You want to save for the future. You've already set aside the maximum amount allowed by the IRS into your 401(k). Still, you know you could be saving more.
Now, you could funnel some funds into a separate savings account. But that just makes it too easy to access. Plus, now you have to pay income taxes on money you don't plan to use any time soon.
If this situation sounds familiar to you, you may be a good fit for a deferred compensation plan. Here's how to determine if this savings strategy is right for you.
What is a deferred compensation plan?
A deferred compensation plan allows an employee to delay collecting money earned money now until the future. These plans are usually available to doctors and other high-income professionals.
Physician groups create deferred compensation plans for partners, physicians and other highly-compensated members. Unlike the qualified retirement plans available to all full-time employees, deferred compensation plans are only for a select group. This allows the employer to provide bonus compensation to key employees without legally having to provide it to everyone.
The two main types of deferred compensation plans used by medical practices for their physicians are:
- Non-qualified deferred plans (NQDC).
- 457(b) plans.
Let's what walk through each plan to determine if they are realistic for you.
Non-qualified deferred compensation plans, explained
The most common type of deferred compensation plan is an NQDC plan. You may also hear it referred to as a 409A plan (after the tax code section that governs it.)
NQDC plans come in two types:
- Elective. The employee receives less of his or her current salary and any bonus compensation until a future year.
- Non-elective. The employer to fund the future benefit without reducing the employee’s salary or bonus incentive payment.
There are no contribution limits attached to NQDC plans, and are available to full-time employees and contractors. However, this doesn't mean NQDC plans don't have limitations. One limitation is when the employee may receive the money. For an IRS-approved NQDC, there are six events that can trigger payment from the plan:
- A fixed date that written into the plan.
- Separation from employment (termination or retirement).
- Change in company ownership.
- An unforeseen emergency.
457(b) plans, explained
If you practice medicine in a non-profit setting, you may also have access to a 457(b) plan.
This type of deferred compensation plan is similar to a 401(k). However, 457(b) plans are only available to two types of employees:
- Work for the government.
- Working for non-profit organizations.
Like a 401(k), the employee makes pre-tax contributions to the plan. This money then grows tax-deferred. Like a 401(k), a 457(b) has an annual contribution limit of $18,500 --- or $24,500 if you are 50 and over.
What makes 457(b) plans advantageous to physicians is the annual contribution limit. Because it's separate from other retirement accounts, you have access to both a 401(k) and 457(b). As of 2018, that means you can contribute $18,500 to both accounts, doubling your retirement savings for the year.
Unlike a 401(k), there is no early withdrawal penalty with a 457(b) is you withdraw funds before age 59 1/2. You will still pay income tax though.
Why you may want to defer compensation
As you can see, doctors can reap a variety of benefits from deferred compensation plans.
It forces you to save. Your deferred compensation is set aside before you ever see it in your paycheck. In fact, it’s not even accessible until a triggering event occurs. This will stunt your urge to splurge on that dream vacation or new sports car.
Deferred compensation offsets current tax obligations, You do not have to pay income tax on deferred compensation until you actually receive the funds.
It can supplement your tax-qualified retirement plan. As of 2018, the IRS limits your annual contribution into your 401(k) plan to:
- $18,500 if you're under 50.
- $24,500 if you’re 50 or older.
The contribution limits to an IRA are much less:
- $5,500 if you’re under 50.
- $6,500 if you’re 50 or older.
These limits apply regardless of your salary. As a highly-compensated physician, you may be able to only contribute a small percentage of your income to a 401(k) or IRA. This will make it difficult to maintain your lifestyle in retirement.
Depending on the type of deferred compensation plan you have, there may not be any limit as to how much your employer can contribute.
Your deferred compensation can supplement your disability or life insurance benefits. These plans typically enable you or your plan beneficiaries to access funds in the event of:
- Unforeseen emergency.
The fine print on deferred compensation plans
Of course, there are potential downsides of deferred compensation plans you should consider.
There are rules to follow. You cannot roll over funds from a NQDC or 457(b) into another type of plan, like an IRA. This holds true even if you terminate your employment with the employer. You also cannot loan yourself funds from your plan. If you have a 457(b) and leave the organization, you either have to:
- Take the distributions (and pay the taxes).
- Keep it where it is, or...
- Move it into another 457(b) account.
There are strings attached. Typically, the money in a deferred compensation plan belongs to your employer until it's paid to you. That's why these plans are often used incentivize staying with your employer for a certain period of time. Your NQDC plan may also dictate that you cannot go to work for a direct competitor. You may also lose the compensation altogether upon termination for cause.
There are no guarantees. When you defer compensation, you’re taking a chance. Organizations do not segregate deferred compensation funds from their general assets. So, what if your employer will be able to pay you at that designated time? If the employer declares bankruptcy, they could lose the funds they intend to pay you later in deferred compensation.Then you will become just another creditor standing in line to collect a fraction of what's yours from the remaining assets. You many collect nothing at all.
Deferred compensation plans are not available to everyone (nor should they be). However, many physicians may have access to do so through your employer. Before setting up a deferred compensation plan, you should consider:
- The differences between NQDC and 457(b) plans.
- How deferring compensation will impact your lifestyle now and in retirement.
- What you stand to gain and lose by this approach to saving for the future.
When done right, deferring extra money you do not need now can change the way you live later on in life.