Generally, both plan formats defer compensation because the employee has elected to defer taking cash in hand to obtain some additional benefit, such as deferring taxes on the money or investing on a tax deferred basis. Under more specific legal definitions, there is a distinction between how these different plans work. Today’s post will discuss some of the key differences between these types of employer-sponsored retirement plans through the eyes of an employment law attorney.
401k plans and ERISA
401k plans are governed by the Employee Retirement Income Security Act (ERISA) along with other defined contributions plans like ESOPs. They must be available to all employees that meet the plan rules. Those rules must conform to ERISA guidelines. In a 401k plan you earned the wages or salary. Rather than taking the income in hand as part of your paycheck you opt to put it in your 401k.
Although you do not pay income tax on the income deferred to your 401k plan until it is paid out of the 401k in a taxable event (such as a withdrawal), you do pay FICA on it up front. According to the IRS, you “received” the income, even though you chose to defer it to the 401k plan. Your employer paid it you. It is under your control. Your employer cannot legally take the money back (unless there was an erroneous overpayment to you or your 401k account).
Deferred compensation plans
Deferred compensation plans are governed by Internal Revenue Code section 409A. Employers can offer these retirement plans to select employees or classes of employees but not others. A deferred compensation plan looks like a 401k plan. You make deferrals, select investments and pay taxes upon distribution.
However, a very important distinction is how the compensation is deferred. In a deferred compensation plan the employee (or director) makes an election to defer compensation and there is no receipt of the compensation. The employer never pays it out of its assets. (They may segregate the funds for the plan to a trust but generally not required to.)
The employee does not “receive” the funds. The employee pays FICA but not income tax at the time the employee could have received the compensation in hand. Instead, the employee will pay income tax at the time of distribution. The employee usually remains locked in to distributions based on prior elections given to the company.
Risks in a deferred compensation plan
A critical point about deferred compensation plans is that the employee does not “receive” the funds. Unlike a 401k with contributions housed in a trust and protected from the employer’s (and the employee’s) creditors, a deferred compensation plan (generally) offers no such protections. Instead, the employee only has a claim under the plan for the deferred compensation.
The employee takes the risk that the employer will be solvent and able to pay the deferred compensation at the time distributions are due. If the employer is not solvent, the employee will have to sue to recover or if the employer is in bankruptcy, line up as a creditor against the employer.
So why would an employee want to participate in a 409A deferred compensation plan if there is a risk of losing the income? There are many reasons why an employer may offer a plan and why an employee may want to participate. One key benefit is the income and deferral limits in 401k plans do not apply to deferred compensation plans. So an employee may defer as much as 100% of income in a year and pay no income taxes. The employee may defer enough income to fit in a lower tax rate. The deferrals may be part of an overall financial plan or retirement plan.
Additionally, the employer may offer a higher return or reduced risk of return in the deferred compensation plan over the 401k investment options. The decision to participate in the deferred compensation plan is highly individualized and should be carefully considered with legal and/or financial counsel.