A deferred compensation plan allows you to delay receiving part of your compensation until a later date. These retirement plans are offered by certain employers to a select group of workers. “Deferred compensation plans are typically designed for high earners, like executives, in order to allow them to push off receiving a portion of their compensation and instead receive that compensation with earnings at a later date,” says Jarred Wilson, vice president and consulting actuary at Segal, an employee benefits consulting firm, in the New York City area.
Before participating in a deferred compensation plan, you’ll want to know:
— How a deferred compensation plan works.
— How a deferred compensation plan compares to a 401(k) and IRA.
— The advantages and disadvantages of a deferred compensation plan.
— What to consider before getting a deferred compensation plan.
Read on to learn what to expect from a deferred compensation plan, and how to know if enrolling in this type of plan is right for you.
What Is a Deferred Compensation Plan?
As its name suggests, a deferred compensation plan allows an employer to defer a portion of an employee’s compensation until a specified date, which usually occurs at retirement. “The lump sum owed to the employee is then paid out on that date or paid across a period of years after the specified date,” says Marco Sarkovich, an associate attorney at Slate Law Group in San Diego. A deferred compensation plan might consist of a pension, a retirement plan or employee stock options.
How Does a Deferred Compensation Plan Work?
Your employer will set aside funds in your deferred compensation plan, and the exact amount will be determined by an agreement. You don’t have to pay federal income taxes on the contributed funds until you receive the money at a later date, but Social Security and Medicare taxes could apply. “State income taxes are paid at distribution and are based on the state in which the income was earned, not the state in which the income is distributed,” Wilson says. If you live and work in New York, and then retire to Florida, the distributions from the plan will be subject to New York state income tax.
Since the money placed into a deferred compensation plan is deducted from your salary, you won’t have to pay taxes on the amount contributed. In this way, your total income taxes for the year could be reduced. “When the funds are later withdrawn, savings are potentially realized through the difference between the retirement tax bracket and the tax bracket in the year the money was earned,” Sarkovich says.
How a Deferred Compensation Plan Compares to a 401(k) or IRA
Like a 401(k) plan or traditional IRA, the money placed in a deferred compensation plan grows in a tax-deferred way. You can exclude the contributions made during the year from your taxable income. The distributions later will be subject to income taxes.
Unlike a 401(k) or traditional IRA, there are no contribution limits for a deferred compensation plan. The 401(k) plan contribution limits for 2021 are $19,500, or $26,000 if you are 50 or older. Traditional IRAs have a maximum contribution of $6,000 in 2021, or $7,000 if you are at least 50 years old. Since there are no limits on a deferred compensation plan, you could defer up to all of your annual bonus and set it aside as retirement income.
Another difference lies in when funds are distributed. For a 401(k) plan or IRA, you typically have to be at least 59 1/2 years old to take withdrawals without facing any penalty. “Many deferred compensation plans require you to make an upfront election of when you will receive the funds,” says Chris Kampitsis, a financial planner at Barnum Financial Group in Elmsford, New York. For example, you might time the payments to come at retirement or when a child is entering college. In addition, the funds could come all at once or in a series of payments. “There is tremendous flexibility often in these plans,” Kampitsis says.
Advantages and Disadvantages of Deferred Compensation Plans
A deferred compensation plan provides more flexibility in taking distributions than other plans. You won’t face some of the same limitations and penalties on early distributions that are commonly found in traditional 401(k) plans and IRAs. The funds will remain in the deferred compensation plan until the arranged date.
Getting a deferred compensation plan involves some risk, since the funds belong to your employer until they are distributed. “In some situations a plan may be designed to only pay out if the employee remains with the company until retirement, resulting in a forfeiture of the entire account balance for switching jobs,” Wilson says. There isn’t as much flexibility for investing the funds, as the money is frequently placed directly into company stock. If the company goes bankrupt, the balance in the account could be completely lost.
What to Consider Before Getting a Deferred Compensation Plan
It may be worthwhile to explore your investment options before signing on to a deferred compensation plan. You might find other areas where your income could be invested, such as in a health savings account or traditional investment account.
You may also review the company’s track record and forecasted future performance. “If one has doubts as to the financial strength of the company, and if one may need to withdraw the money earlier than expected, a deferred compensation plan may not be an ideal option,” Sarkovich says.
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