Deferred compensation refers to an additional pay that an employee earns along with regular compensation but receives later (upon agreed time). Usually, taxes on this additional income are delayed until it’s paid out, which means at the time of deferred compensation payment HR will make the necessary deduction.
These deferred compensation can be given in the form of retirement plans, pensions, and stock options.
But why do employees opt for deferred compensation?
Generally, most employees choose deferred compensation for its immediate tax benefits. Taxes on this income are postponed until the compensation is received (usually received at the time of retirement).
So, if employees predict that they will be in a lower tax bracket after retiring, they can potentially decrease their tax burden.
But, Roth 401(k)s differ from this arrangement, as they need employees to pay taxes on compensation as it’s earned. However, at the time of withdrawal from a Roth account, the compensation will be tax-free. This makes it a suitable choice for employees who are expecting to be in a higher tax bracket after retirement.
However, you also need to be aware of different types of deferred compensation, so that you as an employee can choose the one that is more suitable for your future plans. What are these types? Let’s find out.
Types of deferred compensation
1: Qualified deferred compensation plans
This plan is basically like traditional individual retirement accounts (IRAs) and 401(k)s. It allows employees to contribute a portion of their pre-tax earnings directly from their paychecks into a retirement savings account. However, employees can only contribute a certain limit annually, because the IRS has set a limit to this contribution.
The funds within this account can be invested in different ways to potentially increase in value over time. When employees reach the age of retirement, they can withdraw the money from their accounts. However, any withdrawals they make are subject to taxation as regular income.
2: Nonqualified deferred compensation plans
In this plan, both the employee and the employer need to agree contractually on the deferral terms. This term will include how much amount will be deducted for deferred compensation and when the employee get access to their compensation.
Distribution timing can be based on a specific date or triggered by events like retirement, death, or personal emergencies.
Similar to qualified retirement plans, nonqualified plans also allow employees to delay paying taxes on the income they contribute to the plan. However, when the money is eventually withdrawn from the plan the employee is then required to pay taxes on that income.
You May Also Read..
