Understanding Deferred Compensation Tax and Its Benefits

Deferred compensation tax can be a complex topic, but understanding the basics can help you make informed decisions about your finances.

Deferred compensation tax is a type of tax on income earned but not received until a later date.

This type of tax is often associated with executive compensation packages, where executives receive a portion of their salary in the form of a deferred compensation plan.

Deferred compensation plans can provide tax benefits, such as reducing taxable income in the year the compensation is earned.

According to the IRS, deferred compensation is considered taxable income when it is received, not when it is earned.

The Deferred Compensation Program (DCP) is a special type of savings program that helps you invest for the retirement lifestyle you want to achieve.

DCP is an IRC Section 457 plan, which means it's administered by the Washington State Department of Retirement Systems (DRS).

This program is similar to a 403b program, offering a way to save for retirement beyond what your pension and Social Security can provide.

DCP adheres to administrative codes or rules adopted by Washington agencies, specifically the Washington Administrative Code (WAC).

You can change your contributions to a DCP account at any time, including starting, stopping, increasing, or decreasing the amounts deducted from your paycheck. This flexibility allows you to adjust your contributions as your financial situation changes.

You can contribute to your DCP account in dollar or percentage amounts, giving you the freedom to choose the method that works best for you. One in 20 DCP customers reach the annual maximum limit each year, with the average annual contribution limit being $23,500 for those under 50.

To change your contribution amount, log in to your account and select Change Monthly Contribution from the DCP account page. Your changes can take up to 30 days to go into effect, depending on your employer's payroll cycle.

You can change your contributions to a DCP account at any time, including starting, stopping, increasing, or decreasing the amounts you contribute from your paycheck.

Contributions can be made in dollar or percentage amounts, giving you flexibility in how you save.

The choice between dollar and percentage contributions is yours, and you can choose the method that works best for your financial situation.

To change your contribution amount, log in to your account and select Change Monthly Contribution from the DCP account page.

Your changes can take up to 30 days to go into effect, depending on your employer's payroll cycle.

You can contribute to your DCP account in both Roth and pretax amounts, and the combined totals must fall within IRS annual limits for the DCP 457(b) program.

One in 20 DCP customers reach the annual maximum limit each year, which is $23,500 for those under 50.

You can choose to contribute to your DCP account in a percentage of your salary, with the minimum monthly contribution limit being $30 or 1% of your earnings.

Annual maximum limits apply to all contributions, and you can choose to contribute to your DCP account in Roth, pretax, or both.

Deferring cash-outs of unused annual or sick leave into your DCP account can maximize your contributions, but your employer must participate in DCP for you to be eligible.

Non-qualified compensation plans are often offered to upper management as a way to supplement their regular salary. These plans may include deferred income, such as supplemental executive retirement plans.

One example of a non-qualified compensation plan is a split-dollar arrangement. This type of plan allows employees to receive a portion of their salary in a later year, reducing their taxes in the current year.

Split-dollar arrangements are typically offered to high-level employees as a benefit in addition to traditional qualified deferred compensation plans, such as 401(k)s.

Some non-qualified plans may include stock options, which can be a great benefit for employees, but also come with risks. If the company goes under, the employee may lose the entire amount they've set aside.

Here are some examples of non-qualified plans:

You can roll over certain distributions into your deferred compensation plan (DCP) from a former employer's retirement plan or a non-Roth IRA, but first, you need to enroll in DCP and complete the rollover-in form. You can complete a rollover into DCP at any point once you're enrolled in the program.

Direct deposit is another option for receiving payments from your DCP, Plan 3, or JRA investment account, and you can request or modify direct deposit through your account. You can also request to have federal income tax withheld from each withdrawal or annuity payment you receive using IRS Form W-4P.

Withdrawals from your DCP before reaching the specified triggering event may result in penalties, including taxes and penalties, so it's essential to understand the rules and restrictions. For example, you can't take loans from your deferred compensation plan, and upon receiving plan distributions, funds cannot be rolled into an IRA or other tax-deferred retirement vehicle.

You can roll over certain distributions into DCP from a former employer’s retirement plan or a non-Roth IRA. To do this, you'll need to enroll in DCP first, then complete a rollover-in form before sending over the funds.

You can complete a rollover into DCP at any point once you're enrolled in the program. This is convenient if you're not ready to start taking withdrawals right away.

Contact your IRA custodian or former employer to determine how rollovers are handled, as this can vary. They'll be able to guide you through the process and answer any specific questions you may have.

You can roll over your awarded beneficiary account into your own DCP account, which can be a great way to consolidate your retirement funds.

You can withdraw your deferred compensation funds at any time, but be aware that there may be penalties and taxes involved. Direct deposit is an option for receiving your payments, and you can request or modify it as needed.

If you need to withdraw funds due to an emergency, such as a medical bill, you may be eligible for an emergency withdrawal. However, credit card debt is not considered a qualified unforeseeable emergency.

You can also choose to withdraw your funds in a lump sum or through smaller installments, depending on your agreement with your employer. This can be a good option if you need access to your money sooner rather than later.

Keep in mind that withdrawals before the specified triggering event may result in penalties, including taxes and penalties. This can discourage employees from accessing their funds before they are intended for retirement.

Here are some key things to consider when it comes to tax penalties for early distributions:

It's essential to understand the rules and regulations surrounding withdrawals and tax penalties to make informed decisions about your deferred compensation plan.

If you leave a job and later return to your previous employer, resuming your DCP contributions is easy.

You can reenroll in a DCP by completing a new DCP enrollment request. This process is straightforward and allows you to pick up where you left off.

Deferred compensation plans can be paid out in a lump sum or smaller installments, giving you flexibility in how you receive your funds.

To be eligible for deferred compensation, you typically need to be separated from your job, which is covered by DCP.

You can't withdraw your account funds while still employed, but if you submit a request, it will be held for up to 180 days until your employer confirms your separation date.

Having a deferred compensation plan can be a good idea, especially if you're a highly compensated employee, as it offers compelling reasons to consider such a plan.

Enrolling in a Deferred Compensation Plan (DCP) is relatively easy, and new customers can even do it by mail with a simple paper form.

You can choose how you contribute to your DCP account, including deferring cashed-out leave or a portion of your salary or bonuses, which can be a great way to maximize your contributions.

The agreement between you and your employer outlines the terms and conditions of the deferred comp plan, including how much you'll contribute and when.

One of the compelling reasons to consider a Non-Qualified Deferred Compensation (NQDC) plan is that there are no age restrictions on withdrawals, giving you more flexibility in your retirement planning.

For most customers, you'll need to be separated from your DCP-covered employment to withdraw from your account, but if you submit a withdrawal request while still employed, it will be held until you separate.

Compared to other retirement accounts, NQDC plans can offer more flexibility, with no required minimum distributions, giving you more control over your retirement funds.

Flexibility is a key benefit of nonqualified deferred compensation plans. You can change your contributions at any time, including starting, stopping, increasing, or decreasing the amounts you contribute from your paycheck. This flexibility allows you to adjust your contributions to fit your changing financial situation.

One of the advantages of nonqualified plans is that there are no age restrictions on withdrawals. This means you can access your money when you need it, without having to wait until a certain age. Traditional retirement plans often have age restrictions, which can limit your access to your funds.

You can contribute to your nonqualified deferred compensation plan in dollar or percentage amounts. This gives you control over how much you contribute and when. You can also choose to contribute a fixed amount each month or a percentage of your income.

Nonqualified plans have no required minimum distributions, which means you won't have to take a certain amount of money out of your plan each year. This can be beneficial if you don't need the money right away and want to keep it invested.

Here are some key features of nonqualified deferred compensation plans that offer flexibility:

A 401(k) plan has a maximum contribution limit determined by the IRS.

If you anticipate needing access to your retirement funds before reaching the age of 59 ½, a 401(k) plan may offer more flexibility.

The contribution limits for a 401(k) plan can be a limiting factor for some people.

A deferred compensation plan may be a better fit if you can contribute a larger portion of your income and prefer the potential for higher tax-deferred growth.

In some cases, a 401(k) plan may not offer the flexibility you need, especially if you expect to need access to your retirement funds before age 59 ½.

Types of deferred compensation plans are varied and can be categorized into two primary types: nonqualified and qualified plans. Nonqualified plans are also known as Section 409A plans.

Nonqualified plans offer several options, including bonus deferral plans, which allow you to choose to receive a bonus at a later date. Excess benefit plans enable you to contribute more to your qualified benefit plan. Salary reduction arrangements, or deferred salary, let you delay a portion of your salary to another year. Supplemental Executive Retirement Plans (SERPs) are typically offered to executives and other higher-level employees.

You can contribute up to a certain amount to a qualified deferred compensation plan, and only employees can sign up for these plans. Examples of qualified deferred compensation plans include 401(k) and 403(b) plans, which are outlined in the Employee Retirement Income Security Act of 1974 (ERISA).

Here are some examples of nonqualified plans:

Keogh plans and SEP IRAs are also examples of qualified deferred compensation plans.

Nonqualified vs. 401(k) plans have distinct differences in terms of contribution limits. Nonqualified plans have no contribution limits, allowing employers to contribute as much as they want, whereas 401(k) plans have set contribution limits that renew each year.

One key difference lies in the level of control employers have over the plan. Nonqualified plans can be elective or nonelective, giving employers more flexibility in how employees are compensated, whereas 401(k) plans are elective for employees.

Independent contractors can be offered nonqualified plans, which can help attract top talent, but 401(k) plans are reserved for employees. Nonqualified plans also allow for more flexibility in terms of withdrawal and payment options.

Here's a comparison of the two plans:

Nonqualified plans can be negotiated with employers, allowing for more flexibility in terms of contribution amounts, withdrawal schedules, and payment options. However, this lack of regulation means employers have more control over the plan, which can be beneficial for high earners but may lack protection for participants.

You won't pay taxes on deferred compensation until you receive it, unless you're enrolled in a Roth plan. This helps you build your savings faster than you could by contributing post-tax dollars.

The tax implications of deferred compensation plans depend on the type of plan you have. You'll have to pay taxes on the deferred income when you receive it, usually at retirement.

Deferred income is taxed as regular income, which means the rate depends on the amount you receive. You can minimize your tax obligations by deferring a higher percentage of your income each year.

There are specific rules regarding how deferred compensation can be paid out to avoid penalties and additional taxes. Knowing the IRS regulations and guidelines is crucial to ensure compliance.

If you want to pay a lower tax rate when you receive your deferred compensation, consider an installment plan, where you'll receive smaller portions of the total deferred income spread out over time instead of one lump sum.

Here are some key tax considerations for deferred compensation:

Note: The tax penalty for overpayments and underpayments for Q4 2024 is 8%, though corporations are charged 7% for overpayments.