 2023 if you are 50 or older.
Plans that aren't recognized by the IRS may don't have a contribution limit. For instance, you can usually set aside as much of your salary or wages for a profit-sharing plan. And certain plans meant for executives may not have a limit either. In any case, it's always a good idea to check with the employer if there are any contribution limits.
There are a number of key benefits that employees should be aware of before they begin contributing to a deferred contribution plan. We've listed some of the key advantages below.
A deferred compensation plan reduces income in the year a person puts money into the plan and allows that money to grow without any taxes assessed on the invested earnings. A 401(k) is the most common deferred compensation plan. Contributions are deducted from an employee's paycheck before income taxes are applied, meaning they're pre-tax contributions.
As such, you're only required to pay taxes on a deferred plan when you take a distribution or make a withdrawal. 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 likely to be in a comparatively lower income tax bracket.
Deferred compensation plans also reduce the current year's 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, thus reducing the total income taxes paid. When the funds are withdrawn, savings are potentially realized through the difference between the retirement tax bracket and the tax bracket in the year the money was earned.
Participants of 401(k) plans can withdraw funds penalty-free after the age of 59½. However, there is a loophole known as the IRS Rule of 55. This rule allows anyone between 55 and 59½ to withdraw funds penalty-free if they quit their job, were fired, or were laid off. The loophole only applies to the 401(k) you have with the company from which you are separating.
Deferred compensation has the potential to increase capital gains over time when offered as an investment account or a stock option. Rather than simply receiving the amount that was initially deferred, a 401(k) and other deferred compensation plans can increase in value before retirement.
While investments are not actively managed by participants, people have control over how their deferred compensation accounts are invested. They can choose from options pre-selected 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 participants to schedule distributions based on a specific date. This is called an in-service withdrawal. This added flexibility is one of the most significant 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. Depending on IRS and the plan rules, withdrawals from a qualified plan may not be subject to early withdrawal penalties. However, income taxes will be due on withdrawals from deferred compensation plans.
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 plan. If people are not comfortable leaving deferred compensation in the hands of their employer, pre-retirement distributions allow them to protect their money by withdrawing it from the plan, paying tax on it, and investing it elsewhere.
Disadvantages of Deferred Compensation Plans
Just like any other type of investment, deferred compensation plans come with both benefits and drawbacks. Since we've laid out the advantages of investing in them, this section outlines some of the main disadvantages of taking part in them.
- Contribution Limits: As noted above, you may only be allowed to contribute a certain amount of money to your plan. This rule only applies to plans that are governed by the IRS, such as a 401(k) or 403(b) plan.
- Loss of Investment: You are at the mercy of your employer. if the company you work for files for bankruptcy or becomes insolvent, you risk losing some or all of your money. The money you invested can be claimed by the company's primary creditors before you see a dime. This is true, of course, unless it's held in a trust.
- No Rollovers: While you can roll over money from IRS-regulated deferred plans, you can't do so with non-qualified deferred plans. This means you can't extend the benefits and provide yourself with a tax shelter down the road.
- Loss of Earnings: Setting your money aside in any investment is a risk. While there is a good chance your money will grow, there's an equal chance that your investment will diminish when the market takes a dip.
- No Immediate Access to Funds: Certain deferred compensation plans may not provide you with access to the money you've invested right away. IRS-ruled plans like the 401(k) are only meant for retirement. So if you make a withdrawal before the required date, you will incur a penalty and taxes. Some non-qualified plans may come with a waiting period before you get your money. For instance, a profit-sharing plan may take up to two business days for a transaction to complete before you can access the funds. And they may not give you access to the earnings until you've reached the vesting period.
How Do Deferred Compensation Plans Work?
Deferred compensation plans are perks provided by employers to their employees. They allow employees to elect a certain percentage or dollar amount of their compensation to be withheld for a certain purpose, such as retirement. Plans can be qualified, which means they fall under the purview of the IRS and are governed by the agency's rules. Others are non-qualified, which means the employer sets the rules. Plan types include 401(k), which is a qualified plan that comes with contribution limits and tax benefits, and profit-sharing plans. These plans are non-qualified and may provide the investor with easier access to the funds. The rules and regulations for the type of deferred compensation plan may vary, so it's important to check with your employer to see if it's right for you.
How Are Deferred Compensation Plans Taxed?
The taxation of deferred compensation plans depend on the type. Qualified compensation plans like the 401(k) are not immediately taxed. This means that you don't pay any taxes on the contributions you make. You are, however, taxed when you take the distributions during retirement. In addition to taxation at the rate, early withdrawals also incur penalties. Withdrawals from non-qualified plans typically also count as taxable earnings when the employer distributes them to the employee. Employees may also be responsible for paying capital gains taxes on any of the earnings in their accounts. Be sure to verify the tax implications of your plan with your employer before you invest.
What's the Difference Between a Qualified and a Non-Qualified Deferred Compensation Plan?
Qualified deferred compensation plans comply with ERISA. As such, they are regulated by the IRS. These accounts are commonly used for retirement, such as the 401(k) and 403(b) plans. The IRS sets contribution limits and updates them annually for inflation. It also outlines the rules about when you can withdraw the money, as well as the penalties and taxes you must pay if you want to access the funds before retirement.
Non-qualified plans are governed by the employer. As such, the company outlines the rules and regulations of these plans. These include profit-sharing and other similar options. The rules for these plans may not be as strict (especially when it comes to withdrawals) as qualified plans. Still, it's a good idea to check with your employer to ensure you make the right choice.
The Bottom Line
Some employers may offer more than just a salary to their employees as compensation. These extra perks can come in the form of healthcare, vacation pay, and even investment options like deferred compensation plans. Qualified deferred compensation plans may be used for retirement while non-qualified plans can be used for other purposes. Regardless of the type, these plans allow employees to set aside a portion of their take-home pay to use in the future. Be mindful, though, that the rules and regulations for these plans tend to vary so check with your employer about what happens with your contributions after they're invested.