Employees work and receive compensation in exchange for their services. “To defer” means to postpone or suspend. But how does it apply to compensation? Let us find out how.
What is “deferred compensation?”
Deferred compensation refers to an arrangement wherein an employee is allowed to postpone being paid a certain portion of their compensation and get it at a later date. Meaning: a part of an employee’s compensation is set aside to be paid out in the future. You can also think about it as compensation that you have worked for and earned, but have not yet received from your company.
By choosing to defer compensation, it reduces the employee’s taxable income for the current year. Why? This is because deferred compensation is not considered as taxable income until it is paid out or given to the employee.
What is the purpose of deferred compensation?
While there can be several reasons why organizations offer deferred compensation to employees, its purpose is typically for retirement plans and pension plans. Also, deferred compensation allows the employee to have potential advantages when it comes to tax. Because deferred compensation remains untaxed until the time of withdrawal (which is typically after retirement), the employee’s tax liability can be reduced. This is especially beneficial if the employee expects to be in a lower income tax bracket after they retire.
It is important to note that deferred compensation always occurs with the employee’s consent. The decision to defer compensation primarily depends on the individual’s financial goals and personal tax decisions.
What are the types of deferred compensation plans?
Deferred compensation can be qualified or non-qualified. Let’s take a look at each one.
Qualified deferred compensation plan
These are deferred compensation plans that comply with the Employee Retirement Income Security Act (ERISA). ERISA is the act that protects the retirement assets and funds of workers in the United States. Under ERISA are rules and guidelines that all qualified deferred compensation plans must follow to prevent misuse of the funds under these plans.
Examples of qualified deferred compensation plans are 401(k), 403(b), and 457 plans.
A company that has this plan must offer it to all employees, not just a chosen few. However, it is not offered to independent contractors.
Contributions to this kind of plan have a limit.
The primary purpose of a qualified deferred compensation plan is to benefit the recipients (employees).
In this kind of plan, funds are more secure because funds cannot be used by creditors in the case of company bankruptcy.
Non-qualified Deferred Compensation Plan
Non-qualified deferred compensation plans are often referred to as 409(a) plans.
A company that has this plan is not required to offer it to all employees.
A company can offer this plan to a select few or key employees only. It is used as an incentive to attract and keep executives and other employees.
A company can offer this plan to independent contractors.
Contributions to this kind of plan do not have a limit.
In this kind of plan, funds are potentially less secure because the employer can keep the deferred money together with the funds of the business. This is a risk in case of company bankruptcy.
What are different forms of non-qualified deferred compensation plans?
There are different forms of non-qualified deferred compensation plans or 409(a) plans which the Internal Revenue Service (IRS) recognizes:
Excess Benefit Plans: these are plans to provide particular employees who are currently enrolled in a qualified deferred compensation plan with the option to contribute additional funds to retirement plans. This is an additional plan, hence the term “excess” benefit.
Salary Reduction Arrangements: employees on this kind of plan can opt to defer a part of their compensation until a future year.
Supplemental Executive Retirement Plans (SERPs): these are commonly offered to top-level executives as a long-term incentive. In this kind of plan, the company and the executive sign a written agreement that states a specified amount that serves as a supplemental income upon retirement. This agreement is based on the eligibility conditions set by the company that the executive must pass.
Bonus Deferral Plans: in this plan, the employee can choose to defer or postpone receiving bonuses. They may defer the bonus until a future date and pay taxes once they cash out the bonuses.
I am an employee. Should I consider a deferred compensation plan?
It is always a good thing to plan and prepare for the future. There are a lot of things to consider before deciding to have a deferred compensation plan. Ask yourself some important questions. Are you planning on staying with your company until you retire? Is your organization financially stable? What types of deferred compensation plans are available to you? How comfortable are you in not taking home a portion of your compensation? Can you give that up? What are your financial goals? These are just some sample questions to keep in mind before deciding if a deferred compensation plan can benefit you.
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