Deferred Compensation Plans

Businesses employ people to perform work for the firm. The people hired by the firm are called employees and firms remuneration to the employees for the work performed is called Employee compensation. Compensation in the immediate sense is usually the salary or wages paid to the employees. The compensation offered by firms can be different from one to another. The idea behind compensation is to reward the employee for the work performed and needless to say, the work done by one employee could be different to the work done by another due to the complexity of the job, the skill level required and also previous experience. Firms would want to attract and retain the best people and one way to accomplish that is through employee compensation. But there are other forms of compensation paid to employees besides salary or wages. The major benefits that firms use as part of employee compensation are Educational Benefits, Employee Incentive Benefits, Family Benefits, Government Benefits, Health Benefits, Lifestyle Benefits, Recreational Benefits, Retirement, Savings and Transportation. ("Employee benefits," 2011)

Many of the employee benefits are paid within the same year or as and when the expense is to be reimbursed. Retirement benefits is one compensation that usually accrues and is payable to the employee after retirement from active employment. Firms may offer retirement-related employee benefits through primarily three sources- Social Security, pension plans, and individual savings. Pension plans are primarily financed by employers or firms. The two major categories of pension plans are defined benefit and defined contribution. ("Employee benefits," 2011)

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Essentially, these retirement plans are deferred compensation plans. Over the years, these kinds of retirement plans have been changing and in many cases, employees were not aware of the benefits that are derived from these plans. Many times the management of the retirement plans included taking undue risk which could reduce the value of the contributions. With the introduction of the Employee Retirement Income Security Act of 1974 (ERISA), there was a control and regulation on the investment strategy employed by the retirement plan fiduciaries. ("erisa," )

There are two main types of retirement compensations which are qualified deferred compensation plan and unqualified deferred compensation plan.

Qualified deferred compensations plans are plans that meet the criteria established by ERISA and IRS. The qualification requirements include requirement that the plan must be for the exclusive benefit of the employees, it should also be non-discriminatory and there must be uniform relationship to the compensation payments made to cover employees. There are limits to the amount of contribution that is allowed under these types of plans. Some of the types of plans that are qualified are Pension plans, Profit sharing plans (401(k) plan) and Stock bonus plan (ESOPs). These qualified plans could also be called tax qualified plans as there tax benefits that assist both the employer as well as the employee. (Pope, 2011)

There are tax implications for employers relating to qualified plans. The employer could receive an immediate tax deduction to the contributions made on behalf of employees. Also the tax on the growth of the benefits is deferrable till actual payout of the plan. This is also an

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advantage that the employee also enjoys but it is dependent on the employees decision on the election of deduction on a pre-tax earnings or after-tax earnings. This decision will have the effect of taxing immediately or deferring the taxation to actual payout. (Pope, 2011)

Unqualified compensation plans and plans that firms offer to employees as an incentive. These types of plans are usually used to reward or retain the best employees. The primary use is as an incentive for employees. Some of the unqualified plans are Supplemental executive retirement plans (SERPs), Unfunded plans and Stock Option plans. Unqualified plans are not tax deductible when the contributions are being made. The payout is taxable to the employee. ("Non-qualified deferred,")

The above plans are retirement plans that are initiated by the employer and in some cases, there is employee contribution. There are other retirement plans that are initiated by employees themselves. Some of them are Traditional Individual Retirement Account (IRA) and Roth IRA.

Traditional IRAs are created under federal tax law which is an individual retirement account (IRA) in which any employed person can participate and is also a tax-deferred retirement program. The extent of annual contributions which an employee can make is dependent on the ability of the employee. There are advantages and disadvantages to Traditional IRA. The advantage to Traditional IRA is that contributions may be tax deductible and the money earned is tax deferred till withdrawal. The deductibility of the contributions depends on the individual's filing status, adjusted gross income and coverage by an employer-sponsored plan. But this deferral of the tax is also a disadvantage. When the funds are withdrawn, the

Deferred Compensation Plans

withdrawn funds are not specifically taxed. The funds are added to the aggregate income and taxed. So depending on the reported income, the withdrawal may increase the tax bracket. Also there is a withdrawal requirement which should be started at 70 years without exception. ("Traditional ira,")

Roth IRAs are relatively new hybrid of IRA that came into effect in 1998. The Roth IRA is also called backload IRA because the tax benefits come at the end and not at the beginning of the IRA. The contributions to Roth IRAs are not tax deductible and there is limit of USD 5,000 to the allowable contribution. But all the contributions and earnings in the Roth IRA are not taxable on withdrawal. This advantage can be used to by Traditional IRAs whereby the holders can rollover from a Traditional IRA to a Roth IRA. (Pope, 2011)

Deferred Compensation Plans

References:

Employee benefits. (2011, April 21). Retrieved from http://www.referenceforbusiness.com/encyclopedia/Eco-Ent/Employee-Benefits.html

Pope, Anderson, Kramer. (2011). Federal Taxation. Prentice Hall.

erisa. (n.d.). Retrieved from http://www.investopedia.com/terms/e/erisa.asp

Traditional ira. (n.d.). Retrieved from https://www.lincolntrustco.com/accounttypes/Pages/TraditionalIRA.aspx

Traditional ira. (n.d.). Retrieved from http://traditional-ira.com/disadvantages.html

Non qualified deferred compensation plans. (n.d.). Retrieved from http://www.referenceforbusiness.com/small/Mail-Op/Nonqualified-Deferred-Compensation-Plans.html