You are working as an executive or in the top managerial position. You are pocketing some reasonable amount in that position. Suddenly, someone from the Human Resource knocks at your office and delivers a unique employee benefit- participating in the deferred compensation plan. You excuse yourself and promise you’ll be on it later and give feedback. But honestly, you don’t know how it works. Fortunately, read on and learn how it works.
Deferred Compensation Plan Explained
First off all, a deferred compensation plan is a US retirement plan that employers offer to their employees in the top management to help the employees to set aside some dollars from every paycheck towards the golden years of their retirement.
This plan helps you to bridge the gap occurring between the amount available in your pension and Social Security and the amount you’ll ever need when you retire. Honestly speaking, contributing to the typical bevy of 401(k) and IRAs may not carry you through those future years.
Generally, this excellent retirement plan allows you as an employee to defer income today and then withdraw it in the future (usually after you retire) when IRS is likely to lower the taxable income. Similar to 401(k), you should choose how to invest in that contribution.
In contrast with 401(k), where the distributions are flexible, this plan allows you to decide the amount of distribution you wish while deferring. Therefore,it offers quite a little flexibility to change your method of distribution in the future.
How Does a Deferred Compensation Plan Work?
This plan involves three primary steps which include:
1. Enroll in a Plan
It’s easy and straightforward to participate in a deferred compensation plan. You only need to choose the plan that best suits you. After selecting, your contributions will be deducted automatically from each of your paychecks and then credited to your retirement account. So, you don’t have to keep a diary of when to pay or write a check since it’s automated.
2. Invest Your Dollars
From the list of your investment options, choose the best funds to invest. But before doing that, do thorough research to arrive at the best. It’s essential to know that all investments involve some risks; that’s to say that you are not guaranteed that your fund will hit the investment objectives.
Look for the best-personalized retirement strategy. Yes,seek experts. Share with them your retirement income goal, portfolio asset mix, and savings rate. Let them recommend it to you.
3. Potentially Receive Income
If you made the right decision, you’d definitely receive your return on investment in the future.
Investment Options In a Deferred Compensation Plan
When you are enrolled in this plan, you can access a variety of investment options. Your investment options are determined by the kind of plan you choose. Remember, investing is risky and can involve loosing even the principal amount. Therefore, ensure you understand the market risks and the best strategies to apply.
Here are the five common investment choices
- Bond funds
- Stock funds
- Risk-based funds
- Short-term investments
- Target-date funds
Should You opt for a Deferred Compensation Plan?
This retirement plan can be a great deal. However, before you enroll in it, there are several factors to consider.
1. Your Employer’s Financial Strength
Keep in mind that these plans are primarily an IOU that employers keep. Therefore, in case the company is declared bankrupt, then all the money you’ve contributed to your plan will be lost since this plan is referred to as the company’s unsecured debt.
2. The amount of Your Wealth Tied to the Employer
If you have been working with one company for a long time, you may have distributed your wealth in different forms, such as stock purchase plans, restricted stock units, or stock options- all these tied in the same company plus your salary. Going for a deferred comp plan with the company can be riskier than the appropriate.
3. The Time of Your Retirement
If you plan to retire more than 20 years from now, that can be riskier because you don’t know what can happen to your employer’s financial stability for some years to come. And if you don’t believe it, the ultimate example is GE. Nobody could ever imagine that it can fall 11 years ago.
4. Your Current and Future tax Bracket
Visit the IRS Tax Bracket and oversee your tax bracket today. Determine whether after choosing the deferred comp, you’ll move into a lower tax bracket. Again, project your future sources of income and determine where your tax bracket will fall.
Feel free to check out What Are Federal Income Tax Brackets and Tax Rates For 2020?
However, projecting the future can be challenging since you don’t know how IRS will interfere with the tax brackets and rates in the next five, ten, or twenty years.
Before indulging yourself in the deferred compensation plan, it’s wise enough to seek professional guidance from a tax professional or a financial planner. If you’ve decided to enroll in this plan, then plan carefully and make sure that this asset fits perfectly in your total retirement plan context.
You may also be interested in reading How to Pick the Best State to Retire Based On Your Income