Deferred Compensation Plan

Deferred Compensation Plan Retirement Benefits Executive Benefits Income Deferral Tax Advantage IRS Requirements Employer Loyalty
A Deferred Compensation Plan is a financial arrangement in which a portion of an executive's current earnings is deferred until retirement or a specified future date.
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Definition:

A Deferred Compensation Plan is a method used by an employer to provide additional retirement benefits to executives by deferring a portion of their current earnings. This deferral allows the executives to receive the deferred amount at a specified future date, typically at retirement. The primary benefit to the employer is fostering executive loyalty by offering attractive retirement benefits. To qualify for tax advantages, the Internal Revenue Service (IRS) mandates a written agreement between the executive and the employer, specifying the period of income deferral. The decision to defer income must be irrevocable and must be made before the service for which the income deferral is sought is performed.

Examples:

  1. Executive Retirement Benefit Plan: An executive has a salary of $300,000 and opts to defer $50,000 annually into a deferred compensation plan. This deferred amount accrues interest and will be payable upon the executive’s retirement at age 65.

  2. Long-term Incentive Plan for Sales Executives: A sales executive earning commissions opts to defer a percentage of their annual commissions. This agreement specifies that the deferred commissions will be paid out after 10 years of service or upon reaching the age of 60, whichever comes first.

Frequently Asked Questions:

  1. What are the tax implications of a Deferred Compensation Plan?

    • Deferred compensation is not taxed when earned but is taxed when it is distributed, usually at retirement, at potentially lower tax rates.

  2. Can an executive change their decision about deferred compensation?

    • No, once an election to defer income is made, it is irrevocable and cannot be altered.

  3. What happens if an executive leaves the company before retirement?

    • The payout terms are defined in the written agreement. Some plans allow early distribution with penalties, while others may forfeit the deferred amounts.

  4. Are there limits to the amount of income that can be deferred?

    • There are generally no specific limits imposed by the IRS; however, employers may set their own limits.

  5. Can deferred compensation be used for anything other than retirement?

    • Yes, it can be used for other future financial needs as specified in the agreement, such as education expenses or purchasing a home.

Related Terms with Definitions:

  1. 401(k) Plan:

    • A retirement savings plan sponsored by an employer allowing employees to save and invest a portion of their paycheck before taxes are taken out.

  2. Non-Qualified Deferred Compensation (NQDC) Plan:

    • A type of deferred compensation plan that does not meet the requirements of the Employee Retirement Income Security Act (ERISA) and, therefore, does not receive all the tax benefits of qualified plans.

  3. Executive Bonus Plan:

    • A type of employer-sponsored benefit that provides bonuses to executives, often as a percentage of the company’s profits.

  4. IRS Section 409A:

    • The section of the Internal Revenue Code governing the taxation of nonqualified deferred compensation.

Online References:

Suggested Books for Further Studies:

  1. “Deferred Compensation: A Guide to Design and Implementation” by M. Arthur Myers: A resourceful guide on how to design and implement effective deferred compensation plans.

  2. “Nonqualified Deferred Compensation Answer Book” by Richard S. Rausa: A comprehensive reference detailing the rules and regulations governing nonqualified deferred compensation.

  3. “Employee Benefits and Executive Compensation: A Practical Guide” by Andrew N. McElroy: Practical insights on various types of employee benefits and executive compensation.

Fundamentals of Deferred Compensation Plan: Taxation and Benefits Quiz

### What is a key characteristic of a deferred compensation plan? - [x] Deferral of a portion of current earnings until a future date. - [ ] Immediate taxation of deferred earnings. - [ ] Limited to hourly employees. - [ ] Unwritten agreement between employer and employee. > **Explanation:** A deferred compensation plan involves deferring a portion of current earnings until a future date, often retirement. ### Who benefits from the tax advantage of a deferred compensation plan? - [ ] Only the employer. - [x] Both employer and executive. - [ ] Only the executive. - [ ] The IRS. > **Explanation:** Both the employer and the executive benefit from the tax advantages; the employer retains talented employees, and the executive can defer income tax. ### What must be in place for a deferred compensation plan to qualify for tax advantages? - [x] A written agreement specifying the deferral period. - [ ] An informal verbal agreement. - [ ] Monthly reviews by an accountant. - [ ] Quarterly audits by the IRS. > **Explanation:** The IRS requires a written agreement specifying the period of deferral for tax advantages to apply. ### When must an executive make the election to defer income? - [ ] After performing the service. - [ ] Annually. - [x] Prior to performing the service for which deferral is sought. - [ ] Upon retirement. > **Explanation:** An executive must decide to defer income before performing the service for which the income will be earned. ### What is a potential disadvantage if an executive leaves the company before retirement? - [x] Forfeiture of the deferred amounts. - [ ] Immediate access to all deferred funds without penalty. - [ ] Additional taxation benefits. - [ ] Higher deferral limits. > **Explanation:** Depending on the terms, some plans may result in the forfeiture of deferred amounts if the executive leaves before retirement. ### What type of employment agreement often accompanies a deferred compensation plan? - [x] Long-term commitment or retention agreement. - [ ] Temporary contract. - [ ] Hourly wage agreement. - [ ] Voluntary service agreement. > **Explanation:** A deferred compensation plan is often part of a long-term commitment or retention agreement to foster executive loyalty. ### How are deferred amounts treated for tax purposes? - [ ] Taxed immediately. - [ ] Never taxed. - [x] Not taxed when deferred but taxed when distributed. - [ ] Exempt from all taxation. > **Explanation:** Deferred amounts are not taxed when earned but are taxed upon distribution at a future date. ### Which part of the IRS code governs nonqualified deferred compensation plans? - [ ] Section 401(k). - [ ] Section 125. - [ ] Section 403(b). - [x] Section 409A. > **Explanation:** IRS Section 409A governs the taxation and rules of nonqualified deferred compensation plans. ### Why might an employer offer a deferred compensation plan? - [ ] To reduce the executive’s retirement benefits. - [ ] To decrease corporate tax burden. - [x] To encourage executive loyalty and retention. - [ ] To avoid paying any employee benefits. > **Explanation:** Employers offer deferred compensation plans to encourage executive loyalty and improve retention rates. ### Are there federal limits on the amount of income that can be deferred? - [ ] Yes, set annually by the IRS. - [ ] Yes, similar to 401(k) plans. - [x] No, but employers may impose their own limits. - [ ] No limits or restrictions. > **Explanation:** While there are generally no specific federal limits imposed by the IRS, employers may set their own limits on deferred income.

Thank you for delving into the complexities of Deferred Compensation Plans. Keep enhancing your knowledge of executive benefits and taxation!

Wednesday, August 7, 2024
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