What Is a Deferred Retirement and How Does It Work?
Understand the concept of deferred retirement, including its various forms and how it affects your future finances.
Deferred retirement involves delaying the receipt of income or benefits until a future date, typically during retirement. This allows individuals to postpone access to earned funds or payouts, with the intention of receiving them later. It encompasses various financial arrangements designed to provide income streams in an individual’s later years.
Understanding Deferred Compensation Plans
Non-qualified deferred compensation (NQDC) plans are arrangements where an employer agrees to pay an employee a portion of their current income at a future date. These plans are utilized by executives and highly compensated employees seeking to supplement their retirement savings beyond the limits of qualified plans. NQDC plans offer flexibility because they are not regulated by the Employee Retirement Income Security Act (ERISA), unlike traditional 401(k)s or pension plans.
These arrangements are structured as a contractual agreement between the employer and employee. The employee makes an irrevocable election to defer compensation before it is earned. This deferred amount, along with any credited earnings, is tracked in a bookkeeping account. There are no federal limits on the amount of compensation that can be deferred into an NQDC plan.
A characteristic of NQDC plans is their “unfunded” and “unsecured” nature. This means the money is not held in a separate trust or account for the employee, and the deferred funds remain part of the company’s general assets. Consequently, the employee is considered an unsecured general creditor of the company. In the event of the company’s financial distress or bankruptcy, these deferred amounts may be subject to the claims of the company’s other creditors, potentially leading to a loss of benefits.
Payout schedules for NQDC plans are determined in advance and must be specified in the plan document. Distributions can be triggered by various events, such as separation from service (including retirement), disability, death, a change in company ownership or control, or a fixed future date. Unlike qualified plans, NQDC plans allow for “in-service” distributions, providing access to funds before retirement for specific purposes like purchasing a home or funding education, depending on the plan’s design. Distributions can be taken as a single lump sum or in installments over a specified period.
Other Forms of Deferred Retirement
Beyond non-qualified deferred compensation, individuals can defer income and benefits through various other retirement arrangements.
One common form of deferral involves delaying pension payments beyond the earliest eligibility age. Many pension plans, particularly defined benefit plans, allow participants to begin receiving benefits at a specific age, such as 65. Choosing to defer the start of these payments can result in a higher monthly benefit amount later on. The increase in monthly payments for deferring a pension can vary, with some plans offering a percentage increase for each year of delay.
Delaying the claiming of Social Security benefits is another strategy. Individuals can begin receiving Social Security benefits as early as age 62, but their full retirement age (FRA) is between 66 and 67, depending on their birth year. For each month benefits are delayed past the full retirement age, up to age 70, the monthly payment increases. This delayed retirement credit can enhance the lifetime value of Social Security benefits.
Individuals also have the option to defer taking distributions from qualified retirement plans, such as 401(k)s and traditional Individual Retirement Accounts (IRAs). Contributions to these plans grow tax-deferred, meaning taxes are not paid until funds are withdrawn in retirement. Withdrawals can begin at age 59½ without penalty, and there are no mandatory distributions until a later age. This allows for continued tax-deferred growth of assets within the account.
Taxation and Distribution of Deferred Retirement
The taxation of deferred retirement income occurs when the funds are received by the individual. The tax treatment can vary depending on the type of deferred arrangement.
For non-qualified deferred compensation plans, the deferred amounts are taxed as ordinary income when they are distributed to the employee. This means the employee does not pay income tax on the deferred compensation until the year they receive the payment, rather than when it was earned or deferred. FICA (Social Security and Medicare) taxes may be due on the deferred compensation at the earlier of when the services are performed or when there is no substantial risk of forfeiture.
Pension payments are taxed as ordinary income upon receipt. If the employee made after-tax contributions to the pension plan, a portion of each payment representing the return of those contributions will be tax-free. If the pension was funded entirely with pre-tax dollars, the entire payment is subject to federal income tax.
A portion of Social Security benefits may be subject to federal income tax, depending on the recipient’s “combined income.” For individuals, if combined income is between $25,000 and $34,000, up to 50% of benefits may be taxable. If combined income exceeds $34,000, up to 85% of benefits may be subject to federal income tax. For those filing jointly, the thresholds are higher; if combined income is between $32,000 and $44,000, up to 50% of benefits may be taxed, and above $44,000, up to 85% may be taxed.
Distributions from traditional 401(k)s and traditional IRAs are taxed as ordinary income when withdrawn in retirement. These funds were contributed on a pre-tax basis, allowing them to grow tax-deferred for many years. Withdrawals made before age 59½ are subject to a 10% early withdrawal penalty, in addition to regular income tax, unless an exception applies.
The Internal Revenue Service (IRS) mandates that account owners begin taking Required Minimum Distributions (RMDs) from most traditional retirement accounts, including 401(k)s and IRAs, once they reach age 73. These distributions cannot be deferred indefinitely, ensuring that taxes are eventually paid on the deferred income. Roth IRAs do not have RMDs for the original owner during their lifetime.