We often get asked by attorneys whether they should max out their 401(k) plan or instead establish and fund a deferred compensation plan.

In this video, Greg Maxwell discusses the differences between a 401(k) plan and a deferred compensation plan for attorneys and why we think it’s smart to have both.

2023 Note: Recent legislation, including the SECURE Act of 2019 and the SECURE 2.0 Act of 2022, have changed the dates Required Minimum Distributions (RMDs) must begin. Please contact us if you have specific questions regarding the timing of the required minimum distributions.

Contact Greg Maxwell at (801) 683-7362 or at Maxwell@AmicusPlanners.com if you have any questions about this video.

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A 401k plan and a deferred compensation plan are both popular retirement savings vehicles offered by employers, but there are significant differences between the two. Understanding these variations is crucial for individuals planning for their golden years. In this article, we delve into the dissimilarities between 401k plans and deferred compensation plans, enabling individuals to make informed decisions about which option suits their retirement needs best.

Firstly, a 401k plan is an employer-sponsored retirement savings plan in the United States. Through this plan, employees can contribute a portion of their pre-tax income towards their retirement savings, up to a certain limit set by the Internal Revenue Service (IRS). Employers also have the option to match the employee’s contributions, allowing for a potentially higher retirement fund balance. Contributions and earnings within a 401k grow on a tax-deferred basis until withdrawal, when they are taxed as ordinary income. One key feature of a 401k plan is portability, as employees can usually take their vested balances with them if they change jobs.

On the other hand, a deferred compensation plan is an agreement between an employer and an employee to postpone a part of the employee’s compensation until a later date, typically after retirement. Unlike a 401k plan, which is subject to specific IRS regulations and contribution limits, the terms of a deferred compensation plan are generally more flexible. Employers may use these plans to provide additional benefits to select employees, such as highly compensated executives. Deferred compensation plans are usually funded through a variety of investment options, including stocks, bonds, mutual funds, or annuities. It is important to note that unlike a 401k plan, there are no specific IRS limits on the amount an employee can defer into a deferred compensation plan.

Another key distinction between the two plans is their tax treatment. Contributions made to a 401k plan are typically tax-deductible or made with pre-tax income. This means that the individual’s taxable income is reduced by the amount contributed to the plan. However, when withdrawals are made during retirement, the amount is subject to income tax, as these contributions and earnings grow tax-deferred. Conversely, a deferred compensation plan does not offer immediate tax benefits, as the contributions are made with after-tax income. The crucial advantage lies in the potential tax savings during withdrawal. Since the employee defers the income until retirement, they can potentially be in a lower tax bracket, resulting in reduced tax liability.

Furthermore, withdrawal restrictions differ between the two plans. With a 401k plan, there are specific rules and penalties for early withdrawals made before the age of 59 ½. In such cases, individuals may be subject to a 10% early withdrawal penalty in addition to income tax. However, certain exceptions like financial hardship or medical expenses can waive the penalty, although income tax will still be applicable. Conversely, a deferred compensation plan allows individuals to delay distributions until a predetermined date, typically retirement or a specific number of years of service. This flexibility permits employees to align their distributions with their financial needs and goals.

Lastly, the structure of the plans also varies. 401k plans are usually funded by both the employee and employer contributions, providing a collective pool of funds for investment. Employees have a say in the allocation of their investments among the available options. On the other hand, deferred compensation plans are generally not funded through employee contributions. Instead, the funds are contributed solely by the employer, often in the form of company stock or deferrals of cash bonuses. This allows employers to provide additional benefits to specific employees.

In summary, while both a 401k plan and a deferred compensation plan serve as retirement savings vehicles, there are notable differences to consider. A 401k plan offers pre-tax contributions, specific IRS limits, and potential employer matching, while a deferred compensation plan allows for more flexibility, potential tax savings during withdrawal, and more customized offerings from employers. Each plan has its pros and cons, and individuals should carefully assess their circumstances and goals before selecting the most suitable option for their retirement needs.