You've no doubt been told from a young age that you should be saving up for retirement. But that can be hard in a world with growing debt and stagnant wages.
How can one put even a little bit away in the hopes of a more comfortable retirement? If you have a full-time job, you may be offered a deferred compensation plan. But what is deferred compensation, what are the types of plans that may be available to you and is it the right decision?
Here's what you need to know.
What Is Deferred Compensation?
Deferred compensation is any part of the compensation you make at your place of employment that will be paid out at a later date.
Deferred compensation occurs via a type of plan. Depending on the type of deferred compensation plan your employer offers (if they offer one at all), they may be legally required to offer you the opportunity to put money into it.
Pension plans are an example of deferred compensation, as is offering employees stock options. Different deferred comp plans will vary in terms of how much both you and your employer can contribute, as well as how the contributions are taxed and where the contributions go (many plans put the contributions into various investments, and these will vary as well). For many plans, though, the contributions are not subject to income tax until they are withdrawn.
When Can You Receive Your Compensation?
Many deferred compensation plans are also retirement plans. So the ideal situation is that you work at the company offering you this plan through retirement, don't have any unforeseen emergencies that necessitate early withdrawal, and upon officially retiring you can begin collecting your deferred compensation. Depending on the plan, you may be able to collect it in installments, or you may end up receiving all of your compensation in one lump sum.
Of course, this is the ideal but not always the way it goes. Not that a different situation is necessarily a bad thing; it's possible you've simply left your current job for a new one, and the changing hands triggered a payout. Many employers will necessitate a withdrawal of your deferred compensation in this event.
However, you may also have unforeseen circumstances that can result in you applying for an emergency withdrawal of your funds. These are often large-scale costs like exorbitant medical expenses, funeral expenses or a home foreclosure.
Ultimately you'll have to check with your employer about the specific details of your plan and the circumstances that may allow you to withdraw funds from it.
Is a 401(k) a Deferred Compensation Plan?
A 401(k) plan can be considered a deferred compensation plan, perhaps the best known example of one. After all, you're literally deferring some of your yearly compensation into a plan, wherein it is then placed into an investment account. However, a deferred compensation plan is also often used to supplement a 401(k) to better save for retirement.
The supplemental deferred comp plan is often done by those making six figures or more. Other deferred compensation plans allow you to put more funds in than a 401(k) does. In 2019, the contribution limit for a 401(k) is $19,000 ($25,000 if you're 50 or over as part of a catch-up contribution). You're likely only contributing that much if you have an awfully high salary.
So, yes. While you can supplement it with other deferred compensation plans, a 401(k) would be considered a qualified deferred compensation plan.
Qualified vs. Non-Qualified Deferred Compensation Plans
The most common types of deferred comp plans can be divided into two categories: qualified and non-qualified plans.
A qualified deferred compensation plan is the one you as an employee are most likely to be offered. For a plan to be considered a "qualified" plan, it most legally comply with the Employee Retirement Income Security Act (ERISA).
If an employer offers a qualified deferred compensation plan, they are legally required to offer it to all employees. This is not the case with a non-qualified plan.
Non-qualified deferred compensation plans are not required to be offered to every employee. Instead, they're often offered to only specific (usually high-level) employees as incentive to keep them around. As mentioned with a 401(k) above, a qualified plan generally has a cap on limits. A non-qualified one does not.
That also means qualified and non-qualified plans can, at times, be used in tandem. Say at age an 40 employee making $250,000 a year maxes out his 401(k) contribution and puts $19,000 in. If their employer offers them a non-qualified plan as well, they may choose to take that and put at additional $30,000. That is nearly $50,000 a year they are deferring each year.
The fact that an NQDC doesn't have to be offered to every employee, they can be more flexible for employers. It may be harder for the employee to get an early withdrawal of funds, and the employer may require the employee sign other documents (such as a non-compete agreement) for it.
Perhaps the thing that separates qualified and non-qualified deferred compensation plans the most, though, is what happens to the contributions if the company collapses. If your employer goes bankrupt and you are utilizing a non-qualified deferred compensation plan, it does not have the same ERISA legal protections a qualified plan does, and creditors can seize it along with other assets. With a qualified deferred comp plan, though, you are protected from creditors taking your funds.
Qualified Deferred Compensation Plans
Qualified deferred compensation plans aren't always referred to as such. Because many of them are so much more commonly offered as a job benefit, they are more often known by the actual names of the plans.
Let's take a look at some of the more common ones: the 401(k), 403(b) and 457 plan.
A 401(k) plan is a deferred compensation plan wherein the employee and employer each contribute funds to the plan. The funds go to specific investments. Your employer should have a set number of investment options they present to you for the 401(k), and you can make the decision of which ones to invest in and how much (up to the contribution limit) to invest in them.
Contributions to a traditional 401(k) are not subject to income tax until after they are withdrawn. In the case of a Roth 401(k), after-tax dollars are contributed to the plan and when you withdraw them, the withdrawals are tax free.
A 403(b) plan has many similarities to a 401(k) plan, but is offered to certain employees in certain industries. It is a similar tax-advantaged situation and has similar contribution limits, but a 403(b) plan is made available to some employees such as:
- Public school employees
- Government employees
- Non-profit employees
- Hospital doctors and nurses
- Religious ministers
Essentially, the 403(b) is a qualified deferred compensation plan for public schools and certain tax-exempt organizations.
A 403(b) plan does have fewer options for investing than a 401(k), but they have similar rules for withdrawals, rollover and matching employer contributions.
The 457 plan is a qualified plan available to many state and local government employees, as well as certain non-profit employees.
Like the 401(k), contributions to your 457 plan aren't taxed until they are withdrawn. Unlike a 401(k), though, if you make an early withdrawal from your 457 there is no penalty; 401(k) early withdrawals can incur penalties of up to 10%. 457 plans also have catch-up contributions for older employees like a 401(k) does, but to an even greater degree; those who are close enough to retirement may be able to double the amount in their 457 plan by utilizing catch-up contributions.
However, unlike with many other qualified deferred compensation plans, you're unlikely to have a 457 plan where your employer matches a percentage of your contribution.
Non-Qualified Deferred Compensation Plans
If you're hearing about a plan referred to as a deferred compensation plan, it's likely you're hearing about a non-qualified deferred compensation plan, or an NQDC. Also known as 409(a) plans, an NQDC also allows you to stow away a chunk of your salary each year in the hopes of saving for retirement, with that funding going toward investment options provided by your employer.
Because an NQDC isn't covered under ERISA, there is a lot more flexibility involved with them. That can be both good and bad for an employee, as the employer has a lot more leeway in what they can do; you may be able to put a lot more of your salary into your NQDC than in a qualified plan, but your employer may set more stringent requirements regarding when you can withdraw your funds. Make sure you're fully aware of all of the details involved with your NQDC.
If you are an employer wondering if an NQDC you've offered to an employee is tax-deductible, it is... once it is getting paid anyway. But even before then, you are getting a bump in cash flow from the funds put into the plan.
And, as mentioned earlier, there is nothing to protect the money you put into your non-qualified plan if the company goes bankrupt and creditors seize their assets.
Supplemental Executive Retirement Plan (SERP)
One of the more common forms of non-qualified deferred compensation plans is the supplemental executive retirement plan (SERP). This is a plan offered to particularly high-level executives that the company wishes to keep around for the foreseeable future. This could be incentive to try and lure a sought-after executive in the job interview process, or it could be a reward for an existing employee performing at a high level who the company wants to stay.
Often, a SERP can be packaged as other forms of benefits. One common example of this is cash value life insurance. The employer purchases the life insurance policy to help finance the SERP while paying the premiums. At retirement, the employee will receive their deferred compensation. If the employee passes away, their beneficiary will receive benefits and the employer can recover costs from the insurance.
Since there is so much less regulation with a SERP than with a 401(k), the employer and employee can work to make sure the agreement meets both of their needs.
Do You Need a Deferred Compensation Plan?
As with any financial plan, whether it's a smart of necessary thing for you depends on your financial situation and what you are being offered.
If you are not a high-level employee and are being offered a qualified plan like a 401(k), there are quite a few benefits to putting in at least a minimum contribution so your employer can match a percentage of it. You're not required to max out your contribution; after all, it's pretty rare that you can just stow away $19,000 without needing any of it. Making a contribution of at least a small percentage of your paycheck into a qualified deferred comp plan can help you save for retirement, can rollover into other retirement plans and is protected from creditors in a worst case scenario with your company.
A non-qualified deferred compensation plan, on the other hand, requires much more thinking over. You're getting offered a plan like a SERP and are able to put more money into it because you're likely making a much higher salary than someone who isn't afforded that opportunity. But that also means you could be deferring tens of thousands of dollars into a plan that does not have the protection a qualified plan does. So more thought needs to be put in. How well is your company doing? If it's performing well, will it do so for the foreseeable future? What is the current economic outlook and is there an oncoming recession? Do you have sufficient funds to hold yourself over while deferring your compensation (as well as if that deferred comp gets seized)?
Ultimately, with a deferred compensation plan, take a good, hard look at the risks involved and determine whether it is worth it for you.
It's never too late - or too early - to plan and invest for the retirement you deserve. Get more information and a free trial subscription to TheStreet's Retirement Daily to learn more about saving for and living in retirement. Got questions about money, retirement and/or investments? Email Robert.Powell@TheStreet.com.