A general rule of thumb about managing tax liability is to delay income and accelerate expenses. As much as possible, that is. One way to delay income and taxes is to maximize all of your available deductible retirement savings. After socking away as much as possible in your retirement plans, there could be another way to push taxable income into the future – a deferred compensation plan.
Compensation that employees or independent contractors earn in one year, but that is paid in a future year, is referred to as “nonqualified deferred compensation”. This arrangement has different eligibility rules than deferred compensation in the form of contributions into qualified plans, such as a 401(k) or a 403(b).
A nonqualified deferred compensation plan is a formal written agreement between an employer and an employee or independent contractor. The type of plan is often offered to company officers or other high earners at larger organizations — typically, those making at least $115,000, but often much more. Plan participants can stash away more money than allowed under a qualified retirement plan. Employers may pay interest on the deferred funds, or allow participating employees and contractors to choose from other options.
One benefit of a nonqualified deferred compensation plan vs. a qualified retirement plan is flexibility. Deferred income distributions are not subject to penalty if made before age 59½. Employees and contractors can tailor the timing of payouts from a deferred compensation plan to provide income in the early retirement years, letting their qualified retirement savings and investments grow for later.
One big risk is depending on an employer to remain financial strong enough to pay on its promise. By deferring money, employees and contractors are essentially accepting a promissory note that is not protected if the organization runs into financial difficulty. While funds in a qualified retirement plan are protected in times of trouble, money deferred in a nonqualified plan is not. In case of bankruptcy, individuals with deferrals become unsecured creditors of the organization, and must line up behind secured creditors in the hopes of getting paid.
Looking for more options to delay income and taxes? Check with your employer to see if deferred compensation is an option. Get all the details and see if it fits into your plans.