As its name suggests, 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 deferred compensation plans work.
— Deferred compensation plans versus 401(k)s and IRAs.
— Pros and cons of deferred compensation plans.
— Should you get a deferred compensation plan?
[READ: Deciding Between a Roth vs. Traditional IRA.]
How Deferred Compensation Plans Work
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 Smith, McDowell & Powell in Sacramento, California. A deferred compensation plan might consist of a pension, retirement plan or employee stock options.
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. So 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 in 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 “When the funds are later withdrawn, savings are potentially realized through the difference between the retirement tax bracket and the tax bracket in the year the money was earned,” Sarkovich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.
Deferred Compensation Plans Versus 401(k)s and IRAs
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 2023 are $22,500, or $30,000 if you are 50 or older. Traditional IRAs have a maximum contribution of $6,500 in 2023, or $7,500 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 is when funds are distributed. For a 401(k) plan or IRA, you typically have to be at least 59 1/2 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.
[READ: How to Retire at 65 With $2 Million]
Pros and Cons of Deferred Compensation Plans
A deferred compensation plan comes with several advantages over other retirement savings options. However, there are some potential drawbacks to consider. Reading through the details of a plan and talking to your employer can be useful as you evaluate your circumstances.
Pro: Ability to Set Dates
With a deferred compensation plan, you and your employer can decide on an optimal time for you to receive the funds. This may be helpful as you plan when you’ll retire and what income streams you’ll use to support your lifestyle.
Pro: Ability to Save
If you earn a high income, you might be looking for ways to set aside money that you don’t need to cover your expenses. You might decide to have $60,000 placed in the plan every year for 10 years. This reduces your taxable income during that time too.
Con: Higher Uncertainty
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. If the company goes bankrupt, the balance in the account could be completely lost.
Con: Fewer Investment Options
The money in a deferred compensation plan is frequently placed directly into company stock. You might not have the choice of diversifying the investments. As the value of the company fluctuates, your built-up savings could go up and down too.
[Related:How to Retire at 55 on $1 Million]
Should You Get 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 real estate or a health savings account.
You may also review the company’s track record and forecasted 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.
More from U.S. News
Essential Sources of Retirement Income
What Is a Good Monthly Retirement Income?
How Income Annuities Can Buy You Time Until Social Security Kicks In
What Is a Deferred Compensation Plan? Pros, Cons and Advice originally appeared on usnews.com
Update 09/13/23: This story was published at an earlier date and has been updated with new information.
