Deferred Compensation Plans vs. 401(k)s: What’s the Difference?

Deferred Compensation Plans vs. 401(k): An Overview

Deferred compensation plans offer an additional choice for employees in retirement planning and are often used to supplement participation in a 401(k) plan. Deferred compensation is simply a plan in which an employee defers accepting part of their compensation until a specified future date. For example, at age 55 and earning $250,000 a year, an individual might choose to defer $50,000 of annual compensation per year for the next 10 years until retiring at age 65.

Deferred Compensation Plans

Deferred compensation funds are set aside and can earn a return on investment until the time they're paid out to the employee. At the time of the deferral, the employee pays Social Security and Medicare taxes on the deferred income just as on the rest of their income but doesn't have to pay income tax on the deferred compensation until the funds are received.

High-paid executives who don't need their annual compensation to live on and are looking to reduce their tax burden most commonly use deferred compensation plans (non-qualified deferred compensation plans). Deferred compensation plans reduce an individual’s taxable income during the deferral.

They may also reduce exposure to the alternative minimum tax (AMT) and increase the availability of tax deductions. Ideally, at the time when the individual receives the deferred compensation, such as in retirement, their total compensation will qualify for a lower tax bracket, thereby providing tax savings.

401(k) Plans

One reason deferred compensation plans are often used to supplement a 401(k) or an individual retirement account (IRA) is that the amount of money that can be deferred into the plans is much greater than that allowed for 401(k) contributions, up to as much as 50% of compensation. The maximum allowable annual contribution to a 401(k) account for 2022 is $20,500, increasing to $22,500 for tax year 2023.

Thus, a high-earning employee making $800,000 in 2023 would only be able to contribute 2.8% ($22,500 / $800,000) of their salary to a 401(k). Deferred compensation plans have no limits imposed by the Internal Revenue Service.

Key Differences

Deferred compensation plans tend to offer better investment options than most 401(k) plans, but are at a disadvantage regarding liquidity. Typically, deferred compensation funds cannot be accessed, for any reason, before the specified distribution date. The distribution date, which may be at retirement or after a specified number of years, must be made when the plan is set up and cannot be changed. Nor can deferred compensation funds be borrowed against.

Most 401(k) accounts can be borrowed against, and under certain conditions of financial hardship—such as large, unexpected medical expenses or losing your job—funds may even be withdrawn early. Also, unlike with a 401(k) plan, when funds are received from a deferred compensation plan, they cannot be rolled over into an IRA account.

Risk of Forfeiture

The possibility of forfeiture is one of the main risks of a deferred compensation plan, making it significantly less secure than a 401(k) plan. Deferred compensation plans are funded informally. There's essentially a promise from the employer to pay the deferred funds, plus any investment earnings, to the employee at the time specified. In contrast, with a 401(k), a formally established account exists.

The informal nature of deferred compensation plans puts the employee in the position of being one of the employer’s creditors. A 401(k) plan is separately insured.

By contrast, if the employer goes bankrupt, there's no assurance that the employee will ever receive the deferred compensation funds. The employee in that situation is simply another creditor of the company, standing in line behind other creditors, such as bondholders and preferred stockholders.

It's generally advised that a deferred compensation plan only be used after having made the maximum possible contribution to a 401(k) plan.