It’s important to have a retirement plan, whether that’s in the form of a 401(k), a deferred compensation plan, a Roth IRA, other investments, savings accounts, or some combination of those things and more. It’s never too early to start your retirement account, and the sooner you start, the more money you’ll have saved up when the time comes to stop working.
Let’s take a closer look at two of those retirement plan options: deferred compensation plans and 401(k)s. They each have their pros and cons, and this guide will help you determine which is the right choice for your financial future.
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ToggleWhy You Need to Save For Retirement
Even if you love your job, you probably don’t want to do it forever — and you may not be able to. Someday, your primary income stream will be gone, and you’ll need to have some funds to live on.
Here are some facts to keep in mind:
- You’ll still have the normal expenses to pay, including groceries, gas, and utilities, and you may still have house or car payments.
- You also have to consider your health, as you may see more hospital bills, prescriptions, and higher insurance premiums as you get older.
- You may need to make renovations to your home to make it easier to live in.
However, retirement isn’t just about surviving. It’s about thriving and enjoying those years of your life, so you’ll want money for entertainment and travel, as well.
Social Security will help a little, but:
- The average Social Security payment in January 2020 was $1,503 per month.
- High earners — those who made $137,000 a year for 35 years — receive the maximum Social Security payments of $3,011 per month in 2020.
- Many receive much less.
- No one knows what the program will be like after the next election or by the time you’re ready to retire
Planning for these expenses and ensuring you have enough money to take care of them will greatly decrease your stress after you stop working.
What is a Deferred Compensation Plan?
A deferred compensation plan is an agreement with your employer to withhold some of your earnings to be paid to you at a later date — like when you retire. These plans vary, and there are both qualified and nonqualified versions.
Qualified plans:
- Include the 401(k) and 403(b)
- Are protected by the Employee Retirement Income Security Act
- Are open to everyone in the company in terms of participation
The funds from qualified deferred compensation plans are held in a trust account until the date they are dispersed.
Nonqualified deferred compensation plans:
- Can be offered to some or all employees (usually upper-level high earners)
- Typically do not limit contributions
- Withhold from your paycheck which is then invested and returned to you later
- Is at risk in the event of a company bankruptcy
Both plans have their merits and pitfalls, however, meaning it is important to understand both sides before deciding which is right for your situation.
Pros of Deferred Compensation Plans
- Income Tax Benefits
You are not taxed on the money that is withheld until it’s returned to you. At that point, you may be in a lower tax bracket, so you may pay less federal income tax on it. This can also add up to tax savings during your working years, as putting money into the deferred compensation plan means you’ll have less taxable income each year.
- Payout Options
Depending upon the structure of the plan, you may have the option to receive a lump-sum payout or make gradual withdrawals — whichever is best for your lifestyle.
- Early Payout
Some qualifying life events allow you to withdraw the money early without penalty.
Cons of Deferred Compensation Plans
- Risk of Loss
If the company goes bankrupt or otherwise fails, you could lose your money.
- You Might Not Be Able to Leave Your Job
Once you join the deferred compensation plan, you can’t change your mind — and if you violate the terms, you could lose the money. That includes if you leave your job early or even if you get fired for just cause. You can’t take the plan with you to another job.
The cons may outweigh the pros in this case, as the point of saving for retirement is to have a dependable nest egg on which to rely once your working years are over. You’ll need to carefully consider if the risks are right for your situation.
What is a 401(k)?
The 401(k) has become one of the most popular employee-sponsored retirement plans in the country, and is often a key part of the employee benefits package for new hires. Employees put a portion of their salaries into the account, and those funds are then invested for them in mutual funds. Their employers may or may not match all or part of those contributions.
Pros of a 401(k)
- Qualified Plan
As a qualified retirement plan, the 401(k) has tax benefits according to the IRS guidelines.
- Rollover Option
You can transfer your 401(k) funds into an IRA or Roth IRA to give yourself more investment options.
Cons of a 401(k)
- Contribution Limits
You can only put so much of your salary into your 401(k).
- Tax Penalty
If you need to withdraw the money before the age of 59.5 years old, you will, in most cases, face a tax penalty. (In light of the coronavirus, your employer may be allowing the hardship distribution as outlined by the CARES Act, which would allow you to withdraw without the penalty and would give you three years to pay taxes on the withdrawal
Which One is Right for You?
As both deferred compensation plans and 401(k)s have their advantages, you’ll want to consider your unique situation when choosing the right one (or both) for you.
Here are a few questions to ask yourself as you weigh your options:
Can you afford to take risks?
The deferred compensation plan is inherently more risky, as you could lose your money if something happens to the company.
Do you need liquidity?
A 401(k) can be borrowed against, and you can withdraw early under certain circumstances, like an emergency.
Are you making a lot of money?
There are usually no contribution limits on the deferred compensation plan, so you can put a lot more money away for retirement there than you may be able to put in a 401(k).
What are the tax implications?
When and how you’re taxed may make a big difference in how you tackle retirement planning so you can avoid paying any additional tax. Talk to your financial advisors to assess your situation and determine what is best for you.
Still Can’t Decide? Ask the Experts.
It’s essential to set aside money for retirement, but every savings plan will differ based on your income, what you’ll owe in taxes, as well as your assets, liabilities, goals, and unique needs. You don’t have to figure it out on your own.
Connect with expert financial advisors and create a retirement plan that works for you. We can help! Contact Silver Tax Group today to speak with an expert about deferred compensation plans, 401(k)s, and other retirement planning considerations.