If your employer holds part of your paycheck until a specific date, that would be deferred compensation. Often, your employer withholds these funds until you retire. A company may offer a deferred compensation plan or retirement plans, such as 401(k)s. Management might also have these plans and receive them in the form of life insurance, annuities, or stock options. Of course, having part of your paycheck withheld might not sound appealing, but some benefits could help you out. Keep reading to learn more about these benefits and what they mean for you.
Understanding Non-qualified Vs. Qualified Plans
You will want to know the difference between qualified and non-qualified plans. A non-qualified compensation plan is an agreement between you and the employer to agree to withhold part of your compensation. They can then invest it and give it to you in the future. These plans have no limits on what you can contribute. The company might offer them only to specific employees, like those higher up in the organization.
The company offering the plan can keep the funds as part of the business’s money. That means if the organization goes bankrupt, that portion of the employee’s compensation is at risk.
On the other hand, a qualified deferred compensation plan might offer 403(b) and 401(k) plans. Plus, it complies with the Employee Retirement Income Security Act. They need to have contribution limits, and any company employee needs to be able to contribute to them. Since they are in a trust account, they tend to be more secure. But no matter the type of deferred compensation plan, the advantages include the ability to save money, tax savings, and distributions before you retire.
Increasing Your Savings
If you have deferred compensation, you might choose to have it in your savings account. That is ideal if you have a retirement or pension plan, and you can then help kids with college funds or other expenses. The money is also helpful for financial burdens such as paying off a mortgage. Or you could use it to offer your kids a larger inheritance once you pass away.
Getting Distribution Before Retirement
With some deferred compensation plans, you can schedule distributions at a specific time. That is an in-service withdrawal. Since you have some more flexibility, you might find it appealing for certain financial needs. So, you might choose to use it for saving for a home, college education, or another expensive thing.
You can take money out of the fund early from these plans for some life events, such as homeownership. Withdrawing from the plan might not result in withdrawal penalties, depending on the IRS or the plan’s rules. It depends on the type of plan you have. Still, you can expect to have to pay income taxes on anything you take out.
Providing Income for Retirement
If a company withholds part of your pay, you will get it back once you retire, providing you income in your golden years. You might use the deferred compensation to build up some funds for your later years.
One of the simplest types of income that goes along with deferred compensation is an annuity or 401(k) and other investment products. So, you are not just getting back the income that was withheld from you. You are also getting some more since that money can grow over time. That is one of the reasons it is so essential to begin investing as early as you can. Once you retire, you can cash in your life insurance policy attached to deferred compensation. That gives you some funds you can save, spend, invest, or do something else with. If you have stocks, you can use them all at once, receiving a lump sum. Or you might choose to trade them slowly to get a steady flow of income.
Potential for Earnings
A deferred compensation plan in the form of investment accounts or stocks can increase its returns over time. Instead of just getting the initial deferred amount, a stock option or investment account might increase its value before you retire. That can increase the value even more. Of course, the drawback is that it can also drop in value in the same way that it can grow.
Many times, the contributions you make to your deferred compensation plan will not be taxed. Your dividends and interest are also less likely to get taxed as well. The amount that you withdraw is the only taxable amount. Once you withdraw the money from a deferred compensation plan, you will be taxed at your income tax rate. But often, you will make your withdrawal once you have retired. Since retirees often have a lower income, their tax bracket is lower.
The advantage is that you can decrease your taxable income as you work because the money you earn is taxed at a much lower rate. Distributions from your compensation plan can get rolled into an IRA to offer even more protection against taxes. Your employer will also get tax advantages by offering these plans since they can get tax deductions for each contribution.
You can see the tax advantages of using a deferred compensation plan if you get a professional financial plan created for you. You can also use sophisticated financial planning software such as WealthTrace or MoneyGuidePro to create your own financial plan and see the results in various planning what-if scenarios.
When it comes to deferred compensation, you will want to do your research to determine if it is the right option for you. But if you believe it is, you can save a bit of money in the process. By investing the funds for retirement, you can ensure that you will be well-cared for financially during your golden years.