A deferred income plan isn’t just another name for a retirement plan. There are two types of deferred income plans — qualified and non-qualified. Is it considered earned income when you contribute to one of these plans? Does it matter? We’ll discuss the differences in these plans and cover if their income is considered earned.
What Is Deferred Income?
Many employees utilize deferred income but probably know it by another name — the 401(k). A 401(k), 403(b), and traditional IRA are all qualified deferred income plans (also called ERISA plans). Under a 401(k), employees have a portion of their paycheck deducted directly into their retirement account (established by their employer).
Taxes are deferred in a 401(k). But once in retirement, taxes must be paid on any distributions.
Another type of deferred income is a non-qualified deferred income/contribution (NQDC) plan. High-income earners often utilize an NQDC, which means those in the top income tax brackets. These high earners contribute part of their earnings into an NQDC before taxes, just like a 401(k). When their income is usually much lower during retirement, they can withdraw the funds at a lower tax rate.
Examples of NQDCs are the 457 (government and non-profit) and 409A (for-profit) plans.
Unlike a 401(k), an NQDC doesn't have annual contribution limits. However, there are risks. NQDCs don't have the same protections as 401(k)s. If the company files for bankruptcy, NQDC contributors will likely lose all their funds. Additionally, if employees leave the company or are terminated, they can lose some or all of their NQDC funds. It depends on the agreement the employee has with the company.
Also, with 401(k)'s, employees can roll it into a traditional IRA if they leave the company. An NQDC doesn't have this ability.
NQDCs allow employees to defer their income to one specified date or a series of specified dates, which can occur before retirement. Employees can elect how money comes from their plans — lump sum, a specific year, or installments. Once these options are selected, they are locked in.
The main benefit of an NQDC is that it spreads tax liabilities out over many years.
Is Deferred Income Considered Earned Income?
While some taxes are deferred on a deferred income plan, not all are. FICA (i.e., Social Security) and Medicare taxes are still paid when earned, as are unemployment taxes. Federal and state taxes are deferred until payouts are taken.
From a tax perspective, the same taxes are eventually taken out on deferred income as non-deferred income. For that reason, we can say that deferred income is considered earned income at the time of payout.
An NQDC plan comes with risks. But for those in the top tax brackets, these plans can offer a number of benefits. It's best to speak with a tax professional before deciding if an NQDC is right for you.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.