Knowing the advantages and disadvantages of each of these tax-saving vehicles can help you plan your retirement better.
Most people need to make an effort to save for retirement if they want to retire in financial security. Some workers have access to various types of deferred compensation plans during their careers, and most workers can also use a Roth IRA to save for retirement on their own. Your choice of retirement saving plan can seriously affect your post-work finances, and some workers should consider a combination of both deferred compensation and Roth IRA savings to meet their goals.
The idea behind deferred compensation
Deferred compensation plans are designed to allow workers to shelter income from tax. By agreeing not to receive compensation directly in the form of a salary, workers can avoid having to pay tax on that money until the IRS deems them to have taken possession of it.
Technically, employer-sponsored retirement plans like 401(k) accounts, which are also known as qualified plans, are a form of deferred compensation. However, when most people talk about deferred compensation, they're referring instead to what are known as "nonqualified deferred-compensation plans." These nonqualified plans have different attributes, some of which are advantageous and some of which can be detrimental.
The main advantage of nonqualified deferred compensation is that you're not subject to the contribution limitations of 401(k) plans and similar accounts. Employers typically tailor the provisions of a deferred-compensation plan specifically for key employees. By doing so, they can reward employees for achieving certain business milestones and encourage them to continue working toward reaching long-term strategic goals.
The main problem with nonqualified deferred compensation is that there must be a substantial risk of forfeiture of the money in the plan, because where there is no risk of losing that money, the employee is deemed to have received it, and is therefore taxed on it. Nonqualified deferred-compensation plans often have requirements like minimum tenure in a job, and if the company goes bankrupt, the assets of the nonqualified plan are subject to creditors' claims just like other assets. By contrast, qualified money in a 401(k) plan is held in a separate account and gets protection from the company's creditors.
How Roth IRAs fit in
With both nonqualified deferred compensation and traditional 401(k) plans, contributions are excluded from taxable income at the time of the initial contribution. However, they're included in taxable income later on, typically when the worker withdraws them. That can create high tax liability in retirement.
Roth IRAs, however, don't work that way. They provide no up-front tax deduction, but distributions in retirement are typically treated as tax-free, having no impact on taxable income.
By having a combination of Roth IRAs and deferred compensation, you can manage your tax situation more effectively. If you want less taxable income in a given year, you can withdraw more from a Roth IRA and less from deferred-compensation arrangements. If accelerating your taxable income makes sense, you can do the opposite. Either way, having both types of retirement savings available gives you options that you won't get with one or the other by itself.
To learn more about IRAs of all kinds, check out our IRA Center. We'll run through the basics for you and help you figure out which options are best for your needs.
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