If you are like most salaried employees, you may be eligible for some type of deferred compensation benefit. This includes employer matches on 401(k) contributions, non-taxable contributions to an IRA, salary reduction plans that provide payment in lieu of salary, and voluntary payment plans where you waive salary or interest payments in exchange for future benefits. Not all of these plans are the same. Some are mandatory, some are voluntary, some are specific to certain types of employees, and others are more like “use it or lose it” plans.
Deferred compensation is a popular way to save for retirement. The money is held in a retirement account (like a 401(k) or IRA) where it earns interest until you’re ready to withdraw it. While it may take years for the money to grow to the size you need, the good news is that you typically won’t have to pay taxes on the money you save.
How Deferred Compensation Works
Deferred compensation It is a type of employee benefit that is offered by many employers. The Internal Revenue Code, Internal Revenue Service, and the Department of Labor all have a tax definition of a deferred compensation plan. Generally, a deferred compensation plan begins with a set of deferrable annual payments that are made within a specific time frame. The money is deferred from paychecks and, if not needed, can be applied to a higher tax-deferred status, such as a 401(k) or IRA.
Deferred Compensation (DC) allows employees (or other parties) to defer (or delay) their compensation (either in cash or other forms of earnings) until a later date. The goal of this type of compensation is to provide tax benefits to the employee, while also enabling the employee to take advantage of future tax deductions (for example, contributions to retirement plans, IRA, etc.).
Types of Deferred Compensation
Generally, there are two categories of deferred compensation: non-qualified deferred compensation and qualified deferred compensation. These two differ greatly in the legal treatment and, from the perspective of the employer, the purpose they serve. Oftentimes, deferred compensation is used to refer to non-qualified purposes, but the term technically covers both.
Final Words
In summary, deferred compensation plans allow you to save on taxes. Because tax rates are lower in retirement, you are able to buy more with the same amount of money you are currently paying in taxes. Also, the way the plans are set up now, your money is not taxed until it is distributed to you, so you are able to increase your savings rate without worrying about taxes.
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