Different Types of Deferred Compensation Plans

Different Types of Deferred Compensation Plans
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The two broad categories of deferred compensation plans are qualified plans and non-qualified plans. Contributions to qualified plans, such as a 401(k), allow employers to claim tax deductions for the amount contributed and employees to defer taxes until payout time. Employees are also able to rollover the proceeds to another qualified plan if necessary. Since taxes are paid at the time payout is received, employees may be afforded preferable tax treatment if they fall into a lower income tax bracket. Employers, however, have to implement such plans across the board, and the IRS places limits on the maximum contribution.

Non-qualified plans offer employers the flexibility to select participants and decide the quantum of contributions. However, the employer does not receive any tax benefits until the employee actually receives the benefits. The employee attracts tax for benefits when it becomes due regardless of when they access it. Section 409A of the IRS code imposes restrictions on the timing of deferral elections and the distribution of benefits. Failure to comply with these requirements will result in additional taxes.

Qualified Plans

The Employee Retirement Income Security Act of 1974 (ERISA) regulates pension plans. ERISA lays down stipulations on employee participation, the time employees have to work before they become eligible for a non-forfeitable interest in the pension, how taking time off from the job affects the benefits, and so on. ERISA also requires companies to place pension assets in trusts. Companies going bankrupt cannot access these funds to pay creditors. The most popular qualified plans, all of which come under ERSIA, are 401(k), 403(b), SEP, and ESOP

  • 401(k): The most popular type of qualified plan is a 401(k ). An employee can opt to contribute a portion of salary to the 401(k) plan and the employer has the option to match the contributions. The IRS allows deduction of these contributions when calculating income for tax purposes for both the employer and the employee. Contributions remain subject to dollar limits, which the treasury department revises annually. The employee receives the amount invested in the fund at time of retirement, but can also withdraw or borrow before that time for specific needs, hardships or disability. Premature withdrawal in other cases results in a tax penalty. 401(k) plans can also offer stock bonuses instead of cash.
  • Simplified Employee Pension Plan (SEP): SEP’s are another retirement saving vehicle where the employer sets up individual accounts and allows employees to contribute a portion of their salaries to the accounts. The employer has the option of matching up to 25 percent of the employees pay to this fund, subject to a maximum of $40,000 a year. Employees may contribute up to 15 percent of their salary to this fund.
  • 403(b): 403(b) plans are another retirement savings plans available to public education organizations and some non-profit employers. They are similar to other ERISA backed plans. However, this plan allows withdrawal of funds before the employee reaches 59 ½ years without penalty. Such plans can take the form of annuity contracts, custodial accounts, or retirement income accounts.
  • ESOP: [Employee Stock Option Plans](/tools/Explaining ESOPs or Employee Stock Ownership Plans) constitute a defined contribution plan, where the employee contributes a portion of income due from the company to in exchange for receipt of company shares later.

Non-Qualified Plans

Non-qualified deferred compensation plans (NDCP) supplement qualified deferred plans and provide extra benefits. Non-qualified plans are outside the ambit of ERISA and companies are at liberty to choose employees for the scheme. There is no maximum limit on employer contributions. Companies opt to offer such schemes to key personnel and top executives as a means to defer taxation for such executives. The arrangement serves as a “golden handcuff” for it tempts the executive to stay or risk forfeiting the money. The most popular non-qualified plan is SERPS.

  • Supplemental Executive Retirement Plan (SERPS): SERPS is a stated benefit from the employer at retirement. The benefit could be a flat dollar amount based on years worked, a percentage of the last drawn salary multiplied by years with the company, or any other method decided by the company. Companies fund SERPs through either general assets or corporate-owned life insurance (COLI). Under COLI, businesses buy life insurance plans for the executive and designate the business as the sole beneficiary. The company compensates the executive from the operating assets, but recovers the amount from the insurance company upon the death of the executive.
  • 457 Plan: The 457 plan is a non-qualified deferred scheme for certain governmental and non-governmental employers. The plan works similar to a 401(k) but does not charge a penalty for withdrawal before the employee reaches 59 ½ years.

Participation in non-qualified deferred schemes is voluntarily and they pose an element of risk. The funds are held in a “rabbi trust,” so-called because the trust was first constructed for a rabbi. Such rabbi trusts offer a fair amount of protection against the company using the funds for other purposes or to pay creditors during bankruptcy. Nevertheless, companies can legally opt to divert such funds to other purposes in certain situations and the funds are not safeguarded for the contributors during liquidation.

References

  1. Inc.com. “Nonqualified Deferred Compensation Plans.” https://www.inc.com/encyclopedia/nonqualified-deferred-compensation-plans.html. Retrieved May 25, 2011.
  2. Lieber, Ron. “The Hidden Peril of Deferred-Compensation Plans.” https://www.nytimes.com/2009/05/09/your-money/09money.html. retrieved May 25, 2011.
  3. United States Department of Labor. “Frequently Asked Questions about Pension Plans and ERISA.” https://www.dol.gov/ebsa/faqs/faq_compliance_pension.html. Retrieved May 25, 2011.

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