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They are not subject to the nondiscrimination rules of qualified plans;
therefore, they may be used to reward only a select group of employees. |
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The deferred compensation is generally credited with interest to
compensate the employees for the time value of money while the compensation is
deferred. |
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If properly arranged, the deferred compensation will not be taxable to
the employees until they actually receive it. |
Although
tax deferral is generally beneficial, it can be counter-productive if an
employee’s tax rate increases by the time the compensation is actually
received.
In
the current environment of constantly changing tax policy, growing federal and
state deficits, and economic uncertainty, predicting future tax rates can be
difficult if not impossible. Everything
does, however, point to the strong possibility of increased personal tax rates.
Therefore,
the critical issue for many employees and employers who are contemplating the
use of non-qualified deferred compensation arrangements is whether deferral is
worth it. That is, will employees
be better off with the deferred compensation arrangement than they would be
without it?
Clearly,
if tax rates do not rise, a highly compensated employee will almost always be
better off deferring some of his or her compensation until a later date.
However, if tax rates do rise, an employee will be better off deferring
the compensation to a later date only if the compensation is deferred for a
sufficient period to time - the break-even period.
Specifically,
if compensation is deferred, the employee will be taxed in a future tax year at
a higher future tax rate on the entire amount, including the interest credited
on the account. If compensation is
not deferred, he or she will pay tax at the current lower tax rate immediately
and therefore have less available for investment.
The
tradeoff is between the current lower tax rate, that must be paid immediately
and that reduces the amount available for investment, and the higher future tax
rate, that must be paid later and that allows the entire before-tax amount to
earn interest.
If
the income deferral period of time is sufficiently long, the benefit of earning
interest on the before-tax amount of deferred compensation will exceed the cost
of the higher tax rate that is applied to the whole amount when it is ultimately
received.
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the certification marks CFP®,
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