If you own a small business, you know that your income often fluctuates. When you have a great year, you usually end up with a bigger tax bill too. While that’s not necessarily a bad problem to have, there is a strategy that can help reduce your income taxes by delaying your income until future years. This strategy is called deferred compensation, and in this post, I’ll explain how it works and when it might make sense to use it.
What is deferred compensation?
Deferred compensation is money you earn now but choose to receive later, so instead of paying yourself the full amount today and paying income tax on all that money now, you can delay receiving part of your income until a time that may be more convenient to pay the income taxes on it. For instance, many people defer their compensation until retirement when they will likely be in a lower tax bracket.
For example, let’s say you own a graphic design agency, and you landed a huge project, but you know the client won’t need this much work done every year. Your payout from this one-time job will bump your income for the year to over $150,000, but in the last 5 years, your average income has been $100,000.
Instead of paying yourself the entire amount, you could defer $50,000 until you retire. So for the current tax year, you would only pay income tax on the remaining $100,000.
Why do small business owners use deferred compensation?
Small business owners look into deferred compensation for 3 main reasons:
Deferred compensation is a useful tax-planning strategy if you know your current income is going to push a big portion of your income into a higher tax bracket and you also know that your tax bracket in future years (like in retirement) will be lower.
You can also look at deferred compensation like another type of retirement savings. This can be especially useful for small business owners who might have had a slow start on their retirement savings while they were building their business or for business owners who already max out their traditional retirement account limits each year.
If done correctly, deferred compensation can also help give you cash flow flexibility in the future. For instance, if you want a steady income during retirement or you know you’ll want to scale back how much you work starting at a certain age, you can create a deferred compensation plan catered to your goals for your work/life balance.
And if you’re in a field or market where you know there will be years where business is slower, you can come up with a deferred compensation plan that can help you create a more predictable income and provide peace of mind.
How does deferred compensation work in practice?
There are different types of plans that can be set up for deferred compensation, but the general process goes like this:
- The business owner decides to defer part of their income.
- A formal agreement or plan outlines when that money will be paid.
- The funds remain with the business or within a structured plan.
- Income taxes are paid when the money is distributed to the owner later.
For example, if you earn $200,000 annually and decide to defer $20,000 each year for 10 years, you can structure your deferred payment plan so that the money will come to you in $20,000 yearly distributions that you’ll receive during the first 10 years of your retirement.
What that does is allows you to avoid being taxed on that $200,000 during your highest earning years and instead pay income taxes on it gradually during your retirement.
What are the types of deferred compensation plans?
There are 2 main types of deferred compensation plans: qualified and nonqualified plans.
Qualified deferred compensation plans are usually the easiest to recognize and understand because you’re probably already familiar with the types of retirement plans that are used:
- 401(k)
- SEP IRA
- SIMPLE IRA
- Solo 401(k)
When contributing to these plans, keep in mind that the rules are generally the same or similar to a typical employer-sponsored retirement plan. There are contribution limits that are set by the IRS, but they also come with strong tax advantages and protections.
On the other hand, nonqualified deferred compensation plans are more complex and can have more risk. They usually require:
- A written agreement,
- Defined payment schedules, and
- Careful compliance with Section 409A tax code.
The main difference between qualified and nonqualified plans is that the deferred compensation typically remains part of the business’ assets until paid. This means that if the business goes bankrupt, the money you deferred will be lost.
What are the advantages and disadvantages of deferred compensation plans?
As I discussed earlier, deferred compensation plans can offer tax advantages and can help boost retirement savings, especially for high earners.
However, there are disadvantages to deferred compensation:
- The money isn’t always protected by the government unless it’s placed in a traditional type of account.
- There are strict IRS rules for deferred compensation plans that need to be followed correctly to avoid penalties and immediate taxation.
- Once you’ve set up the terms of a deferred compensation plan, it can be difficult to make changes to them, so if you need to access your money sooner than you thought, you may not be able to do that easily.
Is deferred compensation a good tax-saving strategy for small business owners?
In most cases, traditional retirement plans should be the first tax-saving retirement strategy that small business owners use. Solo 401(k)s, SEP IRAs, and other types of retirement accounts are simpler and often offer strong tax benefits.
The most likely scenario for when you’d want to consider deferred compensation is when you’re a very high earner who maxes out your retirement contributions every year. In this case, shifting income to future years through a nonqualified deferred compensation plan could be a smart move as long as you’re certain that your business will continue to provide a stable income for many years.
You could also consider deferred compensation and consult a certified public accountant about the possibility of using this strategy if:
- Your income varies significantly from year to year, or
- You’re nearing retirement and want to structure your retirement income.
However, for many small business owners, especially creative entrepreneurs, influencers, or makers, cash flow flexibility is very important, so it’s probably not a good idea to lock away income with a deferred compensation plan. That could create more stress than tax savings.
Abridged by Amy
Deferred compensation is not a one-size-fits-all strategy. The main idea is that you earn now, receive the money later, and potentially lower your income tax bill in the process. If you think a deferred compensation plan could make sense for you, then talk with a CPA who can evaluate your specific situation and your long-term goals and work with you to come up with a tailored, tax-saving plan.
