What is Deferred Compensation?
Deferred compensation is a portion of an employee's 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. Forms of deferred compensation include retirement plans, pension plans and stock-option plans.
How Deferred Compensation Works
An employee may opt for deferred compensation because it offers potential tax benefits. In most cases, income tax is deferred until the compensation is paid out, usually when the employee retires. If the employee expects to be in a lower tax bracket after retiring than when they initially earned the compensation, they have a chance to reduce their tax burden.
Roth 401(k)s are an exception, requiring the employee to pay taxes on income when it is earned. They may be preferable, however, for employees who expect to be in a higher tax bracket when they retire and would therefore rather pay taxes in their current, lower bracket. There are many more factors that affect this decision, such as changes to the law. In 2019, the highest federal tax rate was 37% – just over half what it was in 1975. Investors should consult a financial advisor before making decisions based on tax considerations.
- Deferred compensation plans are an incentive that employers use to hold onto key employees.
- Deferred compensation can be qualified or non-qualified.
- The attractiveness of deferred compensation is dependent on the employee's personal tax situation.
Types of Deferred Compensation
There are two broad categories of deferred compensation, qualified and non-qualified. These differ greatly in their legal treatment and, from an employer's perspective, the purpose they serve. Deferred compensation is often used to refer to non-qualified plans, but the term technically covers both.
Qualified Deferred Compensation Plans
Qualified deferred compensation plans are pension plans governed by the Employee Retirement Income Security Act (ERISA), including 401(k) plans, 403(b) plans and 457 plans. A company that has such a plan in place must offer it to all employees, though not to independent contractors. Qualifying deferred compensation is set off for the sole benefit of its recipients, meaning that creditors cannot access the funds if the company fails to pay its debts. Contributions to these plans are capped by law.
Non-Qualifying Deferred Compensation Plans
Non-qualified deferred compensation (NQDC) plans, also known as 409(a) plans and "golden handcuffs," provide employers with a way to attract and retain especially valuable employees, since they do not have to be offered to all employees and have no caps on contributions. In addition, independent contractors are eligible for NQDC plans. For some companies, they offer a way to hire expensive talent without having to pay their full compensation immediately, meaning they can postpone funding these obligations. That approach, however, can be a gamble.
Non-Qualifying Deferred Compensation Plans From the Employee Perspective
NQDCs are contractual agreements between employers and employees, so while their possibilities are limited by laws and regulations, 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 payout can also begin on a fixed date, upon a change in ownership of the company, or due to disability, death or a (strictly defined) emergency. Depending on the terms of the contract, deferred compensation might be retained 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 the possibility of a reduced tax burden and a way to save for retirement. Due to contribution limits, highly compensated executives may only be able to invest tiny portions of their income in qualified plans; NQDC plans do not have this disadvantage. On the other hand, there is a risk that if the company goes bankrupt, creditors will seize funds for NQDC plans, since these do not have the same protections qualified plans do. This can make NQDCs a risky option for employees whose distributions begin years down the line, or whose companies are in a weak financial position.
NQDCs take different forms, including stock or options, deferred savings plans and supplemental executive retirement plans (SERPs), otherwise known as "top hat plans."