A deferred compensation plan withholds a portion of an employee’s pay until a specified date, usually retirement. The lump-sum owed to an employee in this type of plan is paid out on that date. Examples of deferred compensation plans include pensions, retirement plans, and employee stock options.

Key Takeaways

  • Qualified deferred compensation plans have a 10% penalty on withdrawals made prior to age 59½.
  • Most deferred compensation plans do allow pre-retirement distributions for certain life events, such as buying a home.
  • Deferred compensation plans can both increase and decrease in value, so watch them carefully.

Qualified vs. Non-qualified Deferred Compensation Plans

It's important to learn the difference between these two types of plans.

A qualified deferred compensation plan complies with the Employee Retirement Income Security Act (ERISA) and includes 401(k) and 403(b) plans. They are required to have contribution limits and to be nondiscriminatory, open to any employee of the company, and beneficial to all. They are also more secure, being held in a trust account.

A non-qualified compensation plan is a written agreement between an employer and an employee in which part of the employee’s compensation is withheld by the company, invested, and then given to the employee at some point in the future. Non-qualified plans don’t have contribution limits and can be targeted just to certain employees, such as top executives. The employer may keep the deferred money as part of the business’ funds, meaning that the money is at risk in the event of bankruptcy.

Benefits of a deferred compensation plan, whether qualified or not, include tax savings, the realization of capital gains, and pre-retirement distributions.

Tax Benefits

A deferred compensation plan reduces income in the year a person puts money into the plan and allows that money to grow without annual tax being assessed on the invested earnings. In the case of a 401(k), the most common deferred compensation plan, contributions are deducted from an employee’s paycheck before taxation and are limited to a maximum pre-tax annual contribution—$19,500 from employees, as of 2021, plus an additional $6,500 in catch-up contributions for those age 50 and over. 

These deferred plans only require the payment of tax when the participant actually receives the cash. While taxes need to be paid on the withdrawn funds, these plans give the benefit of tax deferral, meaning withdrawals are made during a period when participants are likely to be in a comparatively lower income tax bracket.

This also means that, in the case of a 401(k), participants can withdraw funds penalty-free after the age of 59½, though there is a loophole known as the IRS Rule of 55 that allows anyone between the ages of 55 and 59½ to withdraw funds penalty-free if they have quit their job or been fired or laid off from it. The loophole only applies to the 401(k) you have with the company from which you are separating.

Deferred compensation plans also reduce the current year's tax burden on employees. When a person contributes to a deferred compensation plan, the amount contributed over the year reduces taxable income for that year, therefore reducing the total income taxes paid. Then, when the funds are withdrawn, savings are potentially realized through the difference between the retirement tax bracket and the tax bracket in the year the money was earned.

Capital Gains

Deferred compensation—when offered as an investment account or a stock option—has the potential to increase capital gains over time. Rather than simply receiving the amount that was initially deferred, a 401(k) and other deferred compensation plans can increase in value before retirement. On the other hand, deferred compensation plans can also decrease in value and should be monitored closely.

While investments are not actively managed by participants, people do have control over how their deferred compensation accounts are invested, choosing from options pre-selected by an employer. A typical plan includes a wide range of these options, from more conservative stable value funds and certificates of deposit (CDs) to more-aggressive bond and stock funds. It is possible to create a diversified portfolio from various funds, select a simple target-date or target-risk fund, or rely on specific investment advice.

Pre-Retirement Distributions

Some deferred compensation plans allow participants to schedule distributions based on a specific date, also known as an in-service withdrawal. This added flexibility is one of the largest benefits of a deferred compensation plan. It offers a tax-advantaged way to save for a child’s education, a new house, or other long-term goals.

It is possible to withdraw funds early from most deferred compensation plans for specific life events, such as buying a new home. Withdrawals from a qualified plan may not be subject to early withdrawal penalties, depending on the rules of the plan and of the IRS. Income taxes will be due on withdrawals from deferred compensation plans, however.

In-service distributions can also help people partially mitigate the risk of companies defaulting on obligations. Some deferred compensation plans are completely managed by employers or have large allocations of company stock in the plan. If people are not comfortable leaving deferred compensation in the hands of their employer, pre-retirement distributions allow them to protect their money by withdrawing it from the plan, paying tax on it, and investing it elsewhere.

Note that money from a non-qualified plan cannot be rolled over into an IRA or other tax-advantaged retirement savings vehicle; money from a qualified plan can. Check the rules that apply to you with both your plan's administrators and a tax advisor before taking any in-service withdrawals.