Benefits of Deferred Compensation Plans

A deferred compensation plan withholds a portion of an employee’s pay until a specified date, usually retirement. The lump sum owed to an employee in this type of plan is paid out on that date. Examples of deferred compensation plans include pensions, 401(k) retirement plans, and employee stock options.

Qualified vs. Non-Qualified Deferred Compensation Plans

Although there are similarities, there are also distinct differences between qualified and non-qualified deferred compensation plans.

A qualified deferred compensation plan complies with the Employee Retirement Income Security Act (ERISA) and includes 401(k) and 403(b) plans. They are required to have contribution limits and be nondiscriminatory, open to any employee of the company, and beneficial to all. They are also more secure, being held in a trust account.

A non-qualified compensation plan is a written agreement between an employer and an employee in which part of the employee’s compensation is withheld by the company, invested, and then given to the employee at some point in the future.

Non-qualified plans don’t have contribution limits and can be targeted to specific employees, such as top executives. The employer may keep the deferred money as part of the business’s funds, meaning that the money is at risk in the event of bankruptcy.

Tax Benefits

A deferred compensation plan reduces income in the year a person puts money into the plan and allows that money to grow without annual tax being assessed on the invested earnings. A 401(k) is the most common deferred compensation plan, and contributions are deducted from an employee’s paycheck before income taxes are applied, meaning they’re pre-tax contributions.

Contribution Limits

There are annual contribution limits to 401(k) and 403(b) plans—established by the Internal Revenue Service (IRS). The annual contribution limit for employees is $20,500 for 2022, and $22,500 for 2023. Those employees who are aged 50 and older can make an additional $6,500 catch-up contribution in 2022, increasing to $7,500 in 2023.

Tax Deferred

Deferred plans only require the payment of tax when the participant receives the cash. While taxes need to be paid on the withdrawn funds, these plans give the benefit of tax deferral, meaning withdrawals are made during a period when participants are likely to be in a comparatively lower income tax bracket.

It also means that, in the case of a 401(k), participants can withdraw funds penalty-free after the age of 59½. However, there is a loophole known as the IRS Rule of 55 that allows anyone between the ages of 55 and 59½ to withdraw funds penalty-free if they have quit their job or been fired or laid off from it. The loophole only applies to the 401(k) you have with the company from which you are separating.

Reduce Income Taxes

Deferred compensation plans also reduce the current year’s tax burden on employees. When a person contributes to a deferred compensation plan, the amount contributed over the year reduces taxable income for that year, thus reducing the total income taxes paid. Then, when the funds are withdrawn, savings are potentially realized through the difference between the retirement tax bracket and the tax bracket in the year the money was earned.

Capital Gains

Deferred compensation—when offered as an investment account or a stock option—has the potential to increase capital gains over time. Rather than simply receiving the amount that was initially deferred, a 401(k) and other deferred compensation plans can increase in value before retirement.

On the other hand, deferred compensation plans can also decrease in value and should be monitored closely.

While investments are not actively managed by participants, people have control over how their deferred compensation accounts are invested, choosing from options pre-selected by an employer. A typical plan includes a wide range of these options, from more conservative stable value funds and certificates of deposit (CDs) to more-aggressive bond and stock funds.

It is possible to create a diversified portfolio from various funds, select a simple target-date or target-risk fund, or rely on specific investment advice.

Pre-Retirement Distributions

Some deferred compensation plans allow participants to schedule distributions based on a specific date, called an in-service withdrawal. This added flexibility is one of the most significant benefits of a deferred compensation plan. It offers a tax-advantaged way to save for a child’s education, a new house, or other long-term goals.

It is possible to withdraw funds early from most deferred compensation plans for specific life events, such as buying a new home. Depending on IRS and the plan rules, withdrawals from a qualified plan may not be subject to early withdrawal penalties. However, income taxes will be due on withdrawals from deferred compensation plans.

In-service distributions can also help people partially mitigate the risk of companies defaulting on obligations. Some deferred compensation plans are completely managed by employers or have large allocations of company stock in the plan. If people are not comfortable leaving deferred compensation in the hands of their employer, pre-retirement distributions allow them to protect their money by withdrawing it from the plan, paying tax on it, and investing it elsewhere.

Special Considerations

Please note that money from a non-qualified plan cannot be rolled over into an individual retirement account (IRA) or other tax-advantaged retirement savings vehicle. However, money from a qualified plan can be rolled over. Please check the plan rules that apply to you with your plan’s administrators and consult a tax advisor before taking any in-service withdrawals.