Deferred Compensation is defined as an agreement between an employer and an employee to withhold payments of wages, invest them on the employee's behalf, and pay them later to the employee in the form of retirement benefits. Deferred compensation eliminates the tax the employee would normally pay on their wages and can take the form of a pension, retirement plan, or employee stock option plan.
Every month, an employee expects to earn some income in the form of wages. While some take all of it home, others choose to keep a portion of it with the company's retirement savings plan. In most mid-sized companies, employers purchase an annuity, offer stock options, or some form of pension. These retirement plans are normally designed to replace 60% of your working income after 30 years with the same employer. Just like one would wish to save for the future, deferred compensation is a retirement plan that allows people to avoid the taxes associated with receiving their income right away. Most companies or employers in the USA encourage employees to subscribe to retirement plans.
Understanding of Deferred Compensation
Simply defined, deferred compensation is that part of the income be it from salary or wages that is paid at a later date rather than at the end of each pay period. This is usually done with the aim of reducing the tax burden of the employee. Sometimes taxable income can leave you with 30-50% less to take home at the end of the month. Tax codes enacted by the IRS allow employees to defer part of their payments or salary to a future date. With deferred comp, your taxable income is reduced. Instead the company you work for can select non-taxable investment options on your behalf or pay the taxes out of your returns on taxable investments.
Types of Deferred Comp
There are basically two forms of deferred comp, namely qualifying and non-qualifying. Deferred comp can only be effected through a written agreement between the employee and the company he or she works for. The payment is usually postponed to a future date. If for example one intends to be paid the deferred comp. after five years on a particular date, it will be paid in lump-sum to the employee's retirement account. Let's take a look at non-qualifying and qualifying with regard to their features.
Features of Non-Qualifying Compensation
- Because sometimes an employer chooses who qualifies for deferred comp, non-qualifying compensation provides such a flexibility of choice. In this case, benefits that would accrue to an employer do not necessarily need to abide by guiding rules and principles. The decision on the limits on contributions is at the discretion of the employer.
- In non-qualifying deferred comp, benefits can be extended to independent contractors and not just employees.
- In this form of D.C., contributions are tax free or in other words non-tax deductible.
- Tax is to be paid on the day of receiving the deferred funds.
Features of Qualifying Compensation
As opposed to non-qualifying compensation, this form of deferred comp complies to set rules and guidelines by tax regulatory authorities and employee welfare bodies. In the United States, an example of such Act is the Employee Retirement Income Security Act of 1974 (ERISA). There are a number of compensation plans in this category which include:
- 401 (k) which usually a plan for Non-governmental organizations.
- 403 (b) Which is tailored for employers in public education.
- 501 (c) which is customized for charity/ Non-profit organizations and ministers.
- 457 (b) which is aimed formulated for state and government corporations.
Having outlined some examples of qualifying compensation, it would be important to look into what makes some form of deferred comp to be termed as 'qualifying.' Here are some reasons;
- The 457 (b) plan which is solely formulated for state and government corporations is almost identical to a 401k in every way except that they are for public employees.
- Any qualifying plan, such as a 401 (k) as per ERISA is tax deductible at the time an individual withdraws the deferred earnings. To the company, tax is deducted at the time the plan is implemented.
Key Considerations and Benefits
Every employee wants to take home enough income at the end of the month to pay for monthly expenses and achieve their personal goals. There is also the need for some savings in retirement benefit plans or pension that suits your needs. Employers also seek to ensure that the welfare of their staff is taken care of.
- Income Accumulation / Savings
Deferred comp, whether qualifying or non-qualifying has developed into some of the most preferred pension plans. At retirement, everyone wants to live a good life. This is one of the reasons deferred comp was created. It is a good way to deposit a portion of your monthly income and withdraw it at the future date, five to thirty years later.
- Future Investments
Investing in your future starts with saving money. You're going to need to put away $1,000 for your starter emergency fund, 12-15% of each paycheck into some form of retirement plan, and save up 9 months of expenses for an emergency fund. Generally speaking if you can make 15% consistently, then you will need 6.7 times your desire annual income to retire today. Most people are extremely unprepared and looking forward to a very small monthly social security check. The 6.7 number is determined by dividing 100% by the net annual return you can consistently earn on your investments including any losses.