Deferred compensation plan- A deferred compensation plan can be defined as an arrangement where an employee defers a part of his/her current income until a specified date in future. Wages earned in one period are actually paid at a later date. It is possible to use life insurance to fund a deferred compensation plan. Premiums on cash value life insurance can be paid by the deferred amounts, and the cash value can then be availed at retirement to supplement other income. In case of death before retirement, the designated beneficiary of the insured would receive the death benefits from the insurance policy.
Types of Deferred Compensation Plan
There are two types of deferred compensation plans.
- Qualified Deferred Compensation Plan: The qualified plan gets certain tax preferences:
- The employer is entitled to a tax deduction on the amount contributed to the plan.
- The benefits grow on a tax-deferred basis until they are actually paid under the plan.
- Distributions are generally eligible for rollover to an IRA or other qualified plan, thereby permitting further tax deferral.
Some of the disadvantages of this plan are
- Nondiscrimination requirements prohibit an employer from providing benefits for highly paid employees to the exclusion of other employees.
- The amount of contribution made by the employer is limited.
- Regular reporting is required.
- Non-qualified Compensation Plan: A non-qualified compensation plan does not receive favorable tax treatment
- The employer is not entitled to tax deductions until the benefits are actually paid to the employee.
- Under the doctrine of constructive receipt, the benefits are taxable to the employee at a time when the employee has the right to receive the benefits without regard to when the benefits are actually paid. The taxpayer does not actually have to take possession of the funds.
The advantages of a non-qualified compensation plan are:
- The employer can pick and choose the recipient employees without regard to years of service, salary level or any other criteria.
- This allows an organization to provide benefits to officers, executives, and highly paid employees.
- There is no limit to the amount contributed by the employer.
- A non-qualified plan is less expensive to set up than a qualified plan.
- There are no significant reporting requirements.
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