Small businesses and nonprofits have long looked to deferred compensation plans as a means of rewarding their most valued employees and executives. Since the more common 401(k) and 403(b) plans carry strict contribution limits under the Employee Retirement Income Security Act (ERISA), those who earn very high salaries are not able to put away as much as they would like for retirement. Nonprofits and other businesses turn to deferred compensation plans to allow their highly compensated employees to supplement their retirement savings.

There are two primary types of deferred compensation plans used by nonprofits, each with its own benefits and drawbacks. There is also a third option, popular among nonprofits, which allows employers to provide benefits to high-level employees without requiring salary deferrals.

457(b) "Top Hat" Plans

Under Internal Revenue Code 457, the Internal Revenue Service (IRS) allows certain employers, namely governmental entities and nonprofits, to offer tax-deferred savings plans outside of the more commonly used 401(k) and 403(b) plans. For nongovernmental employers, however, these plans are restricted to only the highest-earning employees, directors, managers, executives and officers.

In 2016, due to a 457(b) "Top Hat" plan, highly compensated employees may elect to defer up to $18,000, or 100% of compensation, whichever is less. This limit is outside of any contributions made to a 403(b) or other qualified plan. In addition, nongovernmental 457(b) plans may also allow for special catch-up contributions in the three years prior to retirement. These catch-up contributions can be up to twice the normal limit, or $36,000 in 2016, but only if the participant has not made the maximum contribution in prior years.

As with a traditional 401(k), contributions made to a 457(b) plan are tax-deferred. The downside of 457(b) plans is the assets are not owned by plan participants until retirement; they are, therefore, subject to seizure by the employer's creditors in the event of bankruptcy.

457(f) Ineligible Plans

The IRS provides for a second type of deferred-compensation plan that carries no contribution limits. In theory, an employee can contribute any amount to a 457(f) plan, thereby potentially eliminating his tax burden for the year. In addition, participation in a 457(f) plan does not prevent the employee from participating in a 401(k) or 403(b) plan. Like the 457(b), nongovernmental 457(f) plans are restricted to key employees or those with very high compensation.

However, there are several downsides to the 457(f). Firstly, like with the 457(b), the assets in a 457(f) account are not owned by the participating employee until retirement. They are subject to forfeiture to pay off the employer's debts, if necessary. More importantly, the tax-deferred status of savings in a 457(f) plan is a result of this ownership structure; when the employee retires and takes ownership of the account assets, the full amount becomes taxable at normal income tax rates.

These plans are considered "ineligible" because the IRS requires there be a "substantial risk of forfeiture" for plan assets to remain tax-deferred. The plan must stipulate the employee forfeits his savings if he separates from employment prior to reaching normal retirement age or before a certain number of years of service have elapsed. While this offers a significant tax benefit, it also means employees risk losing all their savings if they decide to change jobs. Once the risk of forfeiture passes, the full value of the account becomes taxable.

Another Option: SERP

Though it is not a deferred-compensation plan, the Supplemental Executive Retirement Plan (SERP) is another popular option for nonprofits looking to attract and retain high-level employees. Unlike 457 plans, SERPs are funded by voluntary employer contributions and typically do not allow for employee deferrals. A SERP is designed to act as a type of pension or annuity benefit, paying out benefits to the employee at retirement without any participation required during his working years.

SERP plans can be either defined-benefit or defined-contribution, just like qualified retirement savings plans. Under a defined-benefit plan, the benefit amount payable to employees at retirement is predetermined and can be paid out in a lump sum or as an annuity payment each year. Typically, these plans guarantee a benefit equal to a percentage of the employee's average salary, after accounting for Social Security or other retirement benefits. Under a defined-contribution plan, the employer is responsible for contributing a set amount to the employee's SERP account each year without having to guarantee any particular benefit amount in the future.

As with 457 plans, the business itself does not receive any tax benefits until the employee retires and assumes ownership of the assets. Similarly, because plan assets remain owned by the employer, they are subject to forfeiture to the employer's creditors at any point prior to the participating employee's retirement.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.