Many senior executives are looking for ways to enhance retirement benefits while cutting levels of taxable income. Deferred compensation accounts allow an immediate reduction in current income taxes, an accumulation of investment earnings on a tax-deferred basis, and are an important component of a well-rounded retirement plan. The “401(k)” may be the most well-known type of deferred compensation retirement plan, however there are additional types of viable deferred compensation plans as well. If you have not yet explored the various types of deferred compensation, consider the following positive aspects of these plans:
- Your reported earnings for retirement purposes are not affected by your deferred compensation contributions;
- Any contributions to your chosen deferred compensation plan(s) are taken from your gross pay, prior to calculating federal withholding taxes, and
- You choose the investment program and provider for your retirement contributions.
Six Important Facts About Deferred Compensation Retirement Plans
While it would seem there is little not to love about deferred compensation plans, it is important to know and understand the following:
- You are never required to participate in a deferred compensation plan—it is wholly voluntary;
- IRS rules and regulations govern deferred compensation funds;
- The IRS strictly regulates any pre-retirement withdrawals;
- You may discontinue your deferred compensation fund contributions at any time;
- April 1st of the calendar year following the year you reach the age of 70 ½ or the year you retire, if that year is later than 70 ½, are the benchmarks for when you must begin receiving payments from your deferred compensation fund, and
- You can get your money out with no penalty at 1) retirement age, 2) when you leave your employment (only if funds are rolled into an IRS-approved account to avoid penalties) or 3) when you experience an “unforeseeable emergency” as defined under IRS regulations (with a penalty).
What is a 457(b) Plan?
State employees, local government employees, and, in some cases, independent contractors who perform services for an eligible governmental employer, are allowed to participate in a 457(b) plan. Unlike other deferred compensation plans, an employer may establish a mandatory 457 plan (referred to as Social Security replacement plans), when the plan is used as an alternative to Social Security. Most 457 Social Security replacement plans require employers and employees to pay Medicare taxes on employee wages.
Playing “Catch Up” With Your Deferred Compensation Plan(s)
Suppose you are close to retirement age, and feel as though you have not invested enough for a comfortable retirement. If you happen to be age 50 or older, and are actively employed, the 457(b), 401(k) and IRA deferred retirement plans offer provisions to help you add to your retirement account over and above your normal allowed annual limit.
The other is a special retirement catch-up, allowed only under the 457(b) deferred compensation plan. This catch-up plan allows you to make a one-time choice to add money to your plan if you are within three years of your plan’s “Normal Retirement Age.” Your Normal Retirement Age is specified in your 457(b) plan. Typically, you must be at least 65 (but not older than 70 and a half), or your plan must specify that you can receive your full retirement benefits with no reductions for service or for your age.
What is the Maximum Amount You Can Contribute to Deferred Compensation Plans?
For 2017, the following limits apply to the four most common types of deferred compensation plans:
- For a 457(b) deferred compensation plan, your annual limit in 2017 is $18,000. The “age 50” catch-up limit is $6,000, and the “pre-retirement” catch-up limit is $18,000.
- For a 401(a) deferred compensation plan, your annual limit in 2017 is $54,000, with no catch-up allowed.
- For a 401(k) deferred compensation plan, your annual limit in 2017 is $18,000, with an “age 50” catch up limit of $6,000, and no “pre-retirement” catch-up allowed.
- Your IRA deferred compensation plan has an annual limit in 2017 of $5,500, an “age 50” catch-up limit of $1,000 and no “pre-retirement” catch-up allowed.
Solving the Limitations of Deferred Compensation Plans Via a Retention Bonus?
Some employers are actively looking for ways to help their key employees increase their level of supplemental benefits. One way of accomplishing this is to provide the executive with a retention bonus at the end of a term of service, with a portion of this bonus vesting with each year of service, but not payable until the end of the term (retirement). Many of these retention bonus plans (162 plans) use employer bonus payments to purchase life insurance, which can offer the employee access to the cash value of the policy, if needed during retirement, or for typical death benefit protection. These plans generally have little to no IRS interference or oversight and are attractive to both employees and employers, as the plans allow employers to take corresponding deductions.
One caveat to deferred compensation plans: other than a 401(k) plan—which is safe from company creditors—if an employer goes bankrupt, and the company was not legally required to set the money aside in a separate account, the employee’s retirement funds could be vulnerable. It could be beneficial to discuss questions and concerns regarding deferred compensation plans with an experienced, high-level New York employment attorney.