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Whether you work for a
private company or a nonprofit
organization, you may be in the enviable
position of being able to postpone income
taxes on your earned income for years to
come -- even if your employer offers a
regular retirement plan such as a 401(k).
Non-qualified
deferred compensation plans are a fancy
name for a simple concept. It's deferred
because you defer compensation for a later
time (retirement) and it's non-qualified
because it isn’t a retirement plan
officially recognized by the Internal
Revenue Service.
And the results
can be dramatic. Let’s assume you decide
to defer $5,000 a year in current income
for 20 years. You tell your employer not
to put the money in your paycheck but into
your deferred compensation plan. If you
just took it in your paycheck and invested
it after paying 40% in taxes (federal and
state), you would have $92,907. But if you
used deferred compensation, you would
have, after taxes, $131,595. This assumes
you (or your employer) invest the money in
a plan that pays an average annual return
of 7%. You can decide how long you want to
spread out payments from the plan. So
let’s say you decide on a 10-year payout
of the account. If you saved this money
using after-tax income, you’d have $11,456
a year. But you’d have almost twice as
much -- $20,299 -- if you used the
deferred compensation route.
Non-qualified deferred
compensation is most useful for you if:
- You don’t need the
income now.
You want to invest
your tax money instead of paying it to
Uncle Sam.
Your employer doesn’t
offer you a qualified plan, such as a
401(k) or 403(b).
You need the
discipline of saving.
You are an employer,
and you want to give an extra incentive
to key employees (or yourself) to keep
them around.
The rules get a little
complicated because the plans are
different depending on whether you work
for a private or a nonprofit employer.
But the basics essentially
are the same in order to qualify:
- The biggest issue is
“constructive receipt.” This means you
can’t get your hands on the money. You
solve this problem by filling out forms
electing to defer the income before you
receive it.
The plan has to be
selective -- all employees can’t be
eligible. Usually, that means
high-ranking managers and highly paid
employees don’t qualify.
In general, the
employer is promising to pay you the
income in the future. In other words,
it’s an unsecured debt and you’re a
general creditor of the employer if it
gets into financial trouble. There are
ways around this, but they are
complicated.
Non-qualified deferred
compensation is generally a better deal in
the private sector than the public. Why?
- If you work for a
company, you can defer as much money as
you want and you can still put money
into a qualified retirement plan if the
employer offers it. It doesn’t affect
how much you can put into your 401(k).
If you’re putting money into a nonprofit
group’s 403(b) plan, the amount you can
contribute is based on your past
non-qualified deferred compensation
contributions. It goes without saying
that you need your employee benefits
manager to help you out with these
calculations, no matter where you work.
If you work for a
private company, you can choose
distributions based on a certain date,
or for such uses as buying a house, your
kids' college education or your
retirement. With a 501 organization,
you’re limited to retirement (the year
you turn 70 1/2) or an unforeseen
emergency (and divorce doesn’t qualify).
But with either type of plan, whenever
you terminate employment (quitting,
getting laid off, retiring, etc.) the
money has to be distributed to you.
There is one benefit to
working for a nonprofit, and that is the
“catch-up provision.” If you didn’t take
full advantage of your deferred
compensation opportunities in the past (or
even if you left the job for a while) you
can play “catch-up” by putting extra money
in the account three years before your
normal retirement date as defined by the
plan. You can put in a maximum of $15,000
in each of those years, including whatever
you're contributing to your regular
retirement plan (401(k), 403(b), etc.).
This can be a great way to shelter some
extra cash from taxes just as you're
completing your retirement plan.
Non-qualified
deferred compensation is a great way to
build up your retirement portfolio,
provided that you’re willing to let go of
the money and let your employer invest it
for you. You also need to feel confident
of your employer’s financial future. But,
if you meet the criteria above and are
looking for extra ways to shelter money
from taxes so it can be invested in the
meantime, non-qualified deferred
compensation is the way to go. And if your
employer doesn’t offer any other
retirement plan, it is the only way to go.
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