Are you wondering, “What kind of impact does my deferred comp have on my taxes?” Well, you should. If you are going to work now and get paid later, there should be something in it for you.
So, is deferred compensation tax-deductible? Well, it depends on whether you are considering current tax returns for the year 2021 or future tax returns after you retire. For that reason, it would be wise to understand the types of deferred compensation plans available and how the IRS treats them in terms of taxes.
Types of Deferred Compensation
Typically, deferred compensation plans enable you to utilize payroll deductions to defer some of your earnings by investing them in a deferred compensation plan of some sort. You will be paid the accumulated income at some point in the future. And often, you will also receive any interest generated by your deferred income.
Deferred compensation plans fall under two categories: qualified and non-qualified deferred compensation plans.
1. Qualified Deferred Compensation Plan
Qualified deferred compensation plans fall under the supervision of the Employee Retirement Income Security Act (ERISA). That means they must be operated in a transparent manner for the benefit of eligible employees within the plan. And the deferred earnings, together with the matching contributions from your employer, must be held in a trust account.
Examples of qualified deferred compensation plans include 403(b), 457(b) and 401(k) plans. Most permit pre-tax contributions. But the Roth types also permit after-tax contributions.
Generally, these kinds of plans are also subject to strict contribution and withdrawal limits. For the tax year 2021, you can contribute elective deferrals of up to $19,500. But if you are 50 years or older, you can also add catch-up contributions of $6,500.
2. Nonqualified Deferred Compensation Plans (NQDCs)
Nonqualified Deferred Compensation Plans (NQDCs) enable highly compensated employees, such as executives, to defer more of their earnings now in the hopes of being in lower tax brackets in the future. They enable you to save unlimited income on a tax-deferred basis in the hopes of getting into a lower tax bracket in the future.
You should consider NQDCs if you are maxing out all your other deferred compensation plans, but still want to save for retirement. And if you need money, you could always begin withdrawing it while you are still working, either as a lump sum or in the form of periodic payments.
However, NQDCs can be risky, especially since they don’t fall under ERISA. You could end up losing all the assets within the plan if your employer goes under or uses the monies for other activities and refuses to pay. So, that is something to think about. However, you can lessen the risks by writing a binding contract with your employer, and stating the triggering events that will enable you to access your deferred compensation, such as retirement.
It is also worth noting that 457(f) deferred compensation for employees of tax-exempt organizations or government agencies, which fall under the NQDCs, may be subject to taxation as soon as they vest.
Typically, when employer contributions are not subject to any substantial risk of forfeiture, they become taxable income within that first year. However, your contributions will be taxed when you withdraw the monies. In the meantime, you get to reduce your taxable income.
Read More: How Much Is the Standard Tax Deduction?
Is Deferred Compensation Tax-Deductible?
How you make deductions from your deferred comp depends on whether you use pre-tax or post-tax income to fund the deferred compensation plans.
If you defer your pre-tax income, you can deduct the deferred amount from your taxable income. So, any other deductions that come afterward will be based on gross income minus your deferred compensation amounts.
For example, if you are 40 years old, your gross earnings are $100,000 and you opt for the maximum elective deferral of $19,500, you can begin making other tax deductions from the remainder, which is $80,500.
The deferred amount of $19,500 will not be subject to federal or state taxes and will grow tax-deferred. Therefore, you will only pay taxes when you begin making withdrawals.
On the other hand, when dealing with Roth-type accounts, you can only contribute using after-tax deferred compensation. Therefore, your gross earnings will be your taxable income, and you cannot subtract the contributions you make.
In exchange for not reducing your taxable income upfront, if you meet the IRS withdrawal rules, your qualified distributions, including both deferrals and earnings, will be tax-free. So, essentially, you get to reduce the taxes you pay.
There are tax benefits for your deferred comp retirement account. But whether you reduce your taxable income now or taxes in the future depends on what kind of monies you use to fund the account. Pre-tax funds have different implications from post-tax earnings. So, ensure you understand them.
- Corporate Finance Institute: Deferred Compensation
- IRA.Gov: How Much Salary Can You Defer if You’re Eligible for More than One Retirement Plan?
- Fidelity: Nonqualified Deferred Compensation Plans (NQDCs) | Fidelity Investments
- ICMA-RC: Your 457 Plan – The Roth Contribution Option*
- EISNERAMPER: IRS Issues Proposed Regulations for Executive Deferred Compensation Plans of Tax Exempt Organizations
- IRS.Gov: Government Retirement Plans Toolkit
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