Deferred Compensation Tax Rules

Deferred compensation plans allow funds to delay tax charges.

As form of retirement savings, deferred compensation plans provide users a method to divert employee income into a savings account without the payroll taxes taken out right away. This benefit becomes very important as people's tax brackets depend on their income earned. By deferring income to a time when a person earns less, the taxes are lower at the time of withdrawal from the deferred compensation plan, hence the term "deferred."


General Tax Treatment

Given the way deferred compensation plans are written into law, they are subject to reporting and treatment consistency rules that exist both in federal and state law. As plans are used by employers for employee savings, their procedures must follow these rules or be determined as disqualified, resulting in tax penalties.

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Employees need to understand that different deferred compensation plans have nuances. For instance, a 457 plan allows withdrawal at separation from employment with the current employer. A 401K results in penalties for withdrawal and needs to be rolled over to either another employer 401K or an individual retirement account. 457 plans are primarily used by government employers while 401Ks can be used by both private and public employers.


Qualified Plan Tax Treatment Benefits

Employers can write up the cost of the employer's share to a deferred compensation plan as a business expense and deduct it from gross income reported. This in effect reduces the business' tax liability.

Savings and deposits into a deferred compensation plan grow with interest and gains untaxed. Taxes only apply on income in the plan when it is actually withdrawn. The appropriate tax bracket applied depends on annual income at the time of withdrawal (the withdrawal adds to the income total).


Withdrawals do not need to be taxed right away if the funds are rolled over to another tax-deferred account, such as a traditional IRA. Taxes would apply if the rollover goes to a Roth IRA, but then interest afterward is tax free.

Qualified Plan Disadvantages

Some employers may want to give specific performances of certain employees rewards or bonuses. These cannot be deposited into a deferred compensation plan account in an attempt to avoid tax impacts. Any employer benefit must be the same for all employees using the plan. Employers are limited to how much they can deposit into a deferred compensation plan in general. Employers take on reporting duties, regularly providing tax agencies information on existing accounts. These data are then cross-referenced with employee data reported on income tax filings.


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