There are a lot of questions concerning deferred compensation and how it works. It is important to understand this concept due to the fact that it can play a big part in your financial future. Deferred compensation is a method by which an individual is payed a sum of monetary compensation at a later date than would normally be applied. This includes programs such as pensions, stock options, and retirement plans just to name a few.
One of the big advantages is the deferral of the tax date for when the employee receives the compensation. In many cases this is justified under the non-qualified deferred compensation” part of the IRS Code Section 409a tax law. This law provides special benefit to highly paid corporate employees and executives. To fully understand how this works it is important to understand the difference between qualifying and non-qualifying deferrals.
A qualifying deferred compensation program is one that falls within the compliance of the Employee Retirement Income Security Act of 1974. This includes well known programs such as the 401k retirement plan as well as other lesser known versions such as the 403b for public education employees, the 501c for ministers and other non-profit employees, and the 457b for state and local government organizations. These programs are set up in such a way that it encourages employees to save, especially if they are lower or middle class. As upper-class citizens tend to have high amounts of saving anyway these plans aren’t really geared towards them. Non-qualifying programs are instead more along the lines of what they would be dealing with.
The programs that fall into this category are, as previously stated, more for top payed executives and corporate employees. In these cases they agree to have part of their compensation withheld by the company for a specific amount of time. Sometimes it is even invested by the company on their behalf. Unlike qualifying plans this system allows employers to choose which employees receive these benefits instead of having to provide the same plan to every employee. Also this sort of program can be extended to contractors and freelancers in addition to payroll employees.
There are a few drawbacks though. The employer can not claim their contribution to the program as being tax deductible. Also employees must pay taxes on the compensation at the time it is eligible to be received, not when it is withdrawn.
Taxes play a big part when it comes to deferred compensation. There are many different rules and regulations to be followed. For example, with a 401k the employer can tax deduct their contribution when it is created but the employees are not taxed on it until it is withdrawn. The point here is that before taking part in a deferred compensation plan a person needs to familiarize themselves with the various tax laws surrounding it. This will ensure that all laws are followed and that no tax penalties are levied against the individual participating in the program.