How to Insure Your Income: Deferred Compensation as an Income Insurance Tool Introduction
Deferred compensation is an employment benefit that enables an employee to defer current in-come -- such as a commission or bonus -- and have it paid as compensation at a later date (retirement, death or disability). The process works primarily as a mechanism for avoiding taxes -- but it can be used as a form of income insurance.
Generally, in a deferred comp plan, you enter into an agreement with your employer that specifies:
- the amount of money to be paid;
- when it will be paid; and
- the conditions under which it may -- or may not -- be paid.
The agreement usually will specify that the amount deferred will be paid as a retirement benefit or in the event of premature death or disability. It also may state that you will forfeit the right to the money if you leave your employer except for retirement, death or disability.
The advantage of this agreement is that it allows you to avoid current taxation. However, there are some disadvantages. Usually, deferred compensation is a non-qualified plan and, as such, may be funded or unfunded.
A funded plan is one in which the employer actually will set aside a sum of money or other assets into an account or trust as security for the employer's promise to deliver the deferred benefits at a later date. The employee usually is named as the beneficiary of this trust, cash or property.
The funded deferred compensation plan ties you to the company and the employer except for retirement, death or disability. If you leave for any other reason, the deferred amounts will be forfeited. Thus, you will avoid current taxation due to the element of substantial forfeiture.
An unfunded plan is nothing more than an unsecured promise to pay a future benefit. In a funded plan, the assets doing the funding remain corporate assets and are subject to the claims of corporate creditors or other uses by the employer.
Funded deferred compensation plans usually use life insurance contracts, disability income policies, annuities, mutual funds, etc., to provide the needed benefits.
In short, a deferred compensation plan serves as a disability income policy provided by an employer. High-income executives and professionals often use the plans for exactly this purpose.
