Senior management and highly compensated employees have access to a useful tax planning tool.
It's called deferred compensation and it's available to any business or corporation – not just the big boys with a ticker symbol on Wall Street.
In simple terms, deferred compensation is an election to defer a portion of an employee's pay to a later date. This can have important tax benefits for the employee since the deferred portion is not taxed in the current year, but at some later date.
However, a deferred compensation strategy is most frequently employed by a board of directors interested in retaining a highly skilled and highly paid employee. By attaching strings to the deferment, the employee is incentivized to remain with the business.
In recent years, deferred compensation packages have come under increased scrutiny from oversight agencies. It's an extremely regulated and complex method of compensating critical personnel. But in the right employment scenario, it has benefits for both the business and the employee.
Deferred Compensation Essentials
Either the executive or the company's board of directors (or ownership team) can initiate a deferred compensation plan. But no matter who initiates the process, the deferred portion of compensation is placed in an account that is controlled by the company. In other words, the executive has no direct control over the funds or the vehicles in which the funds are invested. The advantage is that the funds accumulate investment income, even on the portion that would be taxed if the executive received the compensation in the current tax year.
Tax Benefits of Deferred Compensation
Deferred compensation plans allow well-paid employees to earn interest on the taxable portion of their earnings until the funds are distributed. However, there are also other potential advantages to deferred compensation. If an executive can afford to live on part of his salary now, he can set aside a portion of the salary for future years in which he will have lower earnings, effectively pushing himself into a lower tax bracket both now and in the years the funds are distributed.
Risks & Considerations
A deferred compensation package is not without its share of risks, starting with the fact that future tax increases could actually result in a higher rate of taxation when the funds are ultimately distributed. But a much bigger risk is the fact that deferred compensation does not enjoy the same protections as pensions or retirement accounts. These funds are considered an asset of the corporation and could be in jeopardy if the company declares bankruptcy.