Last editedJun 20212 min read
How are you planning for retirement? If a significant chunk of your paycheck goes to income taxes, you might want to speak to your employer about deferred compensation. What is a deferred compensation plan and how does it work? We’ll explore these questions below.
What is a deferred compensation plan?
Normally, employees receive all their earnings with each paycheck. A certain percentage of this is paid to the government in state and federal income tax each year when you file your tax returns.
Yet with a deferred compensation plan, a portion of your compensation is instead set aside, or deferred for a specified period. By setting this percentage of compensation aside, you can defer income tax payments on your earnings until you withdraw the money. Examples of deferred compensation include things like pension or retirement plans and company stock options.
Types of deferred compensation
There are two main types of deferred compensation, including qualified and nonqualified. What is nonqualified deferred compensation and how does it differ from qualified plans?
1. What is qualified deferred compensation?
Common pension plans like the 401(k) and 403(b) are examples of qualified deferred compensation plans. These are governed according to the Employee Retirement Income Security Act (ERISA), which states that the company must offer it to all employees rather than a select few. Qualified deferred compensation comes with more rules in place than non-qualified plans, which means there are caps to contribution amounts. Contributions are also protected from creditors should the company default on debts.
2. What is nonqualified deferred compensation?
Nonqualified deferred compensation plans are far more common than qualified. What is the advantage of nonqualified deferred compensation plans? There is no limit to the amount of income that you can defer, or set aside, each year. This can add up to significant tax benefits, particularly for higher earners in the top tax bracket. You can defer as much of your income as needed to drop down into the lower tax bracket, saving money on income tax for the time being.
However, when looking at what is the advantage of nonqualified deferred compensation plans, there are also benefits for employers. While employees enjoy tax benefits, employers often attach a penalty to the plan that is triggered if the employee leaves or retires early. In this way, the plan encourages the employee to stay with the employer for the long haul to maximize deferred compensation benefits. It’s a way to decrease employee turnover.
What is deferred compensation on W2 and how does it work?
The amount of compensation and the length of deferral are determined by the company. Common time frames include five years, ten years, or until retirement. Employees can choose whether they prefer to receive the compensation in a single lump sum or spread out over time, typically between a five- and ten-year pay-out period. Some companies will invest the money by tethering it to company stocks or a national index with a guaranteed rate of return.
When do you pay tax on deferred compensation?
At some point, you will need to pay the IRS for your deferred compensation. While it sits in a retirement account, your funds will be untaxed. Furthermore, you may reap the benefit of a lower tax bracket during your working years.
When you retire and access your compensation, you will then need to pay income tax on the amount. This is why it’s important to consider whether you wish to access it as a single payment, or in smaller installments spread out over a 10-year pay-out period. There are clear tax benefits to a longer installment period, because you’ll face a higher tax on a large lump sum. The specific rates will vary by state, so that’s also something to consider if you plan to move after retirement.
A deferred compensation plan offers numerous benefits, particularly for those who plan to stick with their company until they retire. Just be sure to compare the plan’s terms and conditions carefully so that you’re clear about contributions, tax brackets, and distribution options.
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