Deferred compensation allows individuals to delay receiving part of their income until a future date, often during retirement. This strategy is appealing for retirement savings and tax management, as the income is typically taxed at a lower rate when withdrawn. There are two types: qualified deferred compensation plans and non-qualified deferred compensation (NQDC) plans, each with different rules, benefits and risks.
If you want to plan your retirement, a financial advisor can recommend different savings, investment and tax strategies for your nest egg.
Understanding Deferred Compensation
Deferred compensation refers to an arrangement between an employer and an employee where a portion of the employee’s earnings is set aside to be paid at a future date. Employers may use these plans as a tool to attract and retain key talent, offering employees the ability to delay income until retirement or another predetermined time.
Certain types of deferred compensation, including stock options, can be used as part of an executive compensation package. Other types of deferred compensation can be offered to a broader employee base, including 401(k) or 457 plans.
The primary appeal lies in the potential tax benefits, as the deferred earnings may be taxed at a lower rate when they’re eventually distributed.
Qualified Deferred Compensation Plans
A qualified deferred compensation plan is a retirement savings plan that meets specific requirements outlined by the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code.
These plans are typically employer-sponsored and allow employees to contribute a portion of their salary into a tax-advantaged account, growing their retirement savings. Contributions are usually made pre-tax, which helps lower an individual’s taxable income in the years they contribute.
Types of Qualified Deferred Compensation Plans
There are several types of qualified deferred compensation plans, each offering unique features. The most common include the following:
- 401(k) plans
- 403(b) plans for public school employees and certain non-profit organizations
- 457 plans for state and local government workers
Some plans may also offer employer-matching contributions, which can further boost the retirement savings for employees.
Eligibility and Contribution Limits
Eligibility for qualified deferred compensation plans is generally broad, covering most employees at participating companies. However, some plans may have restrictions based on years of service or job classification. Contribution limits are regulated by the IRS and 401(k) plans being one of the most common types.
For 2024, the maximum employee contribution to a 401(k) is $23,000, with an additional $7,500 catch-up contribution allowed for those aged 50 or older. These limits can vary depending on the type of plan.
Withdrawal Rules
Withdrawals from qualified deferred compensation plans, like 401(k)s and 403(b)s (note that these limits only apply to traditional plans and not Roth), are subject to specific rules set by the IRS. Generally, you can withdraw funds penalty-free starting at age 59½. If you make withdrawals before this age, a 10% early withdrawal penalty applies, in addition to regular income tax. Exceptions to this rule include circumstances like disability, certain medical expenses or separation from service after age 55.
Once individuals reach age 73 (75 for those born in 1960 or later), they must start taking required minimum distributions (RMDs) each year. The amount of the RMD is based on the account balance and life expectancy. Failure to withdraw the RMD results in a hefty penalty of 25% on the amount that should have been withdrawn.
These rules ensure individuals use the funds as intended – primarily for retirement income.
Non-Qualified Deferred Compensation Plans
Non-qualified deferred compensation (NQDC) plans are a type of deferred compensation agreement primarily used by highly compensated executives and key employees. These plans allow individuals to defer a portion of their earnings to a future date, such as retirement, without the contribution limits imposed on qualified plans like 401(k)s.
Types of Non-Qualified Deferred Compensation Plans
Types of non-qualified deferred compensation plans include:
- Supplemental Executive Retirement Plans (SERPs)
- Salary reduction agreements
- Bonus deferral plans
- Top-hat plans
- Excess benefit plans
Because they’re non-qualified, these plans don’t meet the stringent requirements set by the Employee Retirement Income Security Act (ERISA). This gives employers more flexibility in offering these plans to select employees. However, NQDCs also come with more risk for employees: If the company goes bankrupt, there’s no protections in place to ensure employees receive their deferred compensation.
Who’s Eligible for Non-Qualified Deferred Compensation?
Eligibility for NQDC plans is typically limited to top-level employees, such as executives and highly skilled professionals, due to their non-qualified status. Unlike qualified plans, NQDCs aren’t available to rank-and-file employees, and there are no mandatory participation rules.
Tax Treatment
NQDC contributions aren’t immediately taxed. Instead, taxes are deferred until the compensation is paid out, often when the employee retires or leaves the company. They can also be deferred until a set time period, like 10 years. At that point, the deferred income is taxed as ordinary income, which can provide tax advantages if the individual is in a lower tax bracket at this time.
Pros and Cons of Deferred Compensation
Deferred compensation plans offer both advantages and drawbacks that vary depending on whether the plan is qualified or non-qualified. Qualified deferred compensation plans, such as 401(k)s, follow strict IRS regulations, while non-qualified plans offer the opportunity to defer more money from taxes now but the employee has no control over the funds at all until they eventually receive them. Below are some key pros and cons of each type.
Pros of Qualified Deferred Compensation
- Tax advantages: Contributions to qualified plans are often tax-deferred, allowing for potential tax savings until the funds are withdrawn.
- Employer matching: Many employers provide matching contributions, which can significantly increase the value of the plan over time.
- Security: Assets in qualified plans are protected by federal law, guaranteeing compensation even if the employer goes bankrupt.
Cons of Qualified Deferred Compensation
- Contribution limits: The IRS imposes annual contribution limits, restricting the amount of income that can be deferred.
- Required distributions: Many qualified plans mandate required minimum distributions (RMDs) starting at age 73, which can complicate long-term financial planning.
- Limited investment options: Investment choices may be restricted to a pre-selected list, potentially limiting growth opportunities.
Pros of Non-Qualified Deferred Compensation (NQDC)
- No contribution limits: NQDC plans allow participants to defer larger amounts of income without being subject to IRS contribution caps.
- Customizable terms: Employers and employees have more freedom to structure the terms of the NQDC plan, including payout schedules.
- Tax deferral: Similar to qualified plans, NQDCs offer tax-deferred growth, potentially reducing tax obligations if employees are in a lower tax bracket when they receive the income.
Cons of Non-Qualified Deferred Compensation (NQDC)
- Creditor risk: Unlike qualified plans, NQDC assets aren’t protected from creditors if the company faces financial difficulties or bankruptcy.
- Lack of portability: NQDC plans are often tied to the employer, making it difficult to transfer funds if the employee changes jobs.
- Delayed access: Employees generally can’t access funds until a specific event occurs, such as retirement or separation from the company. This limits liquidity.
Bottom Line
Deferred compensation allows individuals to set aside income to be paid at a later date, offering potential tax advantages and retirement savings opportunities. Qualified plans, such as 401(k)s, are subject to IRS regulations, providing tax benefits, employer matching and legal protections. But they also come with contribution limits and required distributions. Non-qualified plans, often used by executives, offer more flexibility with larger deferral amounts and customizable terms, but carry risks like lack of creditor protection and limited portability.
Tips for Retirement Planning
- A financial advisor can help you create a retirement plan based on your needs, goals and risk profile. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to know how much your retirement savings could grow over time, SmartAsset’s free retirement calculator could help you get an estimate.
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