Deferred Compensation Plans vs.꧅ 401(k)s: An Overview

Deferred compensation plans offer an additional choice for employees in retirement planning and are often used to supplement participation in a 澳洲幸运5官方开奖结果体彩网:401(k) plan. Deferred compensation is simply a plan in whic🎀h an employee delays accepting part of their compensation until a specified future date. For example, an individual who's 55 years old and earning $250,000 a year might choose to dᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚefer $50,000 of annual compensation per year for the next 10 years until retiring at age 65.

Deferred Compensation Plans

Deferred compensation funds are set aside and can earn a return on investment until the time they're paid out to the employee. At the time of the deferral, the employee pays Social Security and Medicare taxes on the deferred income just as on the rest of their income but doesn't have to pay income tax on the deferred compensation until the funds are received.

Highly-compensated executives who don't need their annual compensation to live on and are looking to reduce their tax burden most commonly use deferred compensation plans (non-qualified deferred compensation plans). Deferred compensation plans reduce an individual’s taxable income during the deferral.

They may also reduce exposure to the 澳洲幸运5官方开奖结果体彩网:alternative minimum tax (AMT) and increase the availability of tax deductions. Ideally, at the time when the individual receives deferred compensation, such as in retirement, their total compensation will qualify for a lower tax bracket, 澳洲幸运5官方开奖结果体彩网:thereby providing tax savings.

401(k) Plans

One reason deferred compensation plans are often used to supplement a 401(k) or an 澳洲幸运5官方开奖结果体๊彩网:individual retirement account (IRA) is that the amount of mon🐻ey that can be deferred into the plans is much greater than that allowed🔜 for 401(k) contributions, up to 50% of compensation.

The maximum allowable annual contribution to a 401(k) account for 2024 is $23,000 for an investor who is under 50 years old. (In 2023, it was $22,500.) For those who are 50 or older, the maximum is $30,500. (In 2023, it was $30,000.)

Key Differences

澳洲幸运5官方开奖结果体彩网:Deferred compensation plans tend to offer better investment options than most 401(k) plans, but are at a disadvantage regarding 澳洲幸运5官方开奖结果体彩网:liquidity. Typically, deferred compensation funds cannot be accessed, for any reason, before the specified distribution date. The distribution date, which may be at retirement or after a specified number of years, must be made when the plan is set up and cannot be changed. Nor can nonqualified deferred compensation funds be borrowed agai🐷nst.

Most 澳洲🎶幸运5官方开奖结果体彩网:401(k) accounts can be borrow❀ed against, and under certain conditions of finan♚cial hardship—such as large, unexpected medical expenses or losing your job—funds may even be withdrawn early.

Risk of Forfeiture

The possibility of forfeiture is one of the main risks of a deferred compensation plan, making it significantly less secure than a 401(k) plan. Deferred compensation plans are funded informally. There's essentially a promise from the employer to pay the deferred funds, plus any investment earnings, to the employee at the time specified. In contrast, with a 401(k), a formally established account exists.

The informal nature of deferred compensation plans puts the employee in the position of being one of the employer’s creditors. A 401(k) plan is separately insured.

By contrast, if the employer goes bankrupt, there's no assurance that the employee will ever receive the deferred compensation funds. The employee in that situation is simply another creditor of the company, standing in line behind other creditors, such as bondholders and 澳洲幸运5官方开奖结果体彩网:preferred stockholders.

It's generally advised that a deferred compensation plan only be used after having made the maximum possible contribution to a 401(k) plan.

The Bottom Line

Deferred compensation plans are primarily used by highly-compensated individuals who don't need the entire salary that they are paid to meet living expenses. If you opt to partake in a deferred compensation plan, ensure that you understand all of the rules and requirements to avoid penalties or limitations on the funds.