Deferred compensation is an amount of earned income that is payable on a date after which the income was actually earned. The primary benefit to deferred compensation is that it defers taxes on the earned income from the date it was earned until a date in the future when it is withdrawn and used.
Notwithstanding the time value of money, this has the potential benefit of reducing the taxes owed on the income, if the tax rate when it is withdrawn is lower than the tax rate you would have paid had the compensation not been deferred. The use of deferred compensation plans is widespread, and the most common example is a retirement plan.
This is an important concept in divorce because under Texas law, deferred compensation that is earned during marriage is considered to be community property and is thus divisible upon divorce.
Deferred compensation retirement plans are classified as “qualified” or “non-qualified,” according to the Employee Retirement Security Act (ERISA) of 1974. This is an important distinction, as the tax benefits associated with each are different.
Qualified retirement plans generally fall into two different categories: defined contribution plans and defined benefit plans. Under a defined contribution plan, an employer does not guarantee a particular benefit. These plans are characterized by individual accounts to which an employer makes a contribution and to which the employee may contribute as well. The eventual benefit received by the employee depends primarily on the amount contributed and the account’s overall investment performance. Upon retirement, the employee usually has the option of receiving periodic payments or taking a lump sum distribution.
Examples of defined contribution plans include 401(k)s, Traditional IRAs and Roth IRAs. Under §3.007(c) of the Texas Family Code, the separate property interest of a spouse in a defined contribution retirement plan may be traced using the same tracing and characterization principles that apply to a non-retirement asset.
By contrast, defined benefit plans guarantee a set payout upon retirement based on a formula using, among other things, your salary and how long you have worked for the company. The most common example of this is a pension. If the employee spouse is already retired at the time of the divorce, the community portion of the retirement benefit is determined by dividing the total number of months of employment by the total number of months of employment during the marriage.
If the spouse has not yet retired at the time of the divorce, the community’s interest is calculated by the apportionment formula. For that formula, the numerator is the total number of months of plan participation during marriage, while the denominator is total number of months of plan participation up to the date of the divorce. This fraction is then multiplied by the value of the retirement benefit as of the date of the divorce to determine the extent of the community interest in the plan.
The division of all retirement accounts governed by ERISA requires a court-ordered Qualified Domestic Relations Order (QDRO). Absent a QDRO a court cannot divide retirement benefits even if the divorce decree says otherwise.
Non-qualified plans are plans that do not meet the IRS requirements for favorable tax treatment. They are usually provided to key executives and other select employees. Money invested in a non-qualified plan might not get you an upfront tax break. However, they allow employees to defer taxes until retirement, when they are presumably in a lower tax bracket.
Depending on the type of investment you use, you may also be responsible for taxes on the investment earnings each year. Upon retirement, benefits from a non-qualified plan can be paid in the form of annuities or in lump sum payments. If you elect to take the payments in the form of annuities, they are taxed as ordinary income. In order to defer taxes, you also have the option to take lump sum payments and transfer them into an IRA.
The experienced Family Law attorneys at Orsinger, Nelson, Downing & Anderson can help you determine what you and your spouse are entitled to if deferred compensation plans are involved in your marriage estate.