What is deferred compensation?
Deferred compensation is a part of an employee's compensation that is set aside to be paid at a later date. In most cases, taxes on this income are deferred until it is paid out. A representative may decide on deferred compensation since it offers potential tax cuts. As a rule, personal expense is deferred until the compensation is paid out, normally when an employee resigns.
What are the types of deferred compensation?
There are several types of deferred compensation Section 409A plans that the IRS recognizes, including:
1. Excess Benefit Plans
These plans allow employees currently enrolled in qualified benefit plans the option to contribute additional funds to retirement plans as an excess benefit.
2. Salary Reduction Arrangements
Employees on a deferred compensation plan may choose to defer a portion of their salary until a future year. For example, an employee that earns $80,000 per year may choose to defer $30,000 of their salary and only receive $50,000 for the current year. Deferred funds are not eligible as taxable income for employees until they receive the funds in the future.
3. Supplemental Executive Retirement Plans (SERPs)
Some companies choose to contribute non-qualified funds to a supplemental retirement fund the employee can access once they’ve retired and met the conditions set forth in the retirement plan. Employees that receive SERPs are usually key employees or highly compensated employees within a company.
4. Bonus Deferral Plans
Employees can choose to defer any bonuses they receive until a future date and may defer their bonus tax until they receive it in the future.
What is the difference between a 401k and a deferred compensation plan?
Deferred compensation plans are frequently used to augment a 401(k) or an individual retirement account (IRA) since the amount of money that can be deferred into the plans is significantly higher than that allowed for 401(k) contributions, up to 50% of pay. Another benefit of deferred compensation plans is that they typically have more investment possibilities than 401(k) plans.
In terms of liquidity, deferred compensation schemes are at a disadvantage. Deferred compensation funds are often not accessible prior to the set release date for any reason. The payout date, which might be at retirement or after a specific number of years, must be stated when the plan is established and cannot be amended. It is also not possible to borrow against deferred compensation funds.
On the other hand, the majority of 401(k) accounts can be borrowed against, and assets can even be withdrawn early in specific circumstances of financial hardship, such as big, unexpected medical expenditures or losing your job. Furthermore, unlike a 401(k), funds received from a deferred compensation plan cannot be rolled over into an IRA account.
What is a qualified deferred compensation plan?
A qualified deferred compensation plan includes compensation plans such as a 401K. Qualified compensation plans have contributions limits and are only for the employees of a company. Unlike a non-qualified compensation plan, employers are required to separate funds from a qualified plan from the rest of their business funds.
What is a non-qualified deferred compensation plan?
A non-qualified deferred compensation plan includes any plan for deferred compensation between an employee and employer. This means that employees can choose to defer taxable income until a future year. The employee’s deferred income is not eligible to be taxed until they received the funds in the future.
Unlike qualified deferred compensation plans, employers do not need to separate NQDC funds from the rest of your business funds. Non-qualified plans also have no limit on employee contributions, and terms are determined between an employer and employee. The employer may choose to make the non-qualified plan elective and allow employees to choose to contribute, or non-elective and make the decision themselves. Employers can also make deferred compensation agreements with independent contractors.