Deferred compensation is an often-overlooked way of sheltering income from taxes. It’s not right for everyone, but it has one big advantage: There is no limit to how much income can be deferred.
There was a brief moment in November of last year when Congress was considering taxing deferred compensation plans in some manner, which I think gave people the idea that deferred compensation was no longer an option. I’m happy to report that this idea didn’t make it into the final legislation, and there has been effectively no change in the tax advantages of deferred compensation.
What is Deferred Compensation?
Deferred compensation allows an employee to tell their employer, “Don’t pay me now, pay me later, when I retire.” That allows both the income and the income tax liability to be deferred to a later date. Deferred compensation plans are sponsored by the employer, and are used for highly compensated employees, such as the senior executives of an organization. The contributions can come either from the participants themselves or via the employer making contributions on behalf of the employee.
The biggest advantage over qualified tax plans such as a 401(k) plan is that there is no cap on the amount that can be contributed. Qualified plans are limited in how much money can be contributed tax deferred, $18,500 a year in the case of a 401(k), or $24,500 if the employee is over the age of 55. For an executive who makes in excess of $300,000 a year, saving $18,000 to $24,500 a year will not make a dent in the funds they need to save for retirement. Deferred compensation plans can meet that need.
Deferred compensation plans also have their disadvantages. According to the tax code, these “non-qualified” plans are technically “unfunded.” This means that non-qualified plans are not protected. If the employer goes bankrupt, then the plan participants go to the end of the line as a general creditor and it’s unlikely that they would get paid much more than pennies on the dollar. This is in contrast to a qualified retirement plan, where assets are set aside and trusteed, so that if the employer goes bankrupt, the 401(k) is still protected and the retirement money is still there.
An advantage of a deferred compensation plan is the lack of a limit on tax deferred contributions. A disadvantage is that the assets are not protected and are subject to insolvency risk.
Using Deferred Compensation to Keep and Reward Key Employees
Many employers use deferred compensation plans as a form of “golden handcuffs,” to incentivize key employees to stay with the company. In such cases, the employer will fund the plan, perhaps with a contribution of $100,000 per year, but the employee has to remain with the company for five or ten years before they vest in the plan and not be subject to forfeit the money. Such arrangements can be mutually beneficial to the executive and to the firm. The executive will receive a bonus at some future date but is not taxed on it now. The employer is receiving some additional assurances that the executive – a high producer – won’t leave prematurely.
Parameters for Success with a Deferred Compensation Plan
Not every organization is a good candidate for a deferred compensation plan. Here are some of the key characteristics that can result in a successful deferred compensation plan:
Public or private company. Both public and private companies in the United States make use of deferred compensation. It just happens that there are so many more private companies in the world, so sometimes it seems as if deferred compensation is used primarily by private companies.
Established companies with a strong cash flow. This is essential. Deferred compensation is a promise to be paid years, perhaps decades from now. If the company is too young and its cash flow too inconsistent, it may not be able to properly fund the plan consistently each year, particularly with life insurance. The executives will want consistency and predictability, otherwise they may choose to take their compensation now rather than wait for some uncertain future.
A regular C corporation. The better prospective employer is usually in a positive tax bracket, that being a common characteristic of a generally profitable and stable company. Even still, there often can be tax arbitrage between an individual’s personal tax rate versus the corporate tax rate.
A set of highly compensated or otherwise key members of management. To be eligible to participate in a non-qualified plan, the participant needs to either be highly compensated or a key member of management with comparable responsibilities.
An annual average per-participant contribution of about $10,000 or more. And that is probably the lower end of the annual contributions. There is a certain amount of overhead to setting up and administering a deferred comp plan, and firms often don’t find the expense worth it unless they are making substantial contributions.
A concern about turnover among key employees. The “golden handcuffs” can be a great way to incentivize key employees to stay while their benefits are vesting. Often companies implement these plans after they have lost a key employee to a competitor.
A qualified 401(k) plan that is top heavy, or the participation rate is low. A great prospect for the Non-Qualified Deferred Compensation plan may be a firm with highly compensated employees maximizing their 401(k) contributions and getting refunds due to a low participation rate.
This information is for educational purposes only and should not be considered specific tax advice. Depending on individual circumstances, the strategies discussed may not be appropriate for your situation. This information is based upon on our understanding of current laws, which is subject to change. Always consult a qualified financial professional regarding your personal situation. Neither Penn Mutual nor its employees, agents, or representatives provide tax or legal advice.