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Deferred Compensation 101: What You Need To Know

Deferred compensation plans help employees build toward a successful retirement. These plans come in many forms that can be tricky to navigate. Here are a few foundational facts you need to know. 

All deferred compensation plans share one thing in common: they are a place to put money that is set aside for the future and distributed ideally once the individual moves to a lower tax bracket. Some deferred compensation accounts include contributions by both employee and employer. Some accounts are taxed upon contribution (such as Roth accounts) and allow for tax-free distributions. Other accounts give you a tax deduction today — but any distributions are treated as taxable income. The funds are typically allowed to grow tax-deferred while held in the deferred compensation plan.
Let’s dive in!

Importance of Deferred Compensation Plans

Deferred compensation plans come in a variety that offers something for every stakeholder. From the employer’s point of view, a quality plan helps retain key employees, both through offering a valuable tax-management tool and through vesting schedules that incentivize workers to remain with the company. Firms must carefully consider how they construct the employer match (or annual contribution), as well as the vesting period so that the overall benefits package is effective and financially feasible for the company. 

From the employee’s perspective, it is important to understand the difference between qualified deferred compensation plans and non-qualified deferred compensation plans (more on that in a moment). 

Finally, from the business point of view, there are complexities with administering the plan that can be fraught with legal pitfalls. The right guidance is needed for all stakeholders. SYM Financial Advisors in Indiana and Michigan provide plan administration services to help manage and reduce this risk.

How a Deferred Compensation Plan Works

When talking about deferred compensation plans, it is critical to understand the difference between qualified and non-qualified plans. 

A qualified plan meets the requirements of the Employee Retirement Income Security Act (ERISA); 401(k) or 403(b) plans are good examples. Qualified plans are required to have contribution limits, to be open to any employee of the company, and to be beneficial to all. They are also more secure, being held in a trust account. 

A non-qualified deferred compensation plan is a written agreement between the company and an individual employee.  Based on that agreement, a certain portion of the employee’s compensation is set aside, invested, and then given back to the employee in the future. 

What are Examples of Deferred Compensation?

There are several types of deferred compensation plans. Employers and business owners should know the various plans and how each of them fits or does not fit with their goals and resources.

1. Qualified Deferred Compensation Plans.

There are three primary qualified deferred compensation plans: 401(k), 403(b), and profit-sharing plans. 

  1. 401(k) is probably the best-known retirement savings plan in the US. It allows employees (plan participants) to contribute a percentage of their salary (or a certain dollar amount) to the plan each pay period, typically pre-tax. There is often an employer match. The funds are invested to grow tax-free until the employee reaches retirement age. Withdrawals are taxed as regular income. Taking money out of the plan before retirement age can result in penalties. 
  2. A 403(b) works similarly to a 401(k), except it is used by nonprofit organizations. It often takes the form of annuity contracts or mutual fund custodial accounts. 
  3. A profit-sharing plan allows employees to share in their company’s profits based on its quarterly or annual earnings. The company decides how much of the profit it will share, and only the company can make contributions to a profit-sharing plan. 

Keep in mind that both 401(k) and 403(b) plans can exist in their traditional form, whereby the employee’s contribution is made pre-tax and effectively reduces taxable income in the year it is made, and in a Roth form (where the employee is taxed in the year of the contribution, but future distributions are tax-free). 

2. Non-Qualified Deferred Compensation (NQDC) Plans

NQDC plans are typically offered to highly compensated employees. Primary benefits include giving high-income earners an opportunity to defer more taxable income when they might have already maxed out other qualified plans. 

From the employer’s perspective, a NQDC plan is a promise to save a portion of today’s income and to pay it out in the future. However, those future payments are not guaranteed should the firm face financial hardship. During good times, a NQDC can be quite lucrative to the employee — and it can help the employer retain quality talent. 

There are several different forms of NQDCs as defined by the IRS. 

  1. A Salary Reduction Agreement allows the participant to defer a portion of their salary to the future, reducing tax liability in the current year. 
  2. A Bonus Deferral Plan enables an employee to defer bonus income into the future. 
  3. A Top Hat Plan (also called a Supplemental Executive Retirement Plan or SERP) is designed for top executives and highly compensated employees. 
  4. An Excess Benefit Plan is offered to employees whose benefits are limited by Internal Revenue Code 415.

Finally, there are 457 plans, which are available to governmental and certain non-governmental entities. Employees can defer compensation into it on a pre-tax or after-tax (Roth) basis. For the most part, the 457 plan operates similarly to a 401(k) or 403(b) plan. These 457 plans (both governmental and non-governmental) can also allow independent contractors to participate in the plan, where 401(k) and 403(b) plans cannot. Also, because non-profits are often allowed to offer both 403(b) and 457 plans, it is possible for an employee to max out on both plans. 

How is Deferred Compensation Paid Out?

It is important to strategically time your deferred compensation payouts. Taking a lump sum distribution or electing installment distributions can have a significant impact on your tax liability in the year that it hits your income. SYM Financial Advisors can help clients determine the right course of action through investment selection and financial planning strategies.

How Much Should I Put into a Deferred Compensation Plan?

The amount to contribute to a deferred compensation plan depends on several factors, such as your overall net worth and asset mix, other retirement accounts, how much you have in taxable investments, what your anticipated income bracket is for any given year, the opportunity you may have to move to a lower- or zero-income tax state in retirement and the level of your emergency funds. It takes careful financial planning to determine the right amount for each period.

Deferred Compensation Plans in Indiana

Deferred compensation plans can allow employees to reduce tax liability and save toward retirement. The goal is to maximize the value of all forms of compensation by limiting taxes during high-earnings years — and to distribute those accounts during low-earnings years. Managing tax risk is a key piece of good financial planning. SYM Financial Advisors works with clients to formulate the best strategy. We also work with businesses and plan sponsors in this arena. By working with all stakeholders in the process, we have experience in this complex and important piece of financial planning. 

Get customized advice.

SYM offers a complimentary review that comes at no cost or obligation. An advisor will discuss a strategy and timeline that incorporates your unique compensation into your overall financial plan.

What are the distinguishing features of an executive or equity-based compensation?

Where do opportunities arise, and what are the risks and challenges?

Should your retirement strategy include nonqualified deferred compensation plan (NQDC) participation?

SYM advisors explore compensation strategies unique to each corporate environment to offer recommendations for building wealth through the different stages of a career. Contact SYM today.

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