The phrase "deferred compensation" refers to workplace retirement plans that involve the employer withholding pay from an employee and setting it aside in a savings program. Generally, the employee is not taxed on income deferred in this way. These plans come in two main varieties: ERISA-qualified and non-qualified. The Roth IRA is an individual retirement savings vehicle with a different tax treatment than deferred compensation plans.
The two approaches together, however, can work well as a retirement savings strategy.
Read More: Roth IRA Vs. 457
Advantages of a Roth IRA
The Roth IRA does not allow you to deduct contributions, but everything you contribute grows tax free, provided it's been in the account at least five years. Roth IRA accounts therefore help protect the investor against increases in the income tax rate in future years.
Roth IRAs don't impose required minimum distributions – there is no limit to how long you can leave the money in an IRA to compound tax free. Roth IRAs also can help mitigate exposure to possible estate taxes, since, by paying income taxes now, you move assets out of your estate, protecting them from getting taxed under estate tax laws.
Qualified ERISA Plans
The Employee Retirement Income Security Act of 1974 (ERISA) defines the tax incentives for businesses to set up retirement plans on behalf of employees and the eligibility for these tax advantages. Conventional defined benefit pension plans are ERISA-qualified, as are 401(k) plans and 403(b)s. The latter two operate on a salary deferral basis. These plans provide solid asset protection against the claims of creditors and tax-deferred growth.
Non-Qualified Deferred Compensation Plans
Non-qualified deferred compensation plans (NQDCs) are sometimes referred to as "executive benefit" plans, because they primary target senior executives who are ineligible to contribute to IRAs or Roth IRAs or who desire to shelter more money from taxes than their company's 401(k) or 403(b) plan will allow. The so-called "top hat" rules governing these plans frequently limit the ability of senior executives and employee-shareholders with significant stakes in the company to contribute to them.
Risk of Forfeiture
To qualify for tax-deferral on non-qualified deferred compensation, the employee must bear a "substantial risk of loss" on the amount deferred. Otherwise, the Internal Revenue Service will deem the executive to have been in "constructive receipt" of the compensation, and will therefore charge income tax on the amount deferred.
Mechanics of Risk of Forfeiture
To qualify as having a substantial risk of forfeiture, there must be a non-trivial chance that the employee will not receive that money. For example, the money could be tied to a requirement that the employee remain with the company another 10 years, in a so-called "golden handcuff" arrangement. Meanwhile, the deferred compensation remains an asset of the company, not the employee.
The company has a contractual relationship with the employee to provide the compensation as promised. But the compensation, meanwhile, is subject to the claims of company creditors. If the company goes bankrupt, the employee risks losing the deferred compensation.
Considerations for Retirement Plans
Consider using non-qualified deferred compensation plans when the employee's income is so high that he is ineligible for other more traditional retirement savings options. At this level, the employee may not be eligible to contribute to a Roth IRA. However, if he has assets in a qualified plan, he can still roll them into a Roth IRA by paying income taxes.
Combining nonqualified deferred compensation with the tax free growth in Roth IRAs helps provide a hedge against changes in income tax rates – a strategy called "tax diversification."
Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.