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Deferred compensation plans can help businesses recruit and keep key talent—and that’s a big deal for those that want to survive and grow.
In these “golden handcuffs” arrangements, employers and employees agree to withhold part of an employee’s ongoing salary, bonuses or other pay until a future date—usually around retirement.
Deferred compensation lets the most important employees stash away more retirement money than they’re allowed to with rank-and-file retirement plans. Like 401(k)’s and similar plans, deferred compensation funds are shielded from income tax. The money can grow tax-free until it’s cashed out at retirement—and by then, recipients are likely to be in lower tax brackets. No wonder deferred compensation is popular with executives!
Here are three common deferred-comp arrangements:
- Deferred savings plans. These plans essentially work as supplemental 401(k)’s. Employees fund them through deductions from their paychecks, and they can include their bonuses as well. Employers agree to provide a fixed return on the contributions, or to invest the money in investments chosen by the employee.
- Supplemental executive retirement plans (SERPs). While employees fund deferred savings plans from their own income, SERPs are funded entirely by employers. How do businesses calculate the amount of the benefit that will be socked away for the employee? One way is to pick a fixed amount — $50,000, say — and apply it each year, for an agreed-upon number of years. Another is to take a percentage of an employee’s salary just prior to retirement, then multiply that by the number of years he or she has spent with the business.
- Restricted bonus plans. Under this arrangement, the key employee takes out what is known as a cash-value life insurance policy. The employer pays the life insurance premiums. The employee is entitled to a payout from the insurance policy, but only after he or she has been with the company for a certain number of years.
Remember that legally, deferred compensation is only available to senior management and highly paid employees. There also has to be a realistic risk that the employee could leave to join a rival company.
Deferred compensation does involve one important drawback for employers, and it has to do with income taxes. Companies can deduct, as a business expense, the regular salary they pay employees and the contributions they make to workers’ 401(k) plans. But they cannot write off deferred compensation until the benefits are paid to the employee.
That means you might have to wait years, or even decades, to take the deduction.