What Are the Benefits of a Deferred Compensation Plan?

Benefits go far in enticing top talent to join and stay in your organization. Some offer immediate rewards, while others look to the future. Deferred compensation plans are concerned with future investments. They are a way to decrease immediate income and taxes, saving the amount for a later date.

But how do they work and what are the benefits? Let’s dive deeper.

Qualified vs. Non-Qualified Deferred Compensation Plans

Deferred compensation plans withhold a portion of an employee’s income. These include 401(k)s, pensions, and stock options. This perk lets employees elect and withdraw a certain amount of their income. The employee later withdraws the amount at a specified date, typically for a major life event or retirement.

We can break deferred compensation plans into two categories – nonqualified and qualified.

Qualified deferred compensation plans (QDC) are the stricter of the two. They are subject to regulations under the IRS The Act states that individuals have contribution limits, which only allow employees to defer a certain amount per year. There are also non-discrimination rules. If an employer chooses to offer a plan, they must offer them to all employees with equal benefits.

QDC plans tend to be more secure as they are held in trust accounts. 401(k) plans are a well-known example of qualified deferred compensation plans.

Non-qualified deferred compensation plans (NQDC) are more flexible. The deferred amount can grow tax-free before it’s withdrawn. When withdrawn, tax depends on the owner’s income tax rate. NQDC plans do not have contribution limits. Those who choose to defer compensation can withdraw it (ideally) when they have a lower tax rate, like retirement.

NQDC plans are often kept with regular business funds, making them less secure. If the company goes bankrupt, it could lose the funds. Employees and employers should have a deferred compensation plan agreement, stating what will happen if the employee quits and how they’ll handle the tax rate.

The Benefits of Deferred Compensation Plans

There are certain advantages to deferred compensation plans. Let’s discuss three major benefits.

Tax Savings

When an employee puts money into their deferred compensation plan, they reduce their annual income. Employers deduct the contributions from their paychecks before applying income tax. Therefore, they avoid paying tax on the deferred amount.

Employees will still pay tax on these amounts, but not until the participants are likely to be in a lower tax bracket, such as retirement. As such, they reduce their taxable income for that year and their total income taxes paid.

Capital Gains Realization

Another benefit is that deferred compensation plans can increase capital gains. If the employer offers them as an investment account or stock option, the plans can increase in value. Plans usually include a range of options, including stable value funds, certificates of deposit, and stock funds. Employees can pre-select how to invest the money in their plans.

Pre-Retirement Distributions

One of the greatest benefits is in-service withdrawal. With some plans, it’s possible to schedule distributions. These kinds of plans help employees save for tuition fees, mortgage downpayments, and other long-term goals. It’s also a way for participants to control this money if they feel uncomfortable or worry about the security of the funds.

Most deferred compensation plans allow withdrawal for major life events, but there are regulations. The IRS and plan rules determine whether there are withdrawal penalties. These distributions also incur income tax.

The Downsides of Deferred Compensation Plans

Despite the benefits, there are disadvantages to deferred compensation plans.

Contribution limits can restrict the amount you’re allowed to defer. If they aren’t in a trust fund and the company files for bankruptcy, you can lose the investments. You’re at the mercy of the market and stand a chance of losing these earnings if it takes a dip. The other obvious downside is that this money isn’t immediately accessible.

Final Comments

Compensation plans go beyond salaries. They include benefits, such as investment plans. Deferred compensation plans allow employees to set a certain amount of their income aside for the future.

Qualified deferred compensation plans are predominantly for retirement, while non-qualified deferred compensation plans could help with other life investments. Both have their own advantages and disadvantages. The bottom line is that employees and employers must discuss these things before deciding to invest.