Can I Claim a Tax Benefit for My Deferred Comp Retirement Account?

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.

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.

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.

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.