Work now, get paid later – often decades later. That’s the idea of a deferred compensation plan, and such plans basically serve as large tax breaks for employees and employers. However, because these contributions are not taxed at the time they are made, that means that you can't get a tax deduction for them. Later when you receive the withdrawals, you'll be taxed on these contributions as usual.
Since you are not being taxed on a deferred compensation account until you start making withdrawals, you cannot claim a tax deduction.
Deferred Compensation Tax Deduction
Deferred compensation plans fall into two general categories: qualified and non-qualified plans. A qualified plan includes 401(k)s, 403(b)s, 457(b)s and the like, in which all money contributed by the employee and matching funds contributed by the employer are tax-deferred until the employee starts making withdrawals in retirement, at which time the withdrawals are taxed as ordinary income. Many employees will find themselves in a lower tax bracket in retirement. The qualified plan lowers the amount of taxable income an employee receives, so she pays less income tax overall. The employer can deduct the company’s matching contributions on its income tax return, but an employee cannot take deductions for a qualified plan because their contributions are not taxed. Qualified deferred compensation plans must comply with the Employee Retirement Income Security Act (ERISA) and are protected under the act.
Non-Qualified Deferred Compensation Plan
A non-qualified deferred compensation plan allows highly compensated employees set some of their salary or bonus aside, with the deferred compensation funds growing tax-free until the employee receives the money down the road. These plans allow highly compensated employees to put even more money aside than permitted under qualified compensation plans such as 401(k)s. While in theory this is a good deal, there’s a considerable risk factor. Unlike a 401(k) or similar plans, there is no ERISA protection for these funds if the company hits a rough spot. The employer cannot deduct contributions to a non-qualified deferred compensation plan until the employee receives their compensation. These plans must stay compliant with Section 409A of the IRS Code, and violations of the regulations can result in severe consequences. Initial elections for a non-qualified deferred compensation plan, as per Section 409A, must be in writing and irrevocable, must specify a payment date or event for receipt of the funds and the agreement must be made before the beginning of the year in which the employee is earning the deferred compensation.
In a worst-case scenario, the employee is just another unsecured creditor should the firm file for bankruptcy, and they may never see their deferred compensation. There’s also the risk that another entity may buy the company and end the plan, in which case employees receive their deferred compensation in one lump sum, which generally means it is taxed at a high rate, rather than the lower rate they may expect in retirement.
Deferred Compensation Limits 2018
For 2018, the deferred compensation pre-tax limit for a qualified plan is $18,500. Non-qualified deferred compensation plans are always subject to agreements between the highly compensated employee and the employer.
- IRS: IRC 457(b) Deferred Compensation Plans
- New York State Deferred Compensation
- New York Times: Should You Take Advantage of a Deferred Compensation Plan?
- Baker Newman Noyes: Deferred Compensation – Tax, Accounting and Regulatory Considerations
- Cornell Law School: 26 U.S. Code § 409A - Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
- Department of Labor. "Types of Retirement Plans." Accessed Mar. 30, 2020.
- William & Mary Annual Tax Conference. "Qualified and Nonqualified Deferred Compensation Plans in Small Businesses: Creative Uses and Problem Solving," Pages 2-3. Accessed Mar. 30, 2020.
- Internal Revenue Service. "2021 Limitations Adjusted as Provided in Section 415(d), etc." Accessed Oct. 30, 2020.
- Department of Labor. "Private Pension Plan Bulletin," Page 3. Accessed Mar. 30, 2020.
- Internal Revenue Service. "Topic No. 558 Additional Tax on Early Distributions from Retirement Plans Other than IRAs." Accessed Mar. 30, 2020.
- Department of Labor. "Investing And Diversification." Accessed Mar. 30, 2020.
- Internal Revenue Service. "Hardships, Early Withdrawals and Loans." Accessed Mar. 30, 2020.
A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including Sapling, Zack's, Financial Advisor, nj.com, LegalZoom and The Nest.