If you're a government or nonprofit employee, you may have a retirement benefit called a deferred compensation plan, such as a pension plan, as part of your employment compensation package. And some employees of for-profit companies sometimes receive a deferred compensation plan as a financial incentive to stay on the payroll instead of defecting to a competitor. This type of executive deferred compensation, or "golden handcuffs," is used by companies to incentivize and retain key employees and executives. Examples include employee stock ownership plans and some plans that are customized specifically for a given company or specific employee.
Deferred Compensation Plan Characteristics
Deferred compensation plans for government and nonprofit entity employees are known as 457 plans and executive deferred compensation plans are 409A plans, names that reflect the relevant Internal Revenue Code sections. A deferred compensation plan's main benefit lies in deferring part of an employee's income until later years when the employee theoretically will have a lower tax rate than she had when earning income. A 457 plan works somewhat like a 401(k) account, with the same contribution limits, but is available only to employees of nonprofit organizations.
Many companies have embraced 409A executive deferred compensation plans as something to offer executives and other highly compensated employees to save more money once they've reached their IRA and 401(k) contribution limits. For both types of deferred compensation plans, the deferred funds aren't counted as taxable income, so the employee can't take a deduction for them. Also, the employee doesn't get the cash until retirement, so the plan activity doesn't trigger any taxes until money is withdrawn. While the account accumulates value, some companies pay interest on the deferred funds or let employees select certain investments. Both plans' regulations dictate very specific rules regarding the deferral period and timing of future distributions.
Qualified vs. Non-Qualified Plans
Both 409A and 457 deferred compensation plans are called non-qualified plans because they don't qualify for the same deferred-tax status as other retirement vehicles, such as traditional IRA, 401(k) or 403(b) accounts. Because the plans are non-qualified, they can't be rolled into an IRA or other qualified tax-deferred account at any point in the future. The plan's non-qualified status means that companies are not required to offer the plans to all employees. Employees lose the plan if they leave the company, so companies often use them to retain workers who must consider the value of the future compensation they would leave behind if they leave employment at that company.
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When first enrolling in a deferred compensation plan, employees need to elect a schedule for how the money will be paid to them in the future. This long-range planning includes choosing the payment year and the percentage of money they want distributed to them in that year. By the time they withdraw funds, recipients have had the benefit of time to do tax planning and arrange to be in a lower tax bracket. Executive deferred compensation plans, offered by for-profit public or private companies, come with an important risk – the employer may not be solvent when the employee retires, and the employee could lose the income in his deferred compensation plan, becoming a creditor in line with others trying to get money from a bankrupt company.