If you are earning in the hundreds of thousands of dollars per year, and you already have a 401(k), IRAs, and other retirement accounts, there’s one more way to boost your retirement coffers: It’s called a deferred compensation plan.
Here’s how this works and why you should consider it.
What is a deferred compensation plan?
These plans are structured to hold a portion of an employee’s pay until later in life, often retirement. There are two types of plans: qualified deferred compensation plans, and non-qualified.
Here are the fundamental differences between the two:
For a deferred compensation plan to be “qualified,” it means it is in compliance with the Employee Retirement Income Security Act (ERISA). Qualified plans include 401(k) and 403(b) plans, have contribution limits, and must be open to every employee in a company. Funds are secured in a trust account.
A deferred compensation plan that is “non-qualified” (also called a Section 409A deferred compensation plan), on the other hand, has no contribution limits and can be targeted just to top executives and other high-earning employees. It’s entered into via a written agreement between the employee and the employer. The company withholds the funds, invests them, and promises to give them to the employee later on.
This brings up a potential drawback, in that these non-qualified deferred compensation plans are not protected in the same way that 401(k), 403(b) and 457(b) plans are. With those plans, your savings are separated from company assets and 100% yours. But with a non-qualified compensation plan, your contributions are tied to the company assets, and ultimately its financial success.
If your company is in strong financial health, though, there are a number of reasons to look more closely at a Section 409A deferred compensation plan. Here are a few.
#1 Taxes
Not only will your taxable income be reduced in the year that you contribute to a deferred compensation plan, your money will grow tax-deferred.
Just like with a 401(k), you will pay taxes on funds from your deferred compensation plan when you receive payment. However, because it’s possible that you’ll be in a more advantageous tax bracket in retirement, you may wind up paying fewer taxes on withdrawals. (Of course, there are a number of factors at play here, so be sure to consult with your tax advisor.)
#2 Early distributions
Both qualified and non-qualified plans offer some flexibility in distributions. Certain circumstances, such as purchasing a home, funding a child’s education, or early retirement, allow you conditional access to funds before retirement age.
If you have a qualified deferred compensation plan using a 401(k), you are allowed to withdraw funds with no penalty after you turn 59 ½ and possibly even earlier: Because of a loophole in the tax code, you would be able to withdraw funds with no penalty after the age of 55 if you quit, are fired, or are laid off. (This is only applicable to the 401(k) you have with your current employer.)
In this way, a qualified deferred compensation plan could provide you with the income you need to bridge the gap in those early retirement years.
In-service withdrawals may also be available as part of your plan. These involve taking money out so that you can invest it elsewhere.
#3 Capital gains
Sometimes deferred compensation is offered in the form of stock options or investment accounts, meaning your contributions could increase in value over time. (Of course, the inverse could also occur.)
If this is how your employer’s plan works, they will offer investment options or funds for you to select from, similar to how you might select specific investments for your 401(k).
While deferred compensation plans can hold a lot of promise, they bring both risks and benefits that you’ll want to fully understand before you commit. A wealth advisor with Ironwood Wealth Management can help you evaluate this and other retirement planning options in the context of your financial plan. Reach out today.
