Explaining Deferred Compensation And 8 Practical Reasons To Consider It
When it comes to financial planning, many people focus on saving for retirement. But there's another important aspect to consider: how you'll receive your income in retirement.
Deferred compensation can be a great way to supplement your other retirement income sources, and it has some unique benefits that you may not be aware of. It’s definitely worth considering if you’re looking for ways to maximise your retirement income. Here is a brief explanation of deferred compensation, along with 8 practical reasons to consider it.
1. What is deferred compensation?
Deferred compensation is simply income that you receive at a later date after you have already earned it. This can be done in a number of ways, but the most common is through an employer-sponsored retirement plan. With this type of plan, you agree to defer a portion of your salary into the plan, and then you don’t pay taxes on that income until you withdraw it in retirement. The question, what is deferred pay, is really just another way of asking how you can receive your income in retirement without paying taxes on it until later. Additionally, most employer-sponsored deferred compensation plans allow you to invest your deferred income, which can lead to even more tax-deferred growth.
2. Tax-deferred growth
As we just mentioned, one of the key benefits of deferred compensation is tax-deferred growth. This means that any investment earnings on your deferred income are not taxed until you withdraw them in retirement. This can lead to significant tax savings, especially if you’re able to invest in a growth-oriented asset like stocks. Additionally, if you defer compensation into a Roth IRA, your withdrawals in retirement will be completely tax-free. It’s important to note, however, that you will still have to pay taxes on the income when you first earn it (deferring it only delays the tax bill). But if you expect to be in a lower tax bracket in retirement, this can still be a good strategy.
3. Pay yourself first
One of the best things about deferred compensation is that it forces you to pay yourself first. When you defer income into a retirement plan, you’re essentially setting that money aside for yourself before you have a chance to spend it. This can be a great way to make sure that you’re saving enough for retirement, especially if you have a tendency to spend everything you earn. Also, since you’re not paying taxes on the income until later, you’re effectively getting a discount on the money that you’re setting aside.
Another great thing about deferred compensation is that it offers a lot of flexibility. You can choose how much income you want to defer, and you can also change your mind at any time. If you need to access the money before retirement, most plans will allow you to do so (although you may have to pay taxes and penalties). Additionally, many plans allow you to invest your deferred income in a variety of different investments, so you can tailor your portfolio to your specific goals. This flexibility can be extremely helpful if your needs change over time.
5. Employer matching
In some cases, your employer may offer to match a portion of your deferred compensation contributions. This is often done with 401(k) plans, but it can also be done with other types of deferred compensation plans. If your employer offers matching contributions, it’s generally a good idea to take advantage of them. This is essentially free money that can help you grow your retirement savings even faster. Additionally, employer matching contributions often have vesting requirements, which means that you’ll have to stay with the company for a certain period of time before you can keep the money.
6. Reduce your taxable income
Another benefit of deferred compensation is that it can help you reduce your taxable income in the current year. This is because you’re deferring income into the future, which means that you won’t have to pay taxes on it until later. This can be a great way to reduce your tax bill in the short term, and it can also help you manage your cash flow better. Additionally, if you expect to be in a lower tax bracket in retirement, this can be an especially powerful strategy. If you’re in a high tax bracket now but expect to be in a lower one later, you may want to consider accelerating some of your income into the current year so that you can defer it into the future.
7. Access to loans
In some cases, deferred compensation plans may allow you to take out loans against your account balance. This can be a good option if you need access to cash but don’t want to withdraw money from your account (and incur taxes and penalties). However, it’s important to note that not all deferred compensation plans allow loans, and the terms of these loans can vary widely. Additionally, if you take out a loan from your deferred compensation account, you’ll have to pay interest on the loan. This interest will typically be higher than the interest you would pay on a traditional loan, so it’s important to consider this before taking out a loan against your account.
8. Death benefits
If you die before retiring, most deferred compensation plans will allow your beneficiaries to receive your account balance. This can be a great way to provide for your loved ones after you’re gone. Additionally, many plans will allow you to name a specific beneficiary for your account. This can be helpful if you want to make sure that your money goes to the person (or persons) you choose. If you don’t name a beneficiary, your account balance will generally be paid to your estate. It’s important to note that death benefits from deferred compensation plans are generally taxable.
Deferred compensation can be a great way to save for retirement, but it’s important to understand how it works before you decide to participate in a plan. Be sure to consider all of the pros and cons before making a decision, and don’t hesitate to ask your financial advisor for help if you’re not sure whether deferred compensation is right for you.