- The four primary direct forms of compensation are salary, hourly, commission and bonuses.
- Beyond direct compensation, there is indirect compensation, such as benefits and equity-based programs, which is just as important a part of your plan.
- The right way to launch a compensation program has a lot to do with doing your research first and then not skipping or missing any critical steps.
- This article is for small business owners and employee supervisors who want to learn more about what a compensation program consists of and how to implement it successfully.
What is a compensation plan?
A compensation plan, also referred to as a “total compensation plan,” encompasses all of the compensatory components of a company’s strategy – employees’ wages, salaries, benefits and total terms of payment. Employee compensation plans also include raise schedules, all fringe benefits, and any union perks or employer-provided vendor discounts.
A strategically designed compensation philosophy that is kept current, relevant and in accordance with employment laws, supports several important components of your business:
- Strategic plans
- Budgeting and business goals
- Industry-competitive challenges
- Operating needs
- Total reward strategies that support retention of the company’s top talent
The Society for Human Resource Management (SHRM) further outlines the purpose and value of maintaining a dynamic and strategic compensation program:
- It describes how your organization’s pay and compensation philosophies support your business strategy, competitiveness within the industry, operating objectives and staff needs.
- It helps attract qualified candidates to join your organization.
- It serves as a strong motivator for employees to perform at high levels and exceed goals.
- It helps keep your business competitive in the marketplace in terms of base pay, incentives, total compensation and benefits opportunities.
Key takeaway: A compensation program constitutes a company’s total method of renumeration, including payment, benefits and any other form of compensation for services rendered.
Why do companies need a compensation plan?
Companies need a thoughtful compensation program to remain competitive within their industry and to attract and retain top talent. Employers who just go with whatever they feel they should pay their employees will slowly lose the talent game they are playing with their competitors. Additionally, managing a workforce without a predetermined budget is insanity in action. Compensation programs allow for consistent and predictable budgeting and planning.
According to PayScale’s 2020 Compensation Best Practices report, companies are having a tougher time than ever finding (and keeping) enough skilled talent to fill all of their needs. To attract and retain the top workers they desire, more organizations are focusing on building “an employer brand, which includes a more strategic approach to compensation and career pathing as well as better benefits and more varied and incentivizing ways to reward performance.”
Key takeaway: Every company needs a compensation plan to organize and strategize how they will attract and retain top talent, as well as to budget in a wise and predictable manner.
What is direct and indirect compensation?
The most foundational of compensation components are either “direct” forms such as salary, hourly pay, commission, or bonus monies, or “indirect” forms, which are benefits of various kinds.
The 4 types of direct compensation
Although you can use any of the four types to compensate employees for their work, employers typically choose one and stick with it. The exception is bonus pay, which is meant to be an addition to regular pay based on employee or company performance.
Salary
The most traditional form of salary is a monetary amount scheduled over a one-year period. How often salaried employees are paid is another part of the compensation strategy, but businesses typically pay their employees every two weeks.
Salary is the most common method of direct compensation for exempt employees. An exempt employee is not eligible for overtime pay. They receive a base salary for the work they perform rather than an hourly rate, so employers pay exempt employees for the job they do instead of the number of hours they work.
Hourly pay
Nonexempt employees are typically paid an hourly rate, eligible for overtime pay and guaranteed at least minimum wage. When an employee works over 40 hours in a workweek, their employer must pay them overtime.
Hourly rate of pay is typically a predetermined dollar amount per hour of work. Typically, nonexempt employees are paid an hourly rate rather than a salary. They employees generally keep a timecard or clock in and out to begin and end their work shift. During times of slow or reduced work, or a change in a company’s budget, nonexempt employees may not work as many hours as they did in previous weeks. Thus, there is no ensure of a routine number of hours worked per pay period. [Read related article: Salary vs. Hourly: What’s Better for Your Business?]
Commission
When compensation is based on volume, production or a predefined level of performance, this is a commission. Other expressions of this type of renumeration are “piecework” and “piecemeal.”
Most commonly, there are two methods utilized and referred to as paid commission. One calculus is based on volume of services performed or products made. The second form is structured around sales volume. An example of a worker with this type of compensation is a real estate broker: They sell a house and will be compensated off of that sale. It doesn’t matter how long or what work activities it took to sell the house, only that the house was sold.
Bonus pay
Bonuses are used to motivate employees or increase their overall performance. This is a variable method of compensation that is commonly associated with sales professionals, who tend to be salaried or exempt personnel. For example, if a sales professional exceeds her quarterly target by a certain dollar amount, based on a predetermined matrix, she receives a commensurate bonus.
Bonuses can also be paid for company performance, as well as when difficult-to-fill positions are filled with employees with unique or highly sought-after skills or experience.
Types of indirect compensation
Indirect compensation can be any fringe benefit that employers offer. Most commonly, it refers to the various types of insurance offered by employers, including medical, dental, life, short- and long-term disability, and vision. Employee retirement programs, like 401(k) plans, are another common form of indirect compensation.
Equity-based programs are another compensation offering, though these aren’t typically offered within the small business realm. Equity-based compensation is generally some sort of share or stock in the company.
These are some other examples of indirect compensation:
- Disability income protection
- Vacation days or paid time off (PTO)
- Paid holidays
- Flexible working hours or scheduling
- Other forms of retirement benefits
- Opportunities for advancement
- Student loan assistance
- Educational benefits
- Assistance with child care expenses
- Relocation benefits
- Company car
- Company equipment (laptops, mobile phones, etc.)
PayScale’s 2020 survey reveals the most common ways companies reward their top talent and their employees overall:
Source: PayScale
Key takeaway: The four types of direct compensation – salary, hourly pay, commission and bonus pay – are provided in return for completed work. Indirect compensation, on the other hand, can include PTO, healthcare and retirement benefits, flexible work schedules, and so on.
How to develop and implement a compensation plan
Think of the challenge of developing a compensation strategy less in terms of a “right way and wrong way” and more in terms of what’s right for your team. Here are some suggestions to guide you along the way.
- Create an outline. Set an objective for your program and certain targets. We also suggest that you begin with job descriptions for each position on the team and set a generalized budget for your personnel.
- Appoint a compensation manager. This position, which is usually filled by someone in human resources, aligns the program and researches what each position pays within the industry, how job classifications will be determined, and how direct compensation will be selected.
- Create a compensation philosophy. Determine how competitive you are going to be within your industry’s job market. Are you going to lead the market in direct compensation, or offer modest pay with great benefits?
- Rank jobs and place them within a matrix. Outline what, if any, tiers of pay should exist in pay structures for executives and sales employees, for example. You also should determine potential tiers within each job classification.
- Develop grades for seniority within each job classification. It is important to develop opportunities for career advancement. Create levels 1-3 or senior- and entry-level roles that may impact the compensation matrix but will offer advancement for employees.
- Settle on salaries and hourly rates of pay. Once you have your outline for your compensation platform, assign rates of pay and a salary range for each position and job classification. This is when you fine-tune your organizational budget.
- Complete necessary policies. A number of policies related to payroll, fringe benefits and other pay-related matters be impacted by a compensation plan. For example, companies often have policies for paid holidays, healthcare benefits, payroll administration, and company-issued pay advances that need to factor into or at least align with the company’s compensation policy. [Read related article: Employee Handbooks for Startups]
- Get approval or buy-in from your company’s other leaders. Once everything is in place, ensure that all of your company’s leadership remains on board and in full support of what you’ll soon launch.
- Develop a communication plan. All your employees should learn about the compensation program at the same time. Use several methods of communication to share the plan (e.g., email, group gatherings, social media, flyers in common areas, etc.). Issue this messaging in multiple languages if not all your employees speak English as a first language. You should expect a lot of questions. The complexities of total compensation are not easily understood by everyone – and it is essential that every employee understands their compensation package.
- Monitor so you can adjust or evolve as needed. Be prepared to make modifications to your compensation. Over time, adjustments will be necessary for you to remain legally compliant and competitive.
Ensuring equity, fairness, legality and competitiveness
Part of developing a compensation plan is ensuring it’s fair for all your employees. This does not only pertain to gender, culture, race, ethnicity and so on, although that is part of it. We are also talking about skill sets and experience that new team members bring to your company.
SHRM outlines a quality test that your compensation plan should pass before you unveil it to your company. The test addresses the following questions:
- Are the programs in the compensation philosophy and policy legally compliant? Be mindful of both state laws (which include PTO or vacation regulations in some cases) and federal laws (such as the Affordable Care Act).
- Is the overall program equitable (i.e., fair to all employees)?
- Is the overall program defensible and perceived by employees as fair? In this case, perception is reality.
- Is the overall program fiscally sensitive? That is, can you maintain the benefit offerings even if profits dip for a quarter or two?
- Can your organization effectively communicate the philosophy, policy and overall program to employees?
- Are the programs fair, competitive, and in line with your overall compensation philosophy and policies?
- Is the compensation policy competitive? Will it help your organization attract and retain top talent in your industry?
There are many reasons to adjust or update your compensation program. It may grow out of date for your company, or it may not comply with new employment laws. Retention and recruitment purposes are other motivating factors to keep your compensation plan active and relevant.
Source: PayScale
Each of these attributes represents a critical value to any compensation program, as it’s the foundation of the employer’s relationship with each of its employees.
Key takeaway: You need a solid plan for developing and implementing your compensation program. Make certain that you are creating a system that is equitable, fair, legal and competitive – or you’ll have a lot of repair work down the road.
Compensation plan examples
Although it is difficult to see other companies’ total compensation programs (as many companies hide these details from outsiders), we can share a number of resources that have worked well for others. These are a few of the many compensation planning and design companies that the SHRM lists as resources:
- Culpepper and Associates Inc.
Services offered: Compensation surveys and services - PeopleFluent
Services offered: Talent management suite - CompensationCloud Inc.
Services offered: Employee compensation management software - Flex HR
Services offered: Full-service consulting - CRG emPerform
Services offered: All-inclusive employee performance management
Key takeaway: There are many resources for templates and tools for compensation plan development. These options can make the task of creating a comprehensive compensation plan more manageable.
Compensation plans are helpful to anchor down a company’s plan for attracting and retaining the best team members possible. Be sure to take the time necessary to develop a complete program and communicate the plan effectively to everyone on your team.
Date: October 2022
Bowdoin College’s staff compensation philosophy is to offer a highly competitive total compensation (wages and benefits) package that attracts, retains and motivates individuals who enable the College to achieve its mission.
The College maintains a job classification and compensation structure including a College–wide career band framework that reflects how people work and is easy to understand. The basic purpose of the plan is to ensure that all employees are paid competitively, and our benefits compare favorably to local employers and peer institutions
Additional guiding principles of the compensation plan include:
• An employee’s pay will not be capped due to being paid over the pay band maximum.
• The College will review the pay bands on a regular basis
• The College will follow all federal regulations including the Fair Labor Standards Act to determine exemption status.
The complete structure can be found under Staff Compensation and Job Classification Structure.
Rena Dietrich is a freelance writer who has been writing about Topics in the business field since 1997. Her work has appeared in publications ranging from accounting textbooks to financial newsletters. Dietrich received her Master of Business Adminstration from Governor's State University.
457(b) Supplemental Retirement
Eligible Employees
Classified | Operational | Executive | 12-Month Faculty & Professional | 9-Month Faculty & Professional | Hourly
William & Mary offers both a 457(b) Deferred Compensation Plan (DCP) and a 403(b) Tax Sheltered Plan as supplemental retirement plans.
The 457(b) Deferred Compensation Plan offers you the opportunity to contribute up to $22,500 ($30,000 if over age 50) of your annual salary. The contributions are made on a pre-tax basis.
Frequently Asked Questions
Why add a supplemental retirement plan?Benefits of either a DCP or TSA Supplemental Retirement Plan:
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Can I participate in both the 403(b) and 457(b) plans?Yes! As an employee of the university, you have the opportunity to contribute up to the maximum in BOTH a 403(b) TSP plan and the 457(b) Deferred Compensation plan at the same time. However, you are only eligible to receive the cash match with one plan (does not pertain to hourly employees). Employees who join both plans will default their cash match plan to the 457(b) unless they specify otherwise. The Virginia Cash Match Plan 401(a) (does not pertain to hourly employees) * Note: Employees who are enrolled in the Virginia Retirement System Hybrid Retirement Plan must be contributing a total of 9% to the hybrid plan in order to be eligible for the cash match program. If you are interested in participating in either the 457(b) or 403(b) with a cash match plan, please contact University Human Resources at 757-221-3169 or email [[AskHR]] for assistance. |
How do I enroll?403(b) Tax Sheltered Plan: Our Benefits staff have literature and enrollment forms for the 403(b) plans. The effective date of enrollment and contributions in a tax shelter annuity must be the first day of the pay period, the 10th or 25th. You may also enroll using the Retirement@Work platform. 457(b) Deferred Compensation Plan: To enroll, please contact MissionSquare at 877-327-5261 to enroll and/or make changes to your contribution amount or fund lineup. |
How do I update beneficiary information?Participants in the Commonwealth of Virginia 457 Deferred Compensation Plan should log in to MissionSquare's AccountAccess website to update beneficiary information for their defined contribution accounts. |
Who is the vendor of the Deferred Compensation Plan? |
Review current investment option performance
Maximum Limitations on Contributions |
403(b) Limits |
457 Limits |
Over 50(Catch-Up Contributions) |
|---|---|---|---|
| 2021 | $19,500 | $19,500 | $26,000 |
| 2022 | $20,500 | $20,500 | $27,000 |
| 2023 | $22,500 | $22,500 | $30,000 |
When we hear the word compensation, most people tend to think of salaries and wages. But that's not the only form of compensation that employees have available to them. In fact, compensation comes in many forms. It can also include tips, profit-sharing, vacation pay, healthcare coverage, and deferred compensation plans.
A deferred compensation plan withholds a portion of an employee’s pay until a specified date, usually retirement. The lump sum owed to an employee in this type of plan is paid out on that date. Examples of deferred compensation plans include pensions, 401(k) retirement plans, and employee stock options.
Key Takeaways
- Deferred compensation plans allow employees to withhold a certain amount of their salaries or wages for a specific purpose.
- Deferred compensation plans can be qualified or non-qualified.
- Qualified plans fall under the Employee Retirement Income Security Act and include 401(k)s and 403(b)s.
- Non-qualified plans are usually written and regulated by the employer
- There may be contribution limits, tax benefits, rules about withdrawals, penalties, and other regulations depending on the plan.
Qualified vs. Non-Qualified Deferred Compensation Plans
Deferred compensation plans generally come in two different forms: qualified and non-qualified. Although there are similarities, there are also distinct differences between these two types of deferred compensation plans.
- A qualified deferred compensation plan complies with the Employee Retirement Income Security Act (ERISA) and includes 401(k) and 403(b) plans. They are required to have contribution limits and be nondiscriminatory, open to any employee of the company, and beneficial to all. They are also more secure, being held in a trust account.
- A non-qualified compensation plan is a written agreement between an employer and an employee in which part of the employee’s compensation is withheld by the company, invested, and then given to the employee at some point in the future.
Non-qualified plans don’t have contribution limits and can be targeted to specific employees, such as top executives. The employer may keep the deferred money as part of the business’s funds, meaning that the money is at risk in the event of bankruptcy.
It's important to note that money from a qualified plan can be rolled over into an individual retirement account (IRA) or other tax-advantaged retirement savings vehicle. Money from a non-qualified plan, though, cannot be rolled over into another plan. Be sure to check the plan rules that apply to you with your plan's administrators and consult a tax advisor before taking any in-service withdrawals.
Benefits of a deferred compensation plan, whether qualified or not, include tax savings, the realization of capital gains, and pre-retirement distributions.
Contribution Limits
There may be limits to the amount of money employees can set aside for their deferred contribution plans. These are referred to as Internal Revenue Service (IRS)-recognized plans, such as 401(k)s and 403(b)s. These limits are established by the IRS and adjusted annually for inflation. The annual contribution limit for employees for these plans is:
- $20,500 for 2022
- $22,500 for 2023
The IRS allows older individuals to make additional contributions to their plans. You can make a catch-up contribution of $6,500 in 2022 and $7,500 in 2023 if you are 50 or older.
Plans that aren't recognized by the IRS may don't have a contribution limit. For instance, you can usually set aside as much of your salary or wages for a profit-sharing plan. And certain plans meant for executives may not have a limit either. In any case, it's always a good idea to check with the employer if there are any contribution limits.
Benefits
There are a number of key benefits that employees should be aware of before they begin contributing to a deferred contribution plan. We've listed some of the key advantages below.
Tax Benefits
A deferred compensation plan reduces income in the year a person puts money into the plan and allows that money to grow without any taxes assessed on the invested earnings. A 401(k) is the most common deferred compensation plan. Contributions are deducted from an employee's paycheck before income taxes are applied, meaning they're pre-tax contributions.
As such, you're only required to pay taxes on a deferred plan when you take a distribution or make a withdrawal. While taxes need to be paid on the withdrawn funds, these plans provide the benefit of tax deferral, meaning withdrawals are made during a period when participants are likely to be in a comparatively lower income tax bracket.
Deferred compensation plans also reduce the current year's tax burden on employees. When a person contributes to a deferred compensation plan, the amount contributed over the year reduces taxable income for that year, thus reducing the total income taxes paid. When the funds are withdrawn, savings are potentially realized through the difference between the retirement tax bracket and the tax bracket in the year the money was earned.
Participants of 401(k) plans can withdraw funds penalty-free after the age of 59½. However, there is a loophole known as the IRS Rule of 55. This rule allows anyone between 55 and 59½ to withdraw funds penalty-free if they quit their job, were fired, or were laid off. The loophole only applies to the 401(k) you have with the company from which you are separating.
Capital Gains
Deferred compensation has the potential to increase capital gains over time when offered as an investment account or a stock option. Rather than simply receiving the amount that was initially deferred, a 401(k) and other deferred compensation plans can increase in value before retirement.
While investments are not actively managed by participants, people have control over how their deferred compensation accounts are invested. They can choose from options pre-selected by an employer. A typical plan includes a wide range of these options, from more conservative stable value funds and certificates of deposit (CDs) to more-aggressive bond and stock funds.
It is possible to create a diversified portfolio from various funds, select a simple target-date or target-risk fund, or rely on specific investment advice.
Monitor your deferred compensation plan carefully because it can also decrease in value.
Pre-Retirement Distributions
Some deferred compensation plans allow participants to schedule distributions based on a specific date. This is called an in-service withdrawal. This added flexibility is one of the most significant benefits of a deferred compensation plan. It offers a tax-advantaged way to save for a child's education, a new house, or other long-term goals.
It is possible to withdraw funds early from most deferred compensation plans for specific life events, such as buying a new home. Depending on IRS and the plan rules, withdrawals from a qualified plan may not be subject to early withdrawal penalties. However, income taxes will be due on withdrawals from deferred compensation plans.
In-service distributions can also help people partially mitigate the risk of companies defaulting on obligations. Some deferred compensation plans are completely managed by employers or have large allocations of company stock in the plan. If people are not comfortable leaving deferred compensation in the hands of their employer, pre-retirement distributions allow them to protect their money by withdrawing it from the plan, paying tax on it, and investing it elsewhere.
Disadvantages of Deferred Compensation Plans
Just like any other type of investment, deferred compensation plans come with both benefits and drawbacks. Since we've laid out the advantages of investing in them, this section outlines some of the main disadvantages of taking part in them.
- Contribution Limits: As noted above, you may only be allowed to contribute a certain amount of money to your plan. This rule only applies to plans that are governed by the IRS, such as a 401(k) or 403(b) plan.
- Loss of Investment: You are at the mercy of your employer. if the company you work for files for bankruptcy or becomes insolvent, you risk losing some or all of your money. The money you invested can be claimed by the company's primary creditors before you see a dime. This is true, of course, unless it's held in a trust.
- No Rollovers: While you can roll over money from IRS-regulated deferred plans, you can't do so with non-qualified deferred plans. This means you can't extend the benefits and provide yourself with a tax shelter down the road.
- Loss of Earnings: Setting your money aside in any investment is a risk. While there is a good chance your money will grow, there's an equal chance that your investment will diminish when the market takes a dip.
- No Immediate Access to Funds: Certain deferred compensation plans may not provide you with access to the money you've invested right away. IRS-ruled plans like the 401(k) are only meant for retirement. So if you make a withdrawal before the required date, you will incur a penalty and taxes. Some non-qualified plans may come with a waiting period before you get your money. For instance, a profit-sharing plan may take up to two business days for a transaction to complete before you can access the funds. And they may not provide you access to the earnings until you've reached the vesting period.
How Do Deferred Compensation Plans Work?
Deferred compensation plans are perks provided by employers to their employees. They allow employees to elect a certain percentage or dollar amount of their compensation to be withheld for a certain purpose, such as retirement. Plans can be qualified, which means they fall under the purview of the IRS and are governed by the agency's rules. Others are non-qualified, which means the employer sets the rules. Plan types include 401(k), which is a qualified plan that comes with contribution limits and tax benefits, and profit-sharing plans. These plans are non-qualified and may provide the investor with easier access to the funds. The rules and regulations for the type of deferred compensation plan may vary, so it's important to check with your employer to see if it's right for you.
How Are Deferred Compensation Plans Taxed?
The taxation of deferred compensation plans depend on the type. Qualified compensation plans like the 401(k) are not immediately taxed. This means that you don't pay any taxes on the contributions you make. You are, however, taxed when you take the distributions during retirement. In addition to taxation at the rate, early withdrawals also incur penalties. Withdrawals from non-qualified plans typically also count as taxable earnings when the employer distributes them to the employee. Employees may also be responsible for paying capital gains taxes on any of the earnings in their accounts. Be sure to verify the tax implications of your plan with your employer before you invest.
What's the Difference Between a Qualified and a Non-Qualified Deferred Compensation Plan?
Qualified deferred compensation plans comply with ERISA. As such, they are regulated by the IRS. These accounts are commonly used for retirement, such as the 401(k) and 403(b) plans. The IRS sets contribution limits and updates them annually for inflation. It also outlines the rules about when you can withdraw the money, as well as the penalties and taxes you must pay if you want to access the funds before retirement.
Non-qualified plans are governed by the employer. As such, the company outlines the rules and regulations of these plans. These include profit-sharing and other similar options. The rules for these plans may not be as strict (especially when it comes to withdrawals) as qualified plans. Still, it's a good idea to check with your employer to ensure you make the right choice.
The Bottom Line
Some employers may offer more than just a salary to their employees as compensation. These extra perks can come in the form of healthcare, vacation pay, and even investment options like deferred compensation plans. Qualified deferred compensation plans may be used for retirement while non-qualified plans can be used for other purposes. Regardless of the type, these plans allow employees to set aside a portion of their take-home pay to use in the future. Be mindful, though, that the rules and regulations for these plans tend to vary so check with your employer about what happens with your contributions after they're invested.
When it comes to compensation, the more you make, the more you pay — in taxes, that is.
So if your employer provides you with the option of deferred compensation, it can be an intriguing way to put off that tax burden. However, weighing all the benefits and drawbacks can help you determine if using deferred compensation fits in well with your overall financial plan.
What is deferred compensation?
Broadly speaking, deferred compensation refers to any and all compensation plans that allow you to postpone a portion of your income to the future, reducing your current taxable income. This includes both qualified and nonqualified deferred compensation plans.
Qualified deferred compensation plans — 401(k)s, profit-sharing plans, incentive stock options, pensions — are protected by the Employee Retirement Income Security Act of 1974, which sets strict fiduciary standards for employee benefit plans. For instance, all employees must have plan access, there are restrictions on plan contribution amounts, and plan assets must be held in a separate trust account out of reach of creditors.
Here we focus solely on nonqualified deferred compensation plans, also called supplemental executive retirement plans or elective deferral plans, which are not required to follow ERISA guidelines. NQDC plans can offer further flexibility and options for the employee; however, this also means they carry additional risk.
These plans have been dubbed “golden handcuffs'' because they're often used as a retention tool for key talent or highly compensated employees. The significant reduction in taxable income is extremely attractive, or “golden.” Since plans may require that you stay with your employer to receive the deferred income, you’re “handcuffed” or heavily incentivized to remain with your company for the longer term.
One common type of deferred compensation is the 457 plan, which refers to employer-sponsored NQDC plans typically available to governmental employees (local and state) along with certain nongovernmental organizations, such as nonprofits.
How deferred compensation works
Those eligible to participate in a deferred compensation plan will generally need to adhere to certain procedures. To participate, there may be a defined enrollment period, and you’ll need to establish a written agreement with your employer designating details such as:
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Amount of income deferred: Having a good forecast of your expected earnings is important, as you’ll need to decide how much income to withhold for the coming year. Usually, employees can elect to defer a portion of their salary, bonus or other eligible cash payments. Your plan may allow you to roll your elections over from year-to-year, or it may require that you make new elections each year.
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Deferral period: You will also need to schedule when you’d like to receive your deferred income. You may be able to select a lump-sum distribution or installments spread across several years, starting in say five or 10 years’ time. You can weigh your options and strategically plan to have income distributed to meet expected financial goals, such as a child’s future tuition payments, or choose to wait until retirement.
» Other ways to save for college: Learn about 529 plans
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Investments: Deferred compensation is an agreement that your employer will distribute your deferred income to you, at a later date, along with any investment growth you would have earned. Note: Your deferred compensation is not placed directly into an investment, but you designate investment choices for bookkeeping purposes. Your employer uses your choices as a benchmark to calculate the appropriate investment returns owed during the deferral period.
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Benefits of deferred compensation
There are compelling reasons to consider NQDC plans, especially for highly compensated employees.
Tax advantages
When you defer receiving income, you also defer paying federal and state taxes on that income until it’s paid out to you. This can be especially appealing if you’re currently in a high tax bracket and expect to be in a lower tax bracket in the future. You can take advantage of reducing your present taxable income and scheduling your distributions to arrive in lower tax bracket years.
Not only do you benefit from deferring income taxes until later, but the money you’ve socked away in your deferred compensation plan grows tax-deferred as well. This means you’re not responsible for paying taxes on your investment growth until distribution.
Unlimited contributions
Since NQDC plans aren’t subject to ERISA standards, there’s no cap on your contribution amount. Traditional retirement plans and accounts can be insufficient for helping highly compensated employees adequately save for retirement. A supplemental NQDC plan can be an attractive way to generate additional retirement savings and income.
Goal targeting
With deferred compensation plans, employees can choose when to receive distributions. Your plan may allow you to schedule “in-service” withdrawals or distributions so you can access your deferred income prior to retirement to meet other financial goals or obligations. For example, at different points over the years, you may want to buy a new home or pay your child’s college expenses. You can schedule income distribution to meet those needs.
Flexibility
Compared with other retirement accounts such as 401(k)s or traditional IRAs, NQDC plans can offer more flexibility; there are no age restrictions on withdrawals and no required minimum distributions.
Caveats
There are significant reasons to be cautious when deciding whether to move forward with an NQDC plan.
Loss potential
Since assets are not held in a separate trust and are commingled with company funds, you could suffer a complete loss if your company encounters financial hardship. And leaving your employer could mean forfeiture of your deferred income. Making sure to read through the fine print of your company’s NQDC plan can help you understand the risks and stipulations related to your future payout.
Because receiving the income you deferred isn't guaranteed, it’s critical to consider the financial health of your employer when deciding whether to participate in your NQDC plan. Advisors often suggest maxing out all other qualified plans before contributing to the NQDC plan (since qualified plans have ERISA protections) and considering short-term deferral periods if you have concerns about your company’s future outlook.
Withdrawal restrictions
After selecting your distribution date, it can be difficult to make any changes, so tread carefully when timing your deferral period. Many employees with access to NQDC plans may have additional forms of equity compensation with a timing element, such as restricted stock units or stock options. Taking a holistic approach can help you plan out your income stream and minimize your potential tax burden.
In addition, there are some limitations to NQDC plans compared with qualified retirement plans such as 401(k)s. Employees cannot take loans from their deferred compensation plan. And upon receiving plan distributions, funds cannot be rolled into an IRA or other tax-deferred retirement vehicle.
Investment restrictions
The range of investment options that you can designate for bookkeeping purposes varies from employer to employer. Some plans may offer as many investment choices as in your company’s 401(k) investment menu. Other plans may be more restrictive, offering only limited or expensive investment choices, or potentially only company shares. It could add risk to your overall investment portfolio if you’re overly exposed to your company’s stock or unable to sufficiently diversify your portfolio.
Tax changes
Some employees intend to change residency to a lower-tax state upon retirement and consider deferring compensation until they’ve done so. However, certain states base deferred compensation taxes on your elected payout period; for payout periods less than 10 years, you may be required to pay taxes to the state in which the compensation was earned.
And, the tax code changes all the time. When planning far ahead, it’s hard to know what to expect.
With deferred compensation plans, the devil is in the details. Though there are many benefits to participating, NQDC plans bear some important risks. Consulting with a trusted financial advisor to plan out your current and future financial situation can help you decide whether to take advantage of your deferred compensation plan.
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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.
If you’d like professional help finding the smartest way to build your nest egg, SmartAsset’s free matching tool can help you find a financial advisor.
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.
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:
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There are contribution limits each year for a 401(k) but not for the deferred compensation plan unless there are plan limits.
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You must start taking distributions by the age of 72 if you have a 401(k). It is not necessary under deferred compensation.
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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.
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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:
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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.
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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.
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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.
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The owner of a 401(k) can take out a loan from the account. Executive deferred compensation plans do not allow for loans.
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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:
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Do you routinely contribute the full amount to traditional retirement accounts? If the answer is yes, you may want to consider it.
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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.
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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.
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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.
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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
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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.
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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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The post Executive Deferred Compensation Plans appeared first on SmartAsset Blog.
Deferred compensation is a way for employees to reduce their tax burden while ensuring their economic security in their golden years. Deferred compensation plans with a long vesting period are commonly referred to as golden handcuffs because they effectively trap you in a job, no matter how badly you’d like to resign. Here’s what you need to know to determine if your golden handcuffs are worth staying at your job and how much quitting will cost your future self. If you’re looking for guidance in your current financial situation, consider working with a professional financial advisor.
Qualified vs. Non-Qualified Deferred Compensation Plans
In a nutshell, deferred compensation plans are a way to be compensated for your work without receiving money immediately. By delaying your compensation, you’re simultaneously able to save for retirement and reduce your tax burden for the current year by lowering your taxable income.
Deferred compensation plans are either qualified or non-qualified plans. Which one you have will affect how your plan’s funds are treated if you quit.
Qualified Plans
Qualified plans are ones that meet the requirements outlined in the Employee Retirement Income Security Act (ERISA) of 1974. Common qualified plans include 401(k)s, 403(b)s, Keogh plans and SEP IRAs. Qualified plans are more tightly regulated and have stricter rules around contribution limits and withdrawals.
Qualified plans include several characteristics that separate them from non-qualified ones including:
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Allowing all employees who meet eligibility requirements to participate, this type of plan isn’t just limited to executives.
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Vesting after a specified date, meaning that if your account is vested, your balance is yours even if you leave the company on bad terms.
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Standardized compensation is proportionate across all employees, meaning that entry-level employees are entitled to the same percentage rate of compensation as C-suite executives.
Non-Qualified Plans
By contrast, Non-Qualified Deferred Compensation (NQDC) plans are ones that don’t meet the requirements outlined in the ERISA and have no contribution limits and more flexible withdrawal rules. NQDC plans are available only for key employees as defined by the Department of Labor. Key employees are typically executive-level employees or ones with unique and vital roles.
These plans don’t offer the same tax deductions as qualified plans, but the lack of contribution limits allows employees to reduce their taxable income substantially. Assets in non-qualified plans belong to the employer, not the employee and can be seized by the employer’s creditors. If you have an NQDC plan, the terms of your plan could mean that you forfeit all or part of your deferred compensation if you leave the company early.
What You Need to Know About Vesting
Both qualified and non-qualified deferred compensation plans can have vesting periods. Qualified plans are required to have vesting periods. Non-qualified plans are not, but occasionally do.
Vesting periods can be anywhere from immediately after your first contribution to several years long. For qualified plans, typically, the entire amount subject to vesting is vested once it reaches the time requirement. For example, if a qualified plan has a vesting period of one year, then once the participant has reached one year with the company, their entire account balance is vested.
If an NQDC plan has a vesting period, it may only be for a portion of the amount in the plan, rather than the whole balance. NQDC rules are highly specific, so review your plan’s materials carefully.
How To Find Out If You’re Vested
Contacting your human resources office and saying, “I’m thinking about quitting, can you tell me if my deferred compensation plan is vested?” would work, but isn’t advisable. There are several ways you can find out if your deferred compensation is vested without tipping off your job to your unhappiness with your role.
The best place to start is by looking through your plan’s materials. Your account balance summary or quarterly statement will typically have detailed information on what portion of your balance is vested and what portion will be vested by a specified date.
If you have a non-qualified plan, you’ll most likely have to refer to the employment contract you signed when you started the role that gave you the NQDC plan. All NQDC plans must conform to the requirements of secti409(a) of thn Internal Revenue Code and provide documentation to employees. Somewhere there should be an explicit statement saying what you’re eligible for and when.
If you’re still not able to determine what, if any, of your deferred compensation is vested, your situation may call for some subterfuge. Updating your life insurance policies, trust or estate plan are all great reasons to get clarification from HR and don’t make it seem as though you’re considering leaving the company.
Quitting and Forfeiting Money vs. Staying
If there’s anything that we’ve learned in the turmoil of the last few years, it’s that life is precious. If you’re in an unfortunate situation where quitting your job means giving up a large amount of compensation, you have some tough decisions to make.
Sit down with a Certified Financial Planner (CFP) to determine how big of an impact on your future spending giving up your deferred compensation will have. It’s possible that you’re at a point in your career where doing so would prevent you from doing something vital, like paying for your parent’s assisted living facility. If it’s something more frivolous, like having to downgrade from a Lamborghini to a Porsche, it may be worth quitting your job.
Only you know how much you dislike your current role, but an advisor can help you see how large or small of an impact quitting will have on your long-term financial well-being. You may find that quitting now to preserve your mental well-being and regain time with your loved ones is worth the reduced income later on.
The Bottom Line
If you have a qualified plan and have passed the vesting period, your deferred compensation is yours, even if you quit with no notice on very bad terms. If you have a non-qualified plan, you may have to forfeit all of your deferred compensation by quitting depending on your plan’s specific terms. Review your plan documents and your employment contract with a financial professional to help determine if staying or quitting is the best choice for your current and future self.
Tips for Wealth Building
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If you’re looking for ways to maximize the growth of your money, consider working with a financial advisor. An advisor can help you create an investment plan or even manage your wealth for you. If you don’t have an advisor, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve 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 who can help you achieve your financial goals, get started now.
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If you’re not sure how much to invest because you’re curious about the potential return, consider using SmartAsset’s free investment calculator.
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The post What Happens to Deferred Compensation If I Quit? appeared first on SmartAsset Blog.
