Deferred Compensation Plans vs. 401(k)s: What’s the Difference?

Deferred Compensation Plans vs. 401(ok): An Overview

Deferred compensation plans provide an extra selection for workers in retirement planning and are sometimes used to complement participation in a 401(ok) plan. Deferred compensation is just a plan by which an worker defers accepting a part of their compensation till a specified future date. For instance, at age 55 and incomes $250,000 a 12 months, a person may select to defer $50,000 of annual compensation per 12 months for the subsequent 10 years till retiring at age 65.

Key Takeaways

  • Excessive-paid executives typically go for deferred compensation plans.
  • Deferred compensation plans can’t usually be accessed early.
  • Many employees could not be capable of afford to defer compensation.
  • Deferred compensation plans might be at-risk if the corporate goes out of enterprise or recordsdata for chapter.

Deferred Compensation Plans

Deferred compensation funds are put aside and may earn a return on funding till the time they’re paid out to the worker. On the time of the deferral, the worker pays Social Safety and Medicare taxes on the deferred revenue simply as on the remainder of their revenue however would not should pay revenue tax on the deferred compensation till the funds are obtained.

Excessive-paid executives who do not want their annual compensation to dwell on and want to cut back their tax burden mostly use deferred compensation plans (non-qualified deferred compensation plans). Deferred compensation plans cut back a person’s taxable revenue in the course of the deferral.

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They could additionally cut back publicity to the choice minimal tax (AMT) and improve the supply of tax deductions. Ideally, on the time when the person receives the deferred compensation, corresponding to in retirement, their whole compensation will qualify for a decrease tax bracket, thereby offering tax financial savings.

401(ok) Plans

One purpose deferred compensation plans are sometimes used to complement a 401(ok) or a person retirement account (IRA) is that the amount of cash that may be deferred into the plans is far better than that allowed for 401(ok) contributions, as much as as a lot as 50% of compensation. The utmost allowable annual contribution to a 401(ok) account for 2022 is $20,500, growing to $22,500 for tax 12 months 2023.

Thus, a high-earning worker making $800,000 in 2023 would solely be capable of contribute 2.8% ($22,500 / $800,000) of their wage to a 401(ok). Deferred compensation plans don’t have any limits imposed by the Inner Income Service.

Key Variations

Deferred compensation plans have a tendency to supply higher funding choices than most 401(ok) plans, however are at an obstacle relating to liquidity. Usually, deferred compensation funds can’t be accessed, for any purpose, earlier than the desired distribution date. The distribution date, which can be at retirement or after a specified variety of years, should be made when the plan is about up and can’t be modified. Nor can deferred compensation funds be borrowed in opposition to.

Most 401(ok) accounts might be borrowed in opposition to, and beneath sure situations of economic hardship—corresponding to giant, surprising medical bills or shedding your job—funds could even be withdrawn early. Additionally, in contrast to with a 401(ok) plan, when funds are obtained from a deferred compensation plan, they can’t be rolled over into an IRA account.

Threat of Forfeiture

The potential for forfeiture is without doubt one of the predominant dangers of a deferred compensation plan, making it considerably much less safe than a 401(ok) plan. Deferred compensation plans are funded informally. There’s basically a promise from the employer to pay the deferred funds, plus any funding earnings, to the worker on the time specified. In distinction, with a 401(ok), a formally established account exists.

The casual nature of deferred compensation plans places the worker within the place of being one of many employer’s collectors. A 401(ok) plan is individually insured.

In contrast, if the employer goes bankrupt, there isn’t any assurance that the worker will ever obtain the deferred compensation funds. The worker in that state of affairs is just one other creditor of the corporate, standing in line behind different collectors, corresponding to bondholders and most popular stockholders.

It is usually suggested {that a} deferred compensation plan solely be used after having made the utmost doable contribution to a 401(ok) plan.

Why Is Deferred Compensation Higher Than a 401(ok)?

Deferred compensation is usually thought of higher than a 401(ok) for high-paid executives trying to cut back their tax burden. As properly, contribution limits on deferred compensation plans might be a lot greater than 401(ok) limits.

Can You Have a Deferred Compensation Plan and a 401(ok)?

Sure, you possibly can have each a deferred compensation plan and a 401(ok) plan.