What Is Deferred Compensation?

What Is Deferred Compensation?

Deferred compensation is an addition to an employee's regular compensation that is set aside to be paid at a later date. In most cases, taxes on this income are deferred until it is paid out.

There are many forms of deferred compensation, including retirement plans, pension plans, and stock-option plans.

Key Takeaways

  • Deferred compensation plans are an incentive that employers use to hold onto key employees.
  • Deferred compensation can be structured as either qualified or non-qualified under federal regulations.
  • Some deferred compensation is made available only to top executives.
  • A risk of deferred compensation in a non-qualified plan is that the employee can lose the money if the company goes bankrupt,

How Deferred Compensation Works

An employee may negotiate for deferred compensation because it offers immediate tax benefits. In most cases, the taxes due on the income is deferred until the compensation is paid out, often when the employee reaches retirement age.

If employees expect to be in a lower tax bracket after retiring, they have a chance to reduce their tax burden.

Roth 401(k)s are an exception, requiring the employee to pay taxes on income as it is earned. The balance in a Roth account is, however, normally tax-free when it is withdrawn. For this reason, it can be a better option, particularly for people who expect to be in a higher tax bracket after they retire.

Types of Deferred Compensation

There are two broad categories of deferred compensation: qualified deferred compensation and non-qualified deferred compensation. These differ greatly in their legal treatment and, from an employer's perspective, the purpose they serve.

Qualified Deferred Compensation Plans

Qualified deferred compensation plans are pension plans governed by the Employee Retirement Income Security Act (ERISA), a key set of federal regulations for retirement plans.

They include 401(k) plans and 403(b) plans.

A company that has such a plan in place must offer it to all employees, though not to independent contractors.

Funds in qualifying deferred compensation plans are for the sole benefit of their recipients. Creditors cannot access the funds if the company goes bankrupt. Contributions to the plans are capped by law.

Non-Qualifying Deferred Compensation Plans

Non-qualified deferred compensation (NQDC) plans are also known as 409(a) plans and "golden handcuffs," As the name implies, they are typically offered only to top-level executives and key talent that the company really wants to retain.

They do not have to be offered to all employees. They also have no caps on contributions.

Independent contractors are eligible for NQDC plans. For some companies, they are a way to hire expensive talent without having to pay their full compensation immediately, meaning they can postpone funding the obligations. That approach, however, can be a gamble for the employee.

NQDCs are contractual agreements between employers and employees, so they are more flexible than qualified plans. For example, an NQDC might include a non-compete clause.

Compensation is usually paid out when the employee retires, although there can be provisions for earlier payouts in case of certain events like a change in ownership of the company or a strictly defined emergency. Depending on the terms of the contract, deferred compensation might be canceled by the company if the employee is fired, defects to a competitor, or otherwise forfeits the benefit. 

Early distributions on NQDC plans trigger heavy IRS penalties.

From the employee's perspective, NQDC plans offer a reduced tax burden and a retirement savings bonus. This is especially valued by highly compensated executives because their qualified 401(k) plans have annual contribution limits.

On the downside, the money in NQDC plans does not have the same protection as a 401(k) balance. If the company goes bankrupt, creditors can seize funds for NQDC plans.

NQDCs take different forms, including stock or options, deferred savings plans, and supplemental executive retirement plans (SERPs), otherwise known as "top hat plans."

The employee pays Social Security and Medicare taxes on the deferred income at the time of the deferral but does not pay income tax on it until the funds are actually received.

Deferred Compensation vs. 401(k)

If a company offers a 401(k) plan, it must offer it to all its employees.

A deferred compensation plan may be offered only to high-level executives.

Generally, those executives participate in both plans. They max out their contributions to the company 401(k) while enjoying the bonus of a deferred compensation plan.

Advantages and Disadvantages of Deferred Compensation

Deferred compensation plans are available mainly to high-income earners who want to put away funds for retirement and find the company 401(k) plan inadequate to their needs.

Unlike 401(k)s or individual retirement accounts (IRAs), there are no contribution limits to a deferred compensation plan. An eligible employee can, for example, earmark an annual bonus as retirement savings.

The money in both of these plans can grow tax-free until it is withdrawn. (The big exception is the Roth 401(k) or IRA, in which contributions are taxed when they are transferred and no further taxes are due on withdrawals.)

Pros
  • No limits on contributions

  • Tax-deferred asset growth

  • Current-period tax deduction

Cons
  • Balances are not protected in case of company bankruptcy

  • The money is not available until retirement

  • No way to borrow against balance

There are, however, some drawbacks.

Disadvantages of Deferred Compensation

With a deferred compensation plan, you are effectively a creditor of the company, lending the company the salary you have deferred. If the company declares bankruptcy in the future, you can lose some or all of this money.

Even if the company remains solid, your money is locked up in many cases until retirement, meaning that you cannot access it easily.

Depending on the plan's structure, you also may find yourself with limited investment options. It may include only the company's stock, for example.

Unlike with a 401(k) plan, when funds are received from a deferred compensation plan they cannot be rolled over into an IRA account.

Is Deferred Compensation a Good Idea?

Nobody turns down a bonus, and that's what deferred compensation is.

A rare exception might occur if an employee feels that the salary offer for a job is inadequate and merely looks sweeter when the deferred compensation is added in. In particular, a younger employee might be unimpressed with a bonus that won't be paid until decades down the road.

In any case, the downside is that deferred compensation cannot be accessed for years, normally until the employee retires.

For most employees, saving for retirement via a company's 401(k) is most appropriate. However, high-income employees may want to defer a greater amount of their income for retirement than the limits imposed by a 401(k) or IRA.

What Are the Benefits of a Deferred Compensation Plan?

The absence of contribution limits can add a great deal of value to a deferred compensation plan for a highly-paid employee.

The plans also offer tax-deferred growth and a tax deduction for the period that the contributions are made.

What Is the Difference Between a 401(k) and a Deferred Compensation Plan?

A deferred compensation plan is generally an addition to a company 401(k) plan and may be offered only to a few executives and other key employees as an incentive.

Deferred compensation plans are not strictly regulated. They are "non-qualified," meaning that they don't have to stick strictly to federal regulations regarding retirement plans.

Financial advisors usually suggest using a deferred compensation plan only after having made the maximum possible contribution to a 401(k) plan—and only if the employer is very solid financially.

How Is Deferred Compensation Paid Out?

The distribution date may be at retirement or after a specified number of years. This must be designated at the time the plan is set up and cannot be changed.

It is generally better for the employee if the deferred income is distributed over several years. A large single payout can push the recipient into a higher tax bracket for the year.

Note that distributions cannot be rolled into a qualified retirement plan. That means the taxes are due for that year.

How Does Deferred Compensation Affect Your Taxes?

Those making contributions to a plan enjoy a tax deduction in that year, which can in some cases be substantial enough to help a taxpayer avoid alternative minimum tax (AMT).

The funds grow tax-deferred until the payout date.

If you retire in a lower tax bracket or a lower-tax jurisdiction you will benefit from the tax deferral upon retirement.

The Bottom Line

A 401(k) plan that includes a matching contribution from an employer is a form of deferred compensation. It is an addition to a regular salary that is payable only after the employee leaves the company or retires.

The 401(k) also is a qualified plan, meaning that the employer must stick to the federal regulations that insure the integrity of such plans.

Non-qualifying plans are less regulated. In fact, they may be tailored to an employee as a part of a larger compensation plan reserved only for high-level executives. Such a plan is known as a "golden parachute" as it is paid out only when the employee retires or, under certain conditions, leaves the company.

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