Article written by:
Given the recent changes in tax rates for individuals, it may be wise for companies to take advantage of the tax benefits that deferred compensation plans have to offer. Both employers and employees can contribute to deferred compensation plans.
Two plan types
The two main types of deferred compensation plans are qualified and nonqualified plans, with both having significant differences. Qualified plans have annual contribution limits. They are also more secure than a nonqualified plan, meaning the money the employer and employee contribute is deposited into a trust account. An example of a qualified deferred compensation plan is a 401(k) plan.
On the other hand, nonqualified deferred compensation plans are more flexible with no annual contribution limits and provide a business with access to the funds until the deferred compensation is due to the participants. However, these plans can only reward highly compensated or key employees, as defined by the IRS, and creditors could claim an employee’s nonqualified deferred compensation if the business becomes subject to bankruptcy. An example of a nonqualified deferred compensation plan is a supplemental executive retirement plan (SERP).
Accounting for it
The accounting for qualified deferred compensation plans is easy: debiting the expense and crediting cash upon contribution to the 401(k) or similar plan. However, the accounting behind nonqualified deferred compensation plans can be much more complex.
- If an organization decides to compensate a key employee for $50,000 each year for five years, the company will debit the expense and credit the liability equal to the present value of the future payments to be made to the employee. Key assumptions are required for this calculation.
- If the benefit will be paid upon the key employee reaching a certain age, the benefit should be accrued for on a straight-line basis from the effective date of the contract to the end of the service period.
- If the benefit is based on the performance of future services, the organization should accrue the deferred compensation over the employee’s years of service through the full eligibility date.
- In the event the nonqualified deferred compensation plan provides a benefit until the employee is deceased, the benefit obligation should be based on the life expectancy of the individual based on current mortality tables or on the estimated cost of an annuity contract. Additionally, there are different tax treatments that must be addressed as well, which may be different from the financial accounting treatment.
Employees who defer their compensation also defer all of the related taxes on that income, so rather than receive ten years of deferred compensation all at once, it may be advantageous for individuals to make the maximum possible contribution to a 401(k) plan first.
Assistance is available
Reach out to your GBQ advisor for assistance in choosing the deferred compensation plan that best suits you and your company’s needs and to make sense of all of the required accounting entries.