When we hear the word compensation, most of us think of wages, but compensation comes in many forms. Tips, profit-sharing, vacation pay, healthcare coverage, and deferred compensation plans are all examples.
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.
Pensions, 401(k) retirement plans, and employee stock options all are types of deferred compensation.
Key Takeaways
- Deferred compensation plans withhold a certain percentage of an employee's salary or wages to fund a specific future benefit.
- Qualified plans like 401(k) and 403(b) retirement savings accounts have tax advantages and meet the requirements of the Employee Retirement Income Security Act.
- Non-qualified plans are usually regulated by the employer.
Qualified vs. Non-Qualified Deferred Compensation Plans
Deferred compensation plans generally come in two forms: qualified and non-qualified. Although there are similarities, there are also distinct differences:
- A qualified deferred compensation plan complies with theEmployee Retirement Income Security Act (ERISA) and has tax benefits. Examples are 401(k) and 403(b) retirement savings 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 turned over to the employee at a future date, often at retirement.
Non-qualified plans don’t have contribution limits and are often offered only to certain 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 if the company goes bankrupt.
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 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, qualified or not, may include tax savings, the potential for investment gains, and some access to pre-retirement distributions.
Contribution Limits
Because there are tax benefits, there are limits to the amount of money employees can set aside in deferred contribution 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 401(k) plans in 2024 is $23,000. Employees aged 50 and older can add a catch-up contribution of $7,500.
Plans that aren't recognized by the IRS may not have a contribution limit. For instance, a profit-sharing plan may have no cap. And certain plans meant for executives may not have a limit either.
Benefits
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.
Tax Benefits
A deferred compensation plan reduces an employee's taxable income in the year in which it is deposited into the account and allows that money to grow without any taxes assessed on the invested earnings.
A traditional 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 retired and in a lower income tax bracket.
Deferred compensation plans reduce the current year's tax owed by an employee while setting aside that income for retirement. When the funds are withdrawn, the withdrawal amount is subject to income taxes.
Note
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. Anyone between age 55 and 59½ can 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.
Capital Gains
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 range of options from conservative stable value funds and certificates of deposit (CDs) to more aggressive bond and growth stock funds.
It is possible to create a diversified portfolio from various funds, select a target-date or target-risk fund, or rely on specific investment advice.
Monitor your deferred compensation plan account carefully because it can also decrease in value if you're investing in riskier funds.
Pre-Retirement Distributions
Some deferred compensation plans allow participants to schedule distributions based on a specific date for a specific reason. 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 the 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.
This protects people who are not comfortable leaving their retirement funds 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. The drawbacks differ between qualified and non-qualified compensation plans.
- Contribution Limits: You are only allowed to contribute a certain amount of money annually to a qualified plan. This rule applies to plans that are governed by the IRS, such as a 401(k) or 403(b) plan.
- Loss of Investment: If it is a non-qualified plan, you are at the mercy of your employer. If the company files for bankruptcy, you risk losing some or all of your money. It 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. Money in a qualified compensation plan such as a 401(k) is protected by ERISA regulations.
- No Rollovers: If it is a qualified plan, you can roll over money to an IRA or another 401(k) plan if you change jobs. You can't do that with non-qualified deferred plans.
- 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: Most deferred compensation plans do not allow you 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 come with a waiting period or a 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 have tax advantages and are governed by the agency's rules. Others are non-qualified, which means the employer sets the rules.
Qualified plan types include the 401(k), which comes with contribution limits and tax benefits.
Non-qualified plans include profit-sharing programs. The rules and regulations for non-qualified plans are largely up to the employer.
How Are Deferred Compensation Plans Taxed?
The taxation of deferred compensation plans depends 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 and you pay no taxes as your money grows over the years. You are, however, taxed when you take the distributions during retirement.
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 federal regulations under ERISA. These accounts are commonly retirement funds 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 such as profit-sharing plans are governed by the employer. As such, the company outlines the rules and regulations. The rules for these plans may not be as strict (especially when it comes to withdrawals) as qualified plans.
The Bottom Line
Many employers offer more than a salary 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, such as profit-sharing programs.
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 that the rules and regulations vary, so read the fine print before you sign up for a plan.
