An executive deferred compensation plan is a retirement savings plan used by high-level employees, such as CEOs and other executives, to save for their retirement years. This may be the plan for individuals nearing their annual 401(k) contribution limits.
In addition to providing financial security in retirement, executive deferred compensation plans also provide tax advantages that are not available to most other retirement plans. Understanding an executive deferred compensation plan and how it works can help investors maximize their retirement savings.
How an Executive Deferred Compensation Plan Works
An executive deferred compensation plan is an agreement between an employee and an employer wherein the employee agrees to postpone receiving all or part of his or her salary. Put simply, this type of compensation plan allows the employee to defer some or all of their salary into the plan until a future date. The money is then invested in various investments, including stocks, bonds, mutual funds, and cash equivalents. When the employee retires or leaves the company, they can withdraw the money from the plan and use it for whatever purpose.
What are the Tax Advantages?
One of the major advantages of an executive deferred compensation plan is that it offers tax-deferred benefits and allows executives to avoid paying taxes on some or all of their salary until a later date. This means that instead of paying taxes on income right away, executives can defer taxes and invest more money now to receive larger returns in the future. It should also be noted that any dividends or interest earned on investments within the plan will not be taxed until the account is withdrawn.
Should an executive choose to withdraw before 59 1/2 years old, they may face penalties and additional taxes due upon filing a return with the IRS. Nonetheless, this plan can help build up a larger nest egg while still enjoying tax deductions today. Moreover, since 401(k) contributions are made with pre-tax dollars, they don’t count toward income when calculating your annual taxes, which can benefit those looking to minimize their tax burden in the current year.
These plans can help employers attract top talent by providing additional financial security after retirement. Additionally, these plans help employers retain top talent since employees are more likely to stay in their positions if they know they will have additional benefits after retirement. Lastly, offering these plans can help save money since employee contributions do not count toward Social Security or other payroll taxes the employer must pay.
Are there Different Types of Executive Deferred Compensation Plans?
The simple answer is yes. These plans can be complex and confusing, so investors and professionals must understand the different types of executive deferred compensation plans. Let’s dive in and take a look.
Nonqualified Deferred Compensation Plans (NQDC)
The most common executive deferred compensation plan type is the nonqualified deferred compensation plan (NQDC). This type of plan allows an executive to set aside money from current income and defer taxes until the money is withdrawn at some point in the future. The obvious advantage of this type of plan is that the executive can save money now and enjoy tax savings later. However, these plans do not provide specific protections if an employer goes bankrupt or fails to meet its obligations.
Qualified Deferred Compensation Plans (QDC)
Qualified deferred compensation plans (QDC) are similar to NQDC plans. The difference is that they offer greater protection from creditors if an employer goes bankrupt or fails to meet its obligations. These types of plans are typically offered by larger companies with deep pockets and high-level executives who want additional assurance their money will remain secure even if their employer goes under.
Rabbi trusts offer additional security for executives who want to set aside money for retirement or other long-term goals. Unlike NQDC or QDC plans, rabbi trusts are specifically designed to protect assets from creditors if an employer fails financially. Rabbi trusts also offer more flexibility than traditional NQDC or QDC plans because they allow executives to customize their investments according to their needs and risk tolerance levels.
Recap of the Pros & Cons
Let’s briefly summarize the various advantages of this type of compensation plan.
The pros include tax benefits, investment growth, and customization.
By deferring compensation, executives can reduce their taxable income and plan for a potentially lower tax bracket upon receiving the funds during retirement. Because the invested funds are deferred, they can grow tax-deferred until distribution. This provides an opportunity to accumulate wealth over an extended period.
Finally, these plans can be personalized to suit an individual’s needs, preferences, or unique requirements. This means executives can choose their preferred distribution schedule, investment options, and vesting schedules, fostering a sense of control over their financial future.
Meanwhile, the cons also require a level of caution. Individuals considering this type of plan should know these plans have limited security, access, and tax risks.
One of the primary drawbacks of these plans is the risk that an employer’s financial health poses. Funds in a deferred compensation plan are considered company assets, leaving them vulnerable to creditors if the company faces financial hardship such as bankruptcy or insolvency.
And, unlike a traditional retirement account, deferred compensation plans do not permit loans, hardship withdrawals, or multiple distribution options. This can make the funds inaccessible until the predetermined date.
Finally, while the tax benefits are undeniable, there is a potential risk of tax rates increasing over time. Executives may face higher tax rates upon distribution than anticipated, diminishing the plan’s appeal as a tax-saving tool.
Key Takeaways to Consider
Before deciding to implement an executive deferred compensation plan, it’s crucial to consider factors such as:
– Is the employing company financially secure?
– What are the executive’s current and future tax liabilities?
– What is the potential growth of investments within the plan?
– What degree of flexibility and customization does the plan offer?
An executive deferred compensation plan can be a great way for high-level employees such as CEOs and other executives to save for retirement while taking advantage of tax benefits and avoiding immediate taxation on income earned today. Understanding how these plans work and being aware of any potential risks associated with investing before withdrawing funds will allow investors to make informed decisions about whether using this type of retirement savings vehicle is right for them. Ultimately, this type of plan can be beneficial if used correctly but should always be cautiously approached due to the potential risks involved.
Whether you’re an employer or an executive interested in learning more about deferred compensation plans, consider joining Planning Made Simple today. As a member, you’ll be able to work with a Planning Made Simple Coach who will work to understand your retirement plan, ensure you’re on the right track, and help answer your questions; like is an executive deferred compensation plan right for me? You’ll also have unlimited access to financial education courses and additional resources like our retirement planning materials, including How Much Should I Have in My 401 or How to Start Saving for Retirement.