Deferred Compensation Plans vs. 401(k)s: An Overview
Deferred compensation plans offer an additional choice for employees in retirement planning and are often used to supplement participation in a 401(k) plan. Deferred compensation is simply a plan in which an employee defers accepting a part of his compensation until a specified future date. For example, at age 55 and earning $250,000 a year, an individual might choose to defer $50,000 of annual compensation per year for the next 10 years until retiring at age 65.
The deferred compensation funds are then set aside and can earn a return on investment until the time they are designated to be paid out to the employee. At the time of the deferral, the employee pays Social Security and Medicare taxes on the deferred income just as on the rest of his or her income, but does not have to pay income tax on the deferred compensation until the funds are actually received.
- High-paid executives often opt for deferred compensation plans.
- Deferred compensation plans cannot generally be accessed and are a disadvantage in terms of liquidity.
- Unlike many 401(k) plans, deferred compensation plans cannot be borrowed against.
The Advantages of Deferred Compensation Plans
Deferred compensation plans are most commonly used by high-paid executives who do not need the total of their annual compensation to live on and are looking to reduce their tax burden. Deferred compensation plans reduce an individual’s taxable income during the deferral.
They may also reduce exposure to the alternative minimum tax (AMT) and increase the availability of tax deductions. Ideally, at the time when the individual receives the deferred compensation, such as in retirement, his or her total compensation will qualify for a lower tax bracket, thereby providing tax savings.
Deferred compensation plans are often used to supplement 401(k) plans.
How 401(k) Plans Differ
One reason deferred compensation plans are often used to supplement a 401(k) or an individual retirement account (IRA) is that the amount of money that can be deferred into the plans is much greater than that allowed for 401(k) contributions, up to as much as 50% of compensation.
The maximum allowable annual contribution to a 401(k) account, as of 2020, is $19,500. Another advantage of deferred compensation plans is that some offer better investment options than most 401(k) plans.
Deferred compensation plans are at a disadvantage in terms of liquidity. Typically, deferred compensation funds cannot be accessed, for any reason, prior to the specified distribution date. The distribution date, which may be at retirement or after a specified number of years, must be designated at the time the plan is set up and cannot be changed. Nor can deferred compensation funds be borrowed against.
The majority of 401(k) accounts can be borrowed against, and under certain conditions of financial hardship—such as large, unexpected medical expenses or losing your job—funds may even be withdrawn early. Also, unlike with a 401(k) plan, when funds are received from a deferred compensation plan, they cannot be rolled over into an IRA account.
Deferred compensation plans are less secure than 401(k) plans.
Risk of Forfeiture
The possibility of forfeiture is one of the main risks of a deferred compensation plan, making it significantly less secure than a 401(k) plan. Deferred compensation plans are funded informally. There is essentially just a promise from the employer to pay the deferred funds, plus any investment earnings, to the employee at the time specified. In contrast, with a 401(k) a formally established account exists.
The informal nature of deferred compensation plans puts the employee in the position of being one of the employer’s creditors. A 401(k) plan is separately insured.
By contrast, in the event of the employer going bankrupt, there is no assurance that the employee will ever receive the deferred compensation funds. The employee in that situation is simply another creditor of the company, one who is standing in line behind other creditors, such as bondholders and preferred stockholders.
Using Deferred Compensation Plans Wisely
It is generally advantageous for the employee deferring compensation to avoid having all of the deferred income distributed at the same time, as this typically results in the employee receiving enough money to put him or her in the highest possible tax bracket for that year.
Ideally, if the option is available through the employer’s plan, the employee does better to designate each year’s deferred income to be distributed in a different year. For example, rather than receiving 10 years’ worth of deferred compensation all at once, the individual is usually better off receiving year-by-year distributions over the following 10-year period.
Financial advisors usually suggest using a deferred compensation plan only after having made the maximum possible contribution to a 401(k) plan—and only if the company an individual works for is considered very financially solid.