Deferred Compensation: What It Is and How It Compares to a 401K

401(k) | Equity Compensation

 Plancorp Team By: Plancorp Team

Numerous options exist for stashing your discretionary ("extra") money in a safe place and when saving for retirement, it's essential to understand exactly how your savings plan works. That way, you'll maximize your potential earnings so that you have a secure future.  

Are you utilizing your compensation plan to its fullest potential?  

Deferred compensation is just one of many ways to save money for retirement. Learn what deferred compensation is, the types of deferred compensation plans, the benefits of deferred compensation programs, and whether they're better than a 401K.    

What Is Deferred Compensation? 

Deferred compensation is any program set up to set aside a portion of an employee's earnings to be paid out at a later date, at which time it will be taxed. It's more commonly referred to as "non-qualified" deferred compensation (NQDC), which is associated with a tax code benefitting highly compensated corporate employees. The Internal Revenue Code section 409A dictates the purpose, timing, and distributions for non-qualified deferred compensation plans.  

Deferred compensation came about as part of the American Jobs Creation Act of 2004; a federal tax act bill put in place to primarily repeal the export tax incentive (ETI). In addition, it included CEOs and CFOs as part of the group of covered employees subject to the $1 million cap on deductible compensation and repealed the exception for performance-based compensation. Lastly, compensations vested before 2017 were grandfathered under existing contracts. The Tax Cut and Job Act of December 2017 established new tax laws, including changes to non-qualified plans related to broad-based employee equity for private companies. 

How Does a Deferred Compensation Plan Work? 

Deferred compensation plans work by allowing employees to save part of their paycheck in an account before taxes are taken out. This money can't be withdrawn unless certain conditions are met that are primarily based on elections you make but can also be due to death or disability. In some cases, you might withdraw money while you're still working or after you leave a company. You'll be given a lump sum or installments over a specified number of years (usually up to 15 years).

Most people are familiar with employer savings plans where part of their salary is deferred and placed into a trust or fund where they can allocate investment options. However, employers most often use NQDC plans to attract and retain employees. As part of an agreement, the income is deferred for a specific period of time, which can vary from several years to retirement age.  

Types of Deferred Compensation Plans 

There are different types of deferred compensation plans that your employer may offer. For example, they may be available as retirement plans, pension plans, and stock-option plans.  

A deferred compensation program can be structured under federal regulations as a non-qualified or qualified plan. The main difference is that NQDC plans allow employers to choose which employees can receive benefits, offer more flexibility in vesting schedules, permit independent contractors to receive benefits, employer contributions aren't tax-deductible, and employees pay taxes when the compensation is eligible to be withdrawn. Qualifying deferred compensation plans are subject to regulations under the Employee Retirement Income Security Act of 1974 (ERISA), so an individual can defer a certain amount of income though it was designed to boost savings for lower-income employees. 

Deferred Compensation Vs. 401K 

As compared to a 401K plan, an NQDC offers less flexibility when it comes to withdrawals. There's no RMD (required minimum distribution), but you're bound to distribution elections made prior to contributions being made. You can sometimes change these elections, but it results in a five-year delay.

You can withdraw funds from an NQDC whenever you want rather than wait until you're almost 60. Nor are you required to start minimum amounts of withdrawals when you turn 72. That way, you get access to your money if a situation arises, like an emergency or to pay college tuition. Each employer sets rules for how long you must wait before you can withdraw cash. If you leave the job, get fired, or retire early, this could impact the ability or timing to take money out. For this reason, NQDC plans are sometimes called "golden handcuffs." 

Contributions to a 401K aren't tax-deferred, so you won't have to worry about paying taxes on withdrawals. You'll have to pay steep penalties if you make early withdrawals. However, 401Ks offer the option to take out loans that you can pay back without penalty. 

Deferred Compensation Plan Benefits 

Many employers offer NQDC to allow you to defer taxes on a cash bonus and/or salary beyond 401K limits. These programs offer myriad benefits, making them an attractive savings option for many. These benefits include: 

  • No state or federal income tax is taken from the deferred contributions 
  • Investment growth and income are tax-deferred
  • More potential to grow earnings that are tax-deferred 
  • Provides an additional retirement vehicle when 401K plan contributions are maxed out 

The downside of NQDC plans is you can't take out loans or roll your money into an IRA or other retirement account. Unfortunately, if that company goes bankrupt, you risk losing your contributions. This risk is what allows NQDCs to be pretax contributions, and why a savvy financial planner would advise against concentrating a lot of assets in a specific company's deferred compensation plan.

Get the Most Out of Your Compensation Plan 

It can be confusing to navigate the various savings plans. From deferred compensation to 401Ks, it's vital to understand how they work so that you're making the most of them. Deferred compensation is a great way to cut your taxes and save for retirement, especially if you have reached the limit of your 401K contributions.  

Plancorp specializes in wealth and asset management. As part of your overall financial plan, we can help ensure all investments support your life goals. If you're not sure you've been making the right financial decisions, contact us about getting the most out of your equity compensation plan.  

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