With deferred compensation one of the most common executive perks, it is important to understand the basics behind the benefits and the importance of how they should be invested where options are made available.
The Basics of Deferred Compensation
Deferred compensation plans are considered non-qualified and, therefore, do not have nondiscrimination requirements. There is no limit to the amount an employer can contribute to the plan, making them much more flexible than qualified retirement plans. Deferred compensation plans provide you with the opportunity to defer the receipt of currently earned compensation to a later date. You elect to defer the compensation on a pre-tax basis and pay taxes on the money when you take it out. The benefit of delaying receipt of this income is to defer the tax to a date when you will be in a lower tax bracket, therefore leaving you with more for your nest egg after Uncle Sam takes his chunk. Another benefit is the ability to invest monies wisely over time and allow for the compounding of earnings and gains.
Types of Deferred Compensation Plans
- Salary Reduction – Uses some portion of your current compensation to fund the ultimate compensation benefit.
- Salary Continuation – Uses your employer’s
contributions to fund the ultimate compensation benefit.
- Funded – If a plan is funded, your employer maintains it by making contributions to a trust or by paying premiums on an annuity contract. You may or may not have to pay current tax on the contributions depending on your vested rights in the contributions. It is crucial in this plan to be sure to track your investment decisions and adjust over time as either retirement or distribution dates approach.
- Unfunded – If a plan is unfunded, the plan merely involves the employer’s present promise to pay future amounts to the employee. The employee is taxed only when those amounts are actually or constructively received.
Important Information to Keep in Mind with Deferred Compensation
One thing to be aware of is that distributions from your non-qualified plan are subject to the constructive receipt doctrine. That is, they are taxable when you have the right to receive the benefit, regardless of when your benefits are actually paid.
If you have questions about your non-qualified deferred compensation plan, either as an employee or employer, a financial advisor can guide you through the ins and outs. Deferred compensation is an intricate benefit that can become confusing, but taking advantage of its full potential can help you reap rewards now and when it’s time to retire.
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