Our Blog | The Industry Insider

Benefits of Deferred Compensation Plans | Advisor's Resource Company

Written by The Advisor's Resource Team | Apr 7, 2020 9:26:59 PM

When it comes to retirement, it's never too early to start saving. Not only that, but individuals want to diversify their accounts so that they're not keeping all of the funds in one specific place. With the recent market disruption due to the coronavirus, having all of your retirement savings subject to the equity markets can be disastrous if these disruptions occur close to your retirement date. One of the ways that your clients can start saving for retirement is with a deferred compensation plan. In this article, we'll go over what these are, how they can work, and the benefits of using them. 

What is a Deferred Compensation Plan?

As the name suggests, participants are delaying compensation to a later date. These plans exist with employers, and they are almost always designed as a means of saving for retirement. Examples of deferred compensation plans can include, stock options, S.E.R.P (supplemental Executive Retirement Plan), and 401K overlay plan.  Some of these plans are fully funded by the employer as a benefit to the executive, whereas others, the executive is reducing their own salary.  Basically, any system where your clients are putting money away now to withdraw down the line is an example of deferred compensation. 

Qualified vs. Non-Qualified Plans

When talking about retirement planning you should consider both qualified and non-qualified plans. A qualified plan adheres to the Employee Retirement Income Security Act (ERISA), which means that it is open to everyone within the company and have has contribution limits. Examples of qualified plans include: Simple, SEP, Defined Benefit plan, 401k and 403b. 

A non-qualified system is an agreement between the employer and employee directly. In this case, the terms of the plan are written down and agreed to by both parties. The advantage of a non-qualified system is that there are no contribution limits and the term can be relatively short.

Each approach has its disadvantages.  For example, qualified plans incur penalties if the employer accesses funds before turning 59 1/2.  For non-qualified plans, the company can dictate terms favorable to itself, and may use the deferred funds however it likes. If the business goes bankrupt, the money is lost as well. 

Benefits of Deferred Compensation

When talking with your clients about the various options available, you want them to understand the benefits that come along. Here are the primary advantages of deferring one's compensation. 

Tax Savings

As a general rule, any money being put into a deferred compensation plan will not count in the  individual's total earnings for the year. So, if your client made $200,000 and defers $50,000, the IRS will only count the $150,000 as income. For high earners, these savings can be quite substantial, particularly for those that just earned a bonus or a raise and might get bumped into a higher tax bracket. This tax benefit can be a motivator for some of your clients.

While your clients get to deduct these contributions immediately, they will have to pay taxes eventually. However, the benefit of waiting until retirement is that their income level will likely be much lower. Since they're not working anymore, they can withdraw funds from the plan and pay fewer taxes overall. 

Flexibility

Another primary advantage of deferred compensation plans is there are no limits as to the amount you can defer.  As mentioned above, by deferring income, you can manage your effective tax rates based on current tax laws.  And if you are the business owner, you have the flexibility to decide who receives the benefit plan you provide. 

Access to Funds

Unlike qualified plans, there are not restrictions on when you take out funds (no penalties for accessing funds prior to age 59 1/2).  In addition, you are not forced to take money out of the plans at age 72 (no required minimum distributions).   

Bottom Line: Recommend Deferred Compensation Plans 

While there are more risks with a non-qualified, employer-sponsored plan, the advantages offered are too good to pass up. Your high-earning clients can get substantial benefits from these policies, which is why they are so valuable. Contact us today to learn how to leverage a deferred compensation strategy.