Deferred Compensation Plans

Of the many types of benefits available through employment, the deferred compensation plan is available to many high level employees. Under such plans, the employee agrees to have part of his or her pay withheld by the company, deferring the payment of such money until retirement or the end of the employment relationship. The employee does not owe any income tax on the deferred compensation until he or she actually receives it-so deferred compensation plans can work very well as retirement savings.

The plans also operate to keep highly skilled employees in the ranks-the taxman shows up only when the employee takes the money out of the plan. The entitlement to put off paying taxes tends to prolong employee loyalty to the company.

IRS regulations provide that deferred compensation plans can be included in employees’ benefits packages only when the employer needs an incentive to keep highly qualified employees in the ranks. In fact, in order to postpone tax liability, the company must need a “sweetener” to hold on to its highly valued or experienced employees. While there are no precise limits on the number of employees who can be included in a company’s plan, usually only the top 5% to 10% of high ranking employees in a company are included.

What many such employees do not realize is that deferred compensation plans are very different from 401(k)s and employee sponsored IRAs. How? If the company goes bankrupt, the company’s creditors usually can get all of the funds in the deferred compensation plan.

Despite the fact that a deferred compensation plan literally is composed of the saved wages of the working employees, the federal laws that protect retirement funds from seizure do not protect most deferred compensation plans. In fact, federal law generally recognizes that deferred compensation plans are an asset of the company until actually paid out to the employees.

Of course, the employees are also creditors in any bankruptcy and, as such, they have the right to file a claim to be paid their deferred compensation. But the company’s large creditors usually have far more powerful and secured claims. In a bankruptcy meltdown, employees are often the last to receive any portion of the company’s assets.

What is a highly paid employee to do? If company bankruptcy appears likely, an employee can quit and withdraw his or her money from the plan. But, in such cases, the bankruptcy courts later can force the employee to return the money; the court can “recapture” the money if it appears that the employee knew that the bankruptcy was coming.

Most importantly, all employees who enjoy deferred compensation must understand their plan. Every deferred compensation plan is based on a written document. If you have such a plan, get a copy of the plan documents. If your company is struggling, consider whether the sudden departure of the highest ranking employees will precipitate the company’s failure. The risks of a deferred compensation plan are not avoidable, and a full understanding of the plan is the foundation for wise decision making.

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