Employees who participate in deferred compensation plans have an additional choice for saving for retirement, and these programs are often employed as an addition to 401(k) plans. Deferred compensation is just a scheme that enables workers to postpone receiving a portion of their regular salary until after a certain point in time in the future. According to how the law defines each of these various plans, their operational procedures are distinct from one another. A person who is 55 years old and earns $249,999 per year, for instance, has the option of delaying $49,999 of their annual income for the following ten years until they are 65 years old and eligible for retirement. So, deferred compensation plans vs. 401(k)s: what’s the difference. We will break down here the difference between them.

Deferred Compensation Plans

Money from deferred compensation is saved until the worker is ready to get it. Until then, they can get their money back. At the time of the deferral, the employee pays taxes on the deferred income just like they do on the rest of their income. But the employee doesn't have to pay income tax on the deferred compensation until the money is received. Most of the time, high-paid managers who don't require their yearly pay to meet their needs and want to pay less in taxes utilize deferred compensation) plans. With a deferred compensation plan, a person's taxable income decreases while they save the money.

401(k) Plans

One cause deferred compensation plans are frequently used to augment a 401(k) or an IRA is that you can put so much cash into the schemes than you could into a 401(k), approximately 50 percent of your pay. In 2022, you could set - up to $20,499 per year into your 401(k). So, a high-income worker who makes $799,999 could only put $22,499 ($20,499 divided by $799,999) into their 401(k) (k). The Internal Revenue Service does not limit plans for delayed pay (IRS).

Key Differences

Most 401(k) plans don't give you as many investment options as deferred compensation plans do, but they do. Most of the time, you can't do anything with deferred compensation funds before the date set for distribution. When the plan is set up, the distribution date must be chosen and cannot be changed. It can happen when they retire or after a certain amount of time. Also, you can't use money from deferred compensation to get a loan.

Danger of Forfeiture

The money could be lost, which is one of the biggest risks of a deferred compensation plan. It is much less safe than a 401(k) plan. Plans that payout in the future is funded informally. It's a promise from the employer to pay the employee the deferred funds plus any investment earnings at a particular time. On the other hand, a 401(k) is an official account. Because deferred compensation plans are not official, the employee becomes one of the employer's debtors. Insurance is built into a 401(k) plan.

If, on the other hand, the employer goes out of business, there is no guarantee that the employee will ever get the deferred compensation money. The employee is just another creditor of the company in this case. They are behind people who own bonds and preferred stock. Most of the time, it's best to use a deferred compensation plan only after you've put as much as you can into a 401(k) plan.

Why Is Deferred Compensation Best Than a 401(k)?

People who make a lot of money and want to pay less in taxes often think that deferred compensation is better than a 401(k). Also, you can put much more money into a deferred compensation plan than you can into a 401(k). The essential things about deferred compensation plans are that the employee does not "get" the money right away. A deferred compensation plan is not as safe as a 401(k), where contributions are held in a trust and are safe from the employer's creditors. Instead, the employee's only right under the plan is to pay that was put off. The employee risks that the employer will have enough money when the time comes to pay the deferred compensation.

Conclusion

The 401(k) plan is a sort of deferred compensation plan, although it operates differently from other types of deferred compensation plans in general. NQDC plans, 401(k) plans, and 457 plans belong to the same group, as we will see in the next chapter of this book. 401(k) plans, however, are distinct from the other two.