You’ve entered a new workplace; everything seems possible. But HR just handed you the company policy containing terms like deferred compensation plan, 410k retirement benefits and tax regulations. It’s normal to get bogged down by compensation and tax-related jargon.
The good news is that we’re here to help!
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This article serves as a learning resource for all employees looking to accelerate their savings.
What is a deferred compensation plan? Why do they call it “the golden handcuff?” Read on to find out.
Article Roadmap
- What Is a Deferred Compensation Plan?
- Benefits
- Disadvantages
- Should You Opt for Deferred Compensation Plans?
- Specialized Types
- Next Steps
What Is a Deferred Compensation Plan?
A deferred compensation plan is a remuneration strategy where part of an employee’s salary is allowed to stockpile tax-free over a period of time. When the employee retires in a lower tax bracket, they receive the sum.
Employers may invest the deferred earnings in company stock or mutual funds in some cases. The addition of interest payments and the possibility of capital gains raises the value of the payment.
High-earning employees generally opt for deferred plans because they usually max out their 401k savings. Additionally, deferred plans aren’t regulated by the ERISA, so there are no limits to annual contributions.
Primary Benefits
Along with the evident downsides of having a portion of your pay withheld, deferred compensation plans offer benefits in the future.
Tax Benefits
The amount of postponed earnings decreases current income and isn’t taxed until the beneficiary gets the payout. Individuals who intend to move into a lower income tax rate profit significantly from the plan. Furthermore, if future tax rates in the country drop, beneficiaries of deferred compensation schemes will eventually pay less in taxes.
Retirement Savings
People who subscribe to deferred compensation plans receive a steady income once they retire.
A retirement investment product like a 401(k) or an annuity, which pays out a set sum for a predetermined number of years, is the most basic type of retirement income linked to deferred compensation.
Deferred compensation life insurance plans can be cashed out by retirees, giving them a substantial amount they can use for investments, savings, spending or a combination of the three. You can even exchange stock options gradually over time for a more stable cash flow.
Capital Gains
Investment accounts or stock options might rise in value before retirement, amplifying their worth rather than merely passing on the original deferred amount. The value of the post-retirement payout increases through regular interest payments.
Furthermore, if the investment’s worth improves over time, the recipient stands to profit from capital gains.
Smart Savings
What’s the benefit of deferred compensation plans for the earner’s family?
Suppose you have a pension or an independent retirement plan. In that case, you can utilize your deferred salary to support family members with college tuition, mortgage payoffs and other financial woes, or even to leave a higher inheritance to your children.
Disadvantages
Limited Access
Participants may not be able to access their deferred compensation until a certain age or upon retirement, making it less liquid than other forms of savings. Liquifying deferred assets prematurely invites heavy IRS penalties.
Market Risk
Deferred compensation plans are often invested in stocks, bonds or other securities that are open to market vulnerabilities.
Uncertainty
The amount of deferred compensation an individual receives may be uncertain, as it’s often based on company or stock performance. If the employer isn’t financially stable, they may be unable to fulfill their obligations under the deferred compensation plan.
Tax Implications
Deferred compensation plans are often taxed as ordinary income when distributed, which can result in a higher tax bill than expected.
Complexity
Deferred compensation plans can be complex, making it difficult for participants to comprehend the terms and conditions.
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Should You Opt for Deferred Compensation Plans?
If you ask employees why deferred compensation plans appeal to them you’ll probably hear a variety of answers. But here are the top reasons driving them to invest:
- 63% of employees choose NQDC plans to secure their retirement earnings.
- 21% of employees use the payment scheme to reduce their current tax bills.
A deferred compensation plan is appropriate for you based on several variables, including your financial status, future income potential and risk aversion.
Here are some questions to ask yourself and our in-house responses to them.
Questions To Ask
How much risk are you open to taking?
Your DCP account is an uninsured company liability since it’s a non-qualified deferred compensation plan. If your employer declares bankruptcy, you may lose a portion or all of your money in this account.
So, before contributing a penny to your DCP account, you should consider your employer’s financial stability. While only about 70 large corporations filed for bankruptcy in 2021, you should define your contribution as an employer burden.
What is your exposure to your company’s plan?
Calculate your exposure by adding your deferral sum, the market value of company stocks and the value of pension plans. The lower your net worth percentage in your company’s plan the safer it is to invest in a DCP.
How much do you reap in terms of tax benefits?
Here’s an example of deferred income accounting unlocking compounded tax gains:
Even after paying income tax on a lump-sum payment from a deferred compensation plan at the end of the term, postponing income for 15 years at the highest marginal tax band and generating a pre-tax return vs. an after-tax return results in 36% greater wealth.
When do you want to collect your deferred gains?
This choice is a bargain between deferring your income for as long as possible and losing the account in the event of bankruptcy.
Most plans allow you to choose whether to disburse the funds while you are still employed or at termination/retirement. Following that, you must determine whether you want the cash deposited as a one-time deposit or spread out over several years.
A lump sum credit to your account is prone to audits and higher taxable bills.
Alternatives here vary from three years to 15 years.
Specialized Types
Fresh hires generally turn down deferred compensation plans because the funds are inaccessible for years. HR professionals target experts with this strategy, so it’s not popular among younger employees.
If you’re undecided about non-qualified deferred compensation plans, let’s discuss specialized payment plans that are either risk-averse or more suitable to your financial situation.
Roth 401(K) Plan
This plan requires immediate income tax payments. The amount in a Roth account is usually tax-free when liquidated. As a result, it may be a preferable alternative, especially for those who plan to be in a higher tax band after retirement.
Excess Benefit Plans
This plan gives employees who have already enrolled in eligible benefit plans the option of investing more money in retirement plans as an added perk.
Salary Reduction Arrangements
Employees who participate in a deferred compensation plan may postpone a portion of their income to a given year. They don’t have to pay taxes on projected money until they get it in the future.
Supplemental Executive Retirement Plans (SERPs)
Some employers decide to make non-qualified contributions to a supplemental retirement fund that the employee can use after retiring and meeting the requirements of the retirement plan. Employees that earn SERPs inside a corporation are often significant executives or highly compensated employees.
Bonus Deferral Plans
Employees have the option to postpone the payment of any bonuses they earn as well as the bonus tax until a later date.
Next Steps
Securing high returns in a volatile economy is beset with risks but, for what it’s worth, deferred compensation plans offer employees a flexible, tax-exempt way to build their retirement savings.
Once you’ve asked internal questions and browsed the special types of DCPs, you can use software to select a specific amount of your salary to be deferred each pay period and then invested in a pre-selected investment option.
Refer to our compensation management requirements template to easily set up the list of features you want from a solution.
Are you opting for deferred compensation plans? If so, which one did you pick? Write to us in the comments!