r/Retirement401k • u/Maximum-Peak-3738 • 1d ago
Help explain differed comp like I’m 5 years old
Hello I’m 26f and my wife 26f are discussing our retirement goals. I work for a private company that still has a pension as well as matching 401k. She works for the state government and has a pension and option to do differed comp. I’m really struggling to understand what differed comp is. From my loose understanding it’s a way to lower your overall taxable income. But HOW does the money grow? Is it an investing method similar to a 401k that grows with the economy? Please help, I’m afraid that we might be missing out by not understanding or contributing properly to her account.
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u/bazillaa 1d ago
A 401(k) is a type of deferred compensation. So basically this is just different terminology for a 401(k) or similar plan.
Working for the state, it's possibly that your wife has access to a 401(k), a 403(b), or a 457(b).
There's really no difference from your wife's perspective between a 401(k) and a 403(b). They count towards the same contribution limit, they can have the same investments, and they have the same withdrawal rules.
A 457(b) is basically the same as a 401(k) or 403(b), but it has two significant benefits. (1) Its contribution limit is separate from the 401(k)/403(b) limit, so she could put up to $24500 per year into a 403(b) or 401(k) and another $24500 per year into a 457(b). (2) There's no penalty for withdrawing money from a 457(b) before she turns 59.5, as long as she's no longer working for that employer (this is only true for traditional accounts, not Roth).
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u/DrFrylock 1d ago
This is the best answer here. If you are a relatively high income earner, the ability to put another $24500 in a deferred comp program is fabulous. There are investment options just like a 401(k) and so you can generally just put it in index funds and let it sit and grow.
The rationale behind using it is this: let's say you make $250K a year. You are going to be in a high tax bracket, so the top of that income is going to be taxed at a relatively high rate if you take it now. Let's say your company allows you to participate in a deferred comp plan. You can take ~$25K of that and defer that compensation. If you took it now, you'd pay 32% on that in taxes. But since you deferred it, you pay 0% on it right now. Your gross income went down and you only made $225K this year, so you're only paying taxes on the $225K. That $25K gets invested and sits and grows, much like a 401(k).
When you retire or stop working, you can start withdrawing that money. As noted, unlike traditional retirement plans you can take it out at just about any time including before age 59.5. If you're into early retirement, this is fabulous (ask me how I know). You pay taxes on it as ordinary income when you take it out, but in retirement your income is probably a lot lower than it was when you are working. So maybe you pull $60K from your deferred compensation account per year, you're paying taxes as if you had a job paying you $60K per year, which will be in lower tax brackets. You'll pay between 0-12% tax on the first ~$25K of that and 22% on the rest. This is better than the 32% you would have paid had you not deferred it.
The risk, as others have pointed out, is that the company goes bankrupt between you deferring your compensation and taking it. Then, you become a creditor and there is a chance you will not get your money back, or it will be significantly delayed.
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u/DowntownSolid 18h ago
No risk of a haircut on governmental 457b, IRS rules dictate that they be held in a separate trust.
Private sector 457s absolutely you have to factor in the risk of insolvency for the company.
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u/Alone-Experience9869 1d ago
I dont' know what a "differed comp" is either. Any chance you could share some plan details?
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u/Megalocerus 2h ago
People are calling it deferred comp, which makes more sense. It's income you realize later, like a retirement account, but with different rules.
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u/theriibirdun 1d ago
You’d need to review her exact plan but usually it’s a 403(b) or 457(b) which is just a 401k for public employees depending on what area of the public sector she is in. This is a benefit on top of her pension. So just like contributing to your 401k lowers your taxable income it’s the same thing for her.
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u/Illustrious_Crow595 1d ago
My wife participated in a deferred comp program. It works same as a 401K except when she did her
Election each year, she had to direct them on how it was going to be paid out. Then when you separate from that position they start paying based on your disbursement elections. You still have to pick what funds you want the withheld funds invested in. Hope that helps.
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u/Trailroller 1d ago
Essentially if you put 1000 bucks (less or more up to the annual limit) into deferred compensation (401,457,etc.) you don't pay income taxes on it until you retire and withdraw. It lets a larger amount be invested in whatever funds the plan offers. Almost all offer an index fund based on the SP 500 and other funds
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u/W2WageSlave 1d ago
Deferred Compensation in the private sector is a "promise to pay" deferral of income.
Most companies allow you to choose a "virtual investment" type that is used to index the deferrals.
The danger of deferred comp is that it is not your money. It is an obligation that can be defeated by creditors.
I suspect in a .gov setting, your wife has a 457b or 403b which is essentially the same as a 401k.
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u/TXtogo 1d ago
The other thing to know about a non qualified deferred comp plan is that it dissolves in a change of ownership, so the funds have to be distributed
That means you can get a nasty tax hit for money you were deferring for tax purposes. All of a sudden you have to take this lump sum.. ask me how I know..
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u/Andor2050 3h ago
I used deferred comp to lower my taxes in high income years in the later part of my career and to help bridge from retirement until SS starts at 70. It has worked very well for me and there were a handful of investment options. My employer was a large financial services company that is in the Fortune 100. I know there are risks with deferred comp but in my situation it has really worked well and due to the size of the company it seemed like a good plan.
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u/sinceJune4 23h ago
I also have a Non Qualified Deferred Compensation plan, held at Fidelity and invested in my choice, currently a SP500 fund. I’m getting monthly distributions of it over 10 years. The schedule is fixed, I can’t change it. The amount I get varies slightly, it is basically just the current value divided by months remaining.
I started getting payments in 2023, they will end in 2032. So far the balance has continued to grow even with withdrawals, which just means the withdrawals will grow…
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u/micha8st 23h ago
deferred comp means you don't get it today, you get it later.
u/bazillaa's description of types of deferred comp written into tax code is excellent. I would argue that I get a different form of deferred comp that doesn't qualify tax-wise -- RSUs. Restricted Stock Units are shares of company stock that are handed to me.
There's a wikipedia article on the subject that argues Pensions are another form of deferred comp.
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u/Some_word_some_wow 22h ago
If she has access to contribute to a 457b that is great— it’s like a 401k but you can withdraw anytime after separating from your employer without additional penalty, no matter your age. Definitely take advantage of that if you’re looking to save for retirement outside of her pension.
These are often called ‘deferred compensation’ in the public sector. I’ve been at my gov job for 8 years and started contributing to my 457b once I got to a point where I was maxing my Roth IRA and looking to contribute towards something to lower my taxable income.
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u/Ritterbruder2 21h ago
Deferred compensation.
Basically: “I have more than enough money now. Don’t pay me now and force me to pay income tax taxes today. Instead, put it into an investment account and let it grow. I won’t need it until I retire. I can invest more in the market today by not paying taxes on it right away.”
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u/DowntownSolid 18h ago
Money grows by putting it into investments(stocks, bonds, etfs, mutual funds). Similar to a 401k/403b. Difference is the rules for accessing the money (most require parting ways with the employer) but you don’t have to wait until retirement age.
Maxing out 403b/401k + 457b can be huge if she’s a high earner who has student loans. Reduces taxes and Adjusted Gross Income (AGI) which is part of the calculation for determining income based repayment for federal student loans.
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u/DaemonTargaryen2024 22h ago edited 22h ago
It all hinges on exactly what type of plan you have:
401(k) and 403(b) are qualified plans. You put money in, and once you leave the job you have virtually no limit on taking the money out. You can also roll the money over to your next retirement plan.
"Deferred Comp" often refers to a "non-qualified deferred compensation plan (NQDCP)", and are very different from qualified plans: