Which Deferred Compensation Plan Is Right for You?
Deferred compensation plans are great tools to help you save for retirement and build wealth. In the following guide, we will look at the differences between qualified and non-qualified deferred compensation plans, including benefits and drawbacks of each, so you can decide which plan is right for you. Read on to find out more.
What Is a Deferred Compensation Plan?
A deferred compensation plan is an incentive offered by an employer which allows the employee to withhold a certain percentage or dollar amount of his or her compensation for the future. With a deferred compensation plan, you can reduce your taxable income in the present and postpone a portion of your income (and the federal and state taxes that apply) to the future. Deferred compensation plans are especially attractive to taxpayers in a high tax bracket who expect to be in a lower tax bracket when they reach retirement age.
Let’s take a look at the two categories of deferred compensation plans: qualified and non-qualified.
Qualified Deferred Compensation Plan
Qualified deferred compensation plans are protected by the Employee Retirement Income Security Act of 1974, which is a federal law that sets minimum standards for most voluntarily established retirement and health plans in private businesses to protect employees who participate in these plans.
Qualified deferred compensation plans include 401(k) plans and 403(b) plans, profit-sharing plans, and pensions. These plans are required to have contribution limits and be non-discriminatory, or open to all employees at a company. Here are a few quick facts about qualified deferred compensation plans:
- 401(k) plans are the most common deferred compensation plans.
- The annual contribution limit for IRS-recognized plans, including 401(k) plans and 403(b) plans, is $22,500 for 2023.
- Individuals ages 50 and older can make a catch-up contribution of $7,500 for 2023.
- Individuals who participate in 401(k) plans can withdraw the funds penalty-free after the age of 59½.
- The IRS Rule of 55 states that individuals who turn 55 during the calendar year in which they lose or leave their job may withdraw the funds penalty-free, provided the 401(k) resides with the company from which they are separating.
- Money from a qualified deferred compensation plan can be rolled over into an individual retirement account (IRA) or other tax-advantaged savings account.
There are several important benefits to qualified deferred compensation plans to consider: most importantly, these plans are federally protected by ERISA, making them more secure. The funds are held in a separate trust account away from creditors, better protecting the participant’s investments. Qualified deferred compensation plans help the participant reduce taxable income in the present, grow tax-deferred savings for retirement and other future purposes, and build wealth over the long term.
There are also several drawbacks to qualified deferred compensation plans: namely, these plans are strictly regulated by the IRS, and as such come with many rules regarding contribution limits, when the funds can be withdrawn, and what kind of penalties and taxes apply if you want to access the funds before retirement. Qualified deferred compensation plans are designed for retirement savings, and you may find it difficult to use the cash invested for other purposes without incurring penalties. With more protection and security comes more rules and regulations.
Non-Qualified Deferred Compensation Plan
Non-qualified deferred compensation plans are not federally protected plans; instead, they are private written agreements between employers and employees in which part of the employee’s compensation is withheld by the company and invested at the employer’s discretion, then given to the employee sometime in the future. Although these plans operate the same way as qualified deferred compensation plans, they do not have to follow IRS rules, such as contribution limits.
In addition, these plans can be targeted to a company’s top-earning executives or other high-value employees as a wealth-building incentive to encourage desirable talent to stay with the company. Here are a few quick facts about non-qualified deferred compensation plans:
- These plans have high wealth-building potential for top-earners, but they also carry more risk. The investments are used by the employer and are not federally protected if the company folds.
- Money from a non-qualified plan cannot be rolled over into an individual retirement account (IRA) or other tax-advantaged savings account, unlike a qualified plan.
- The employer makes all the rules and regulations for a non-qualified plan; sometimes these rules are less stringent than IRS-backed plans, but they vary from employer to employer.
- These plans are sometimes called “golden handcuffs” because they are used to incentivize top talent to stay with a company. These “golden” plans offer sizable reductions to taxable income and high wealth-building potential, but they “handcuff” the employee to the company in order to retain the opportunity provided.
- Non-qualified plans generally offer more flexibility when it comes to withdrawing and using funds than qualified plans do. However, investments in these plans also carry more risk for loss.
Just as with qualified plans, non-qualified plans have several benefits: greater wealth-building potential, greater reduction in taxable income, more flexibility for withdrawal and use of funds, and less stringent rules and regulations.
They also have significant drawbacks: the potential risk is much greater, and the funds invested are not protected should the company go bankrupt. Furthermore, non-qualified plans “handcuff” top talent to a company as the funds are generally unable to be rolled over into other retirement savings vehicles when the employer-employee relationship is terminated.
It’s clear that both qualified and non-qualified deferred compensation plans offer significant opportunities for retirement savings and building wealth. Considering the benefits and drawbacks of each type of plan is essential in order to make the right choice for your own future savings needs.
Honest Buck Accounting offers financial expertise and professional accounting services for Early Childhood Education businesses. Reach out to our team of experts to learn more about how we can help you build a profitable childcare business. Contact us today.
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