In the world of retirement savings, employer-sponsored retirement plans can be divided into two categories: qualified and nonqualified. Qualified plans include 401(k) and 403(b) plans; employers offering such plans must enable participation by all employees who meet certain qualifications and cannot discriminate in favor of executives or key employees. Such plans also have contribution limits. Nonqualified plans, on the other hand, are designed to reward and incentivize selected important workers – usually, executives like you – with additional, unlimited compensation. One of the most common forms of nonqualified plans is an executive deferred compensation plan.
What Is Deferred Compensation?
With a nonqualified deferred compensation plan, the employer defers paying a portion of an executive’s salary until after retirement or another triggering event, such as termination or change in company ownership, occurs.
The money is not under your control to be invested; it is simply recorded as an obligation of the company to pay out to you in the future. (A big risk of nonqualified deferred compensation plans: If your employer goes bankrupt, your deferred-compensation balance is simply another company debt that isn’t likely to be paid out.)
The balance of deferred compensation plans is assigned a rate of interest at which the financial obligation to you grows over time. This interest can be based on a fixed rate of interest, the rate of growth of an actual investment or the performance of a financial benchmark, such as the S&P 500 Index.
You avoid taxes on the deferred income in the year you earn it, and you don’t pay taxes on the interest accrued along the way. You then request distributions from the balance owed in retirement (there are no minimum required distributions each year!) until the deferred compensation’s balance has been exhausted or your death. Any leftover money can be paid to a beneficiary (depending upon the terms of the agreement).
The tax savings can be extraordinary for high earners in the top tax brackets who will fall into lower tax brackets in retirement. For example, if you currently earn $2 million per year, then the IRS will tax all of your taxable income in excess of $628,300 (if you are married) at 37%. Deferring $500,000 of that income will save you $185,000 in taxes now. And over, say, 10 years at your company, you’ll amass $5 million (plus accrued interest) in deferred compensation! Assuming consistent distributions from your deferred compensation plan over 30 years of retirement, your taxable income in retirement may fall below the top tax brackets – saving you tens of thousands of dollars in taxes.
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Is Deferred Compensation Considered Earned Income? How is Deferred Compensation Taxed?
Yes, deferred compensation is considered to be earned income in the tax years in which you take the distributions. You’ll owe Social Security and Medicare taxes on this income just like you did on income during your working years.
Employer Advantages of Deferred Compensation Plans
For employers, nonqualified deferred compensation plans are simple and inexpensive to administer. They allow the employer to keep and use the money that would have been paid up-front to you. And the plan serves as a form of “golden handcuffs” to incentivize you to stay with the company until you retire. Many of these plans have mandates stipulating that you will forfeit the amount owed in retirement if you go to work for one of the company’s competitors.