Are you maxing out the 401(k) plan you have at work every year? Do you still have money left for saving and investment after contributing the maximum to your 401(k) and maybe an IRA or two? If so, then you may want to consider contributing to an executive deferred compensation plan. An executive deferred compensation plan allows high-income employees to put off paying taxes on part of their income until retirement. Here’s how it works.
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Executive Deferred Compensation Plans Defined
An executive deferred compensation plan allows employers to defer a part of their executives’ income so that they will pay taxes on it later when they start withdrawing from it. Contributing to an executive deferred compensation plan allows an executive to shield part of their income from taxes until they are in a lower tax bracket at a later time, usually at retirement.
Participants in an executive deferred compensation plan have to decide when to start taking distributions when they enroll in the plan. Depending on your age when you enroll, anticipating your correct retirement date can be difficult. The longer the time period between enrolling in a plan and retiring, the more difficult it is to predict your retirement date. Many participants choose a retirement date that falls during their late 60s or before they start taking distributions from their 401(k) or individual retirement plans (IRAs).
It is also necessary to specify how you want to take your distribution when you first enroll. You have to state that you either want a lump-sum distribution or equal payments over a certain number of years. If you want to change when or how you are going to take distributions from an executive deferred compensation plan, it is difficult. You may have to wait up to five years before the change is reflected in the terms of your plan.
Offering employees access to an executive deferred compensation plan is a valuable employee benefit. Having such a plan can draw in well-qualified executives. It can also keep executives from leaving to go to work for a competitor because they would lose their ability to make future contributions.
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Types & Categories of Deferred Compensation Plans
There are two types of deferred compensation plans. The qualified plan must conform to the Employee Retirement and Income Security Act (ERISA) rules. Qualified plans include 401(k), 403(b) and 457 plans. These plans must be offered to all employees. There is also a limit to how much you can contribute each year under qualified plans. Executive deferred compensation plans are non-qualified plans or NQDCs. The rules are not as strict for these plans as they are for qualified plans.
There are four categories of executive deferred compensation plans. Salary reduction and bonus deferral plans are very much like defined contribution plans. SERPs and excess benefit plans are funded by the employer and act like defined benefit plans.
Pros and Cons of Executive Deferred Compensation Plans
There are several important differences between these plans. What follows are some of the advantages of an executive deferred compensation plan. Just remember that this is not an exhaustive list:
There are contribution limits each year for a 401(k) but not for the deferred compensation plan unless there are plan limits.
You must start taking distributions by the age of 72 if you have a 401(k). It is not necessary under deferred compensation.
If the executive is a high earner and wishes to defer more of their income for current tax purposes, the deferred compensation plan allows for that.
The executive deferred compensation plans can be geared to certain classifications of employees.
Here are some of the disadvantages of the executive deferred compensation plan:
If the company you are employed by goes bankrupt, 401(k) funds are protected. This is not the case for funds in an executive deferred compensation plan. You could take a 100% loss.
You can receive distributions for financial hardship, at any time after age 59.5, if you have a 401(k). You have to follow the distribution schedule you set up when you enrolled in an executive deferred compensation plan.
If you lose your job, you can roll the money in your 401(k) over into an IRA or into a 401(k) plan sponsored by your new employer. The owner of a deferred compensation plan has no rollover option.
The owner of a 401(k) can take out a loan from the account. Executive deferred compensation plans do not allow for loans.
You generally do not have as many investments to choose from as you do with a 401(k).
Deciding on an Executive Deferred Compensation Program
Before you decide to invest in an executive deferred compensation plan, consider these questions:
Do you routinely contribute the full amount to traditional retirement accounts? If the answer is yes, you may want to consider it.
What kind of distribution do you want from an executive deferred compensation plan? Plans that pay out lump sum distributions aren’t always as beneficial as plans that offer distributions over many years.
Is the company financially secure? Before investing, you should determine the financial stability of your company. Older, established companies may be more secure than startups.
What type of investment is available with the plan? Some plans offer a fixed or variable rate of return on their deferred compensation plans. Others offer a range of possible investments in other investments such as stock.
What is my tax and investment situation? First, look at whether you have the disposable income to invest in the plan. Then look at how it will impact your tax situation.
The Bottom Line
Executive deferred compensation plans are an excellent way to attract and keep high-income executives since they can’t roll over their contributions and keep them when they retire. If you are an executive, learn about these plans before you invest, including the pros and cons. If you still need tax-sheltered income after maxing out your traditional retirement account options, this plan may be your ticket if your firm is financially stable.
Tips for Retirement
Retirement planning is complex so it makes a lot of sense to engage a financial advisor as you work through the various aspects of it. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor, get started now.
Use the SmartAsset retirement calculator to estimate how much money you will need in retirement. It will help you determine if you should invest in an executive deferred compensation program.
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