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How Does a Deferred Compensation Plan Work
If you are a business owner that has a very successful company this may be something your accountant will bring to you, well if you have an accountant that is worth talking about.
Again, having a successful company is great! You create jobs and you provide a service that is needed. But when the tax man comes it seems the tax write-offs aren’t big enough.
This is where a Deferred Compensation will come into play. Its a win-win for everyone!
Above all, deferred compensation plans allow a worker or employee to earn a W2 wage, bonuses and other compensation in a certain year and receive earnings in another.
This allows deferring income tax to a later year. In fact, doing so provides income often after you leave the workforce and are ready for retirement income.
Furthermore, this may reduce the payable tax on income, especially in a lower tax bracket when the deferred compensation is received.
Quick Article Navigation
- Is Deferred Compensation a Good Idea
- Deferred Compensation Using Leveraged Life Insurance
- Types of Deferred Compensation Plans
- Deferred Compensation Plans Pros Cons
- Executive Deferred Compensation Plan EDCP
- Nonqualified Deferred Compensation Plan Distributions
- Non Qualified Retirement Plan Distributions
- Non Qualified Retirement Plan Rollover
- Reporting Non Qualified Deferred Compensation On W2
- Other Business Life Insurance
- Key Man Life Insurance
- BUY-SELL LIFE INSURANCE
- WHY IS BUSINESS LIFE INSURANCE SO IMPORTANT
- HOW MUCH KEY MAN LIFE INSURANCE SHOULD I GET
- HOW DO I GO ABOUT GETTING A BUSINESS INSURANCE POLICY
Is Deferred Compensation a Good Idea
The thought of deferring compensation and the taxes can be an attractive scenario, to say the least, to just about anyone.
However, even affluent income taxpayers and the delay taxation must balance against some of the pitfalls or risks involved.
If you are a high-income taxpayer making mid-six-figures or more, then a 10% match to the 401k is not optimizing the contribution.
Your main goal should be to contribute to a plan, max out employer contribution, and limit taxes. A deferred compensation plan is worth considering!
These plans will no doubt save you money on your taxes and provide a possible tax-free income later on. The amount to defer will depend on your goals.
For instance, instead of receiving all your income, you allocate 15-20% to be set aside and taken later.
Lower tax bracket payers, when they receive it in retirement, save the difference between the high rate tax when you earned to a lower rate after retirement when you collect.
Deferred Compensation Using Leveraged Life Insurance
In creating a non-qualified retirement solution using a structured life insurance plan can come in handy, especially for the employer.
In some cases, using bank loans to finance life insurance can be very useful. Usually, these types of policies have a minimum face amount of 1 million dollars.
In some life insurance products, you can take advantage of the tax-deferred growth provided by using an Index Universal Life IUL or a Variable Universal Life VUL.
These can be very effective in a low-interest environment that we have seen in the last few years.
Another benefit in a deferred compensation plan using life insurance is that if the employee does pass away, the policy covers the compensation at no loss to the employer.
Deferred Compensation Plans
When you are a business owner, you can choose to have a compensation arrangement with your employee that would pay their income at a later date.
In fact, this would be after earned income. This would be beneficial for the employee as a deferred income and a tax benefit for the business (Qualified Deferred Compensation Plans).
Here are some examples of a Deferred Compensation Plan:
- Retirements Plans
- Employee Stock Options
Types of Deferred Compensation Plans
When you think of deferred compensation plans there are really only two types in general. You have Top-Hat plans and Deferred Savings Plans.
Top-Hat Plans: Paid by employers,
Deferred Savings Plan: deferred by the employee based on the savings plan and the amount of compensation deferred. Under this they have several sub-types:
- Salary Reduction Arrangements
- Bonus Deferred Plans
- SERPs (Supplemental Executive Retirement Plans)
- Excess Benefits Plans.
- Phantom Stock Plans (NQDC Plan)
Deferred Compensation Plans Pros Cons
There are many benefits to a deferred compensation plan. As a matter of fact, it can attract employees, in some cases a “Key” employee.
It can also help retain an employee that is vital to the company.
Furthermore, Non-qualified deferred compensation plans are also known as golden handcuffs as they have the intention of keeping top executives and employees.
The key here for the company is if the “Key” employee leaves before living up to their end of the deferred compensation agreement, they lose their money.
Another key point is to have more cash flow, offering deferred compensation NQDC plans can do this. The reason for this is it does not need to be placed in a trust account and the business can access it up until the deferred compensation is due.
Again, the business can receive tax benefits by providing qualified deferred compensation plans. To clarify, the business can claim those tax deductions based on the employee’s compensation, and contributions that were made. With this in mind, NQDC plans, the company can receive benefits when the employee receives the deferred income. In some cases, these are multi-million dollar compensation plans.
Executive Deferred Compensation Plan EDCP
This type of plan allows executives to defer large amounts of income to defer taxes on the compensation until the deferred is paid. This usually happens at retirement or when the employee turned 70 when tax rates are lower.
Nonqualified Deferred Compensation Plan Distributions
These distributions are considered wages and are subject to pay taxes upon distribution. Because these are subject to FICA taxes, they should be reported on the employees W-2.
Non Qualified Retirement Plan Distributions
These are usually very important to a companies benefits package for key executives. If paid after retirement, they are not considered retirement income versus a 401k or defined plan. These are protected under the Employee Retirement Income Security Act of 1974 (ERISA).
Non Qualified Retirement Plan Rollover
Although non qualified plans have many advantages, not all allow a tax-free rollover. However, you can roll over benefit amounts but you will be taxed on NQDC plans. Remember, all contributions are made with after tax dials as far as non qualified plans are concerned.
They are not the same as rolling over a Roth IRA and or a 403 b plan. These types of plans allow deferral elections. Also, employees over 50 at the end of the year can make annual catch up contributions of up to $6,000.
Reporting Non Qualified Deferred Compensation On W2
If you are reporting payments and deferrals in the same year, the amount earned is reported in box 1 of Form w-2 less the payments from a non qualified or section 457 plan. Also, you must include any amounts deferred during the tax year.
These are very common how 457 deferred compensations work.
Other Business Life Insurance
Above all, life insurance is always necessary to protect financial assets. Buying life insurance is one of the most selfless purchases that a person can make. With a life insurance policy, you are protecting your family.
Without life insurance, any of your debts, mortgage bills, and final expenses will need to be paid by them after you pass. Life insurance, however, can take this burden off of their shoulders, and much more. With a decent life insurance policy, you can pay for your children’s college tuition’s, replace any income you had, and fund many other things for your loved ones.
Likewise, this is no different with a business. Business insurance protects both the business itself (legally and financially), as well as the businesses’ employees. An insured business can keep running and maintain employees, even if the company itself goes down the tubes.
Let’s go over a couple of the different types of business life insurance.
Key Man Life Insurance
Key man life insurance protects companies from dependence on individual people. This way, if someone extremely important to the company, like an owner or key employee, decides to back away, key man life insurance will keep the business financially afloat.
BUY-SELL LIFE INSURANCE
Buy-sell life insurance is an affordable business life insurance policy that many owners take. Basically, with this policy, owners are tied to an agreement that if one of them were to die, the other(s) would buy their share of the company, and the money would go to the deceased owner’s family. Also, this also prevents outsiders from inheriting a significant percentage of the business — which has caused several major issues in the past.
WHY IS BUSINESS LIFE INSURANCE SO IMPORTANT
When a business has a lot of money to make and a lot of money at stake. It’s risky to have an uninsured business that many employees and their families depend on for income. It’s essential to insure a business for the same reasons that it is essential to insure a car!
HOW MUCH KEY MAN LIFE INSURANCE SHOULD I GET
It depends on how valuable the person you are employing is. It’s usually similar to the general rule of thumb for life insurance; the figure should probably be at least 5 to 10 times the person’s salary. You also need to consider how much money it will cost to hire a new person to fill the position, or how much it will cost to fulfill their duties without them.
HOW DO I GO ABOUT GETTING A BUSINESS INSURANCE POLICY
For key man life insurance, the process will be similar to getting a term life insurance policy or a permanent life insurance policy. You’ll submit an application that answers general questions about the person that you would like to be insured.
For any business life insurance policy, the insurance companies will want to know about the business as well, including the history of the business, how much the business is worth, what kind of business it is, etc.
Some of the general rules of finding the best life insurance also apply to business life insurance! Actually, this includes comparing several quotes from the best insurance companies before deciding. This way, you can compare rates and coverage, and make the most informed decision for the business.
Hiring an independent insurance agent is often an excellent investment. They’ll be able to connect you with the right carriers, and they’ll help you find the most affordable prices.