EDITOR'S POST

How does deferred compensation (retirement benefits, profit sharing, etc.) work?

Q. How does deferred compensation (retirement benefits, profit sharing, etc.) work?

A. In various deferred compensation plans, the employer defers part of the compensation until later. Sometimes no income tax is paid on the deferred compensation until it's actually paid. Sometimes the employee can make additional voluntary contributions funds to the plan and not pay income tax on them. Sometimes the employer makes a matching contribution.

In the US, retirement plans can be qualified (confirming to S.401 of the Internal Revenue Code, and qualifying for tax benefits) or nonqualified. In qualified plans, neither the contributions nor the interest from the investments in the plan are taxed until actually received by the employee. Nonqualified plans can't be unconditionally funded by placing the deferred payment in escrow. The employee has the company's promise of payment, but the compensation is not secured. If the company goes bankrupt, it may be lost.

Under nonqualified plans, some companies require their employees that in order to receive their pensions they must not compete and must make themselves available for consultations after retirement. Read the fine print.

Unlike a pension plan, a profit sharing plan has no commitment by the employer to contribute a fixed amount of money. Instead, the contributions are typically a portion of the employer's profit in a given year. In bad years, contributions may be reduced or skipped altogether. Wording like UP TO 15% of profits means that the management may choose to contribute a much smaller percentage in a good year.

Pension plans can only be used to save for retirement or disability. Profit-sharing plans can sometimes be used after as little as two years for house mortgage financing, college tuition, emergency loans, etc.

If you leave the job, you may be able to withdraw your vested contributions (and pay income taxes) or do a rollover into your new employer's plan or your own Individual Retirement Account (IRA) within 60 days.

Some plans (even qualified) have rigorous vesting provisions. For example, if you become 50% vested after 5 years of employment, with 10% increments each year, this means that if your employment is terminated within the first five years, you forfeit all your contributions, and if you leave in the seventh year, you forfeit 30% of your contributions. Read the fine print.

Some companies also allow an employee to set aside a specific amount for child care, dental and medical expenses not covered by the insurance, etc. The employee does not pay income tax on this portion of the compensation. During the year, this fund is used to pay for these expenses. At the end of the year any unused funds are forfeited (to allow for the tax deduction).

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