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Deferred Compensation

The use of non-qualified deferred compensation arrangements has grown substantially in recent years. This growth is attributable to many factors, including restrictive limits on contributions or accruals for the benefit of the highly compensated covered under qualified retirement plans, the increasingly burdensome and complex compliance requirements of qualified plans, and the need for more flexible, selective, and cost-effective mechanisms for compensating key employees.

Plan Characteristics

There are many different types of deferred compensation plans, but they all generally have several features in common.

  • They are not subject to the nondiscrimination rules of qualified plans; therefore, they may be used to reward only a select group of employees.
  • The deferred compensation is generally credited with interest to compensate the employees for the time value of money while the compensation is deferred.
  • If properly arranged, the deferred compensation will not be taxable to the employees until they actually receive it.

Tax Considerations

Although tax deferral is generally beneficial, it can be counter-productive if an employee’s tax rate increases by the time the compensation is actually received.

In the current environment of constantly changing tax policy, growing federal and state deficits, and economic uncertainty, predicting future tax rates can be difficult if not impossible. Everything does, however, point to the strong possibility of increased personal tax rates.

Therefore, the critical issue for many employees and employers who are contemplating the use of non-qualified deferred compensation arrangements is whether deferral is worth it. That is, will employees be better off with the deferred compensation arrangement than they would be without it?

Clearly, if tax rates do not rise, a highly compensated employee will almost always be better off deferring some of his or her compensation until a later date. However, if tax rates do rise, an employee will be better off deferring the compensation to a later date only if the compensation is deferred for a sufficient period to time - the break-even period.

Specifically, if compensation is deferred, the employee will be taxed in a future tax year at a higher future tax rate on the entire amount, including the interest credited on the account. If compensation is not deferred, he or she will pay tax at the current lower tax rate immediately and therefore have less available for investment.

The tradeoff is between the current lower tax rate, that must be paid immediately and that reduces the amount available for investment, and the higher future tax rate, that must be paid later and that allows the entire before-tax amount to earn interest.

If the income deferral period of time is sufficiently long, the benefit of earning interest on the before-tax amount of deferred compensation will exceed the cost of the higher tax rate that is applied to the whole amount when it is ultimately received.

This information is not intended to be a substitute for specific indvidualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

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