Even though deferred compensation plans are not as popular as 401(k) plans, many employees in some large companies or some selective employees in other companies (can be a large or small company) are still being offered to participate. Let’s do some detailed comparison between deferred compensation plans and 401(k) retirement accounts,
Deferred Compensation Plans
A deferred compensation plan, also known as a nonqualified deferred compensation plan (NQDC), is an agreement between an employer and an employee that allows for the deferral of a portion of the employee’s income until a future date, typically retirement. Here are important aspects to consider when evaluating deferred compensation plans:
- Eligibility and Availability: Deferred compensation plans are generally offered to select highly compensated employees, executives, or key personnel within an organization. They are typically not available to all employees, unlike 401(k) plans, which often have broader eligibility criteria.
- Contribution Limits: Deferred compensation plans have more flexible contribution limits compared to 401(k) plans. While 401(k) plans have specific annual contribution limits set by the IRS (e.g., $19,500 in 2021, with catch-up contributions available for individuals aged 50 or older), deferred compensation plans allow participants to defer a larger portion of their income, subject to certain restrictions and company policies.
- Timing of Contributions and Distributions: In deferred compensation plans, contributions are made before taxes are withheld, thereby reducing the participant’s current taxable income. However, participants pay taxes on the deferred amounts and any earnings upon distribution, typically during retirement or at a specified future date. 401(k) plans, on the other hand, allow participants to contribute on a pre-tax basis, reducing their current taxable income, and distributions are taxed when withdrawn during retirement.
- Investment Options: Deferred compensation plans usually provide a range of investment options, similar to 401(k) plans. Participants can choose from various investment vehicles such as stocks, bonds, mutual funds, or other options, depending on the offerings provided by their employer.
401(k) Retirement Accounts
A 401(k) retirement account is an employer-sponsored retirement savings plan that allows employees to contribute a portion of their salary on a pre-tax basis. Here’s how 401(k) plans compare to deferred compensation plans:
- Eligibility and Availability: 401(k) plans are often more inclusive and available to a broader range of employees. Many employers offer 401(k) plans as part of their benefits package, allowing most employees to participate, regardless of their compensation level or job title.
- Contribution Limits: As mentioned earlier, 401(k) plans have annual contribution limits set by the IRS. These limits determine the maximum amount participants can contribute each year. However, 401(k) plans also offer catch-up contributions for individuals aged 50 or older, allowing them to contribute additional funds beyond the regular limits.
- Timing of Contributions and Distributions: 401(k) plans allow participants to contribute a portion of their salary on a pre-tax basis, reducing their taxable income in the year of contribution. The contributions and any earnings within the account grow tax-deferred until withdrawals are made during retirement. Withdrawals from a 401(k) account are generally subject to income tax.
- Employer Match: One significant advantage of 401(k) plans is the potential for employer matching contributions. Employers may choose to match a portion of the employee’s contributions, effectively providing additional funds to boost retirement savings. This employer match can significantly enhance the overall growth of a 401(k) account
Deferred Compensation Plans Are Liabilities From Employers
One key difference between a deferred compensation plan and a 401(k) retirement account is the nature of the plan and the associated risks in the event of an employer’s bankruptcy. In a deferred compensation plan, the deferred amounts are essentially a liability from the employer to the participant, whereas a 401(k) account is an individual account owned by the employee. This fundamental distinction can have implications for the safety of the funds in case of an employer’s financial instability.
In the unfortunate event that a company goes bankrupt, employees’ deferred compensation can be at risk. Since deferred compensation plans are considered obligations or promises from the employer to pay future benefits, they are subject to the claims of creditors during bankruptcy proceedings. If the employer cannot fulfill these obligations, employees may face potential losses on their deferred compensation.
On the other hand, 401(k) retirement accounts are generally held in individual accounts, separate from the employer’s financial position. In the event of an employer’s bankruptcy, the funds in a 401(k) account are typically protected and are not considered company assets available to creditors. This separation helps safeguard employees’ retirement savings, offering a layer of protection against the employer’s financial difficulties.
It is important to note that even though 401(k) accounts are generally protected in case of employer bankruptcy, investments within the account can still be subject to market fluctuations and other investment risks. However, the structure of the 401(k) plan itself provides a level of legal protection for the account balance.
Given these distinctions, individuals considering deferred compensation plans should carefully assess the financial health and stability of their employer. Understanding the employer’s financial standing and the potential risks associated with deferred compensation plans is crucial for making informed decisions about retirement savings.
As always, it is advisable to consult with a financial advisor or legal professional to understand the specific implications and risks related to your employer’s deferred compensation plan and to develop a comprehensive retirement savings strategy that aligns with your goals and risk tolerance.