Deferred Compensation

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. Investors should consult a financial advisor before making decisions based on tax considerations.

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. 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 and 403(b) 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.

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."

At the time of the deferral, the employee pays Social Security and Medicare taxes on the deferred income just as on the rest of his or her income but does not have to pay income tax on the deferred compensation until the funds are actually received.

Advantages and Disadvantages of Deferred Compensation

Deferred compensation plans are best suited for high-income earners who want to put away funds for retirement. Like 401(k) plans or IRAs, the money in these plans grows tax-deferred and the contributions can be deducted from taxable income in the current period. Unlike 401(k)s or IRAs there are no contribution limits to a deferred compensation plan, so you can defer up to all of your annual bonus, for example, as retirement income.

There are, however, some drawbacks. Unlike a 401(k), with a deferred compensation plan you are effectively a creditor of the company, lending them the money you have deferred. If the company declares bankruptcy in the future, you may 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 very limited investment options, for instance, it may only include company stock. Unlike with a 401(k) plan, when funds are received from a deferred compensation plan, they cannot be rolled over into an IRA account. Nor can deferred compensation funds be borrowed against.

Frequently Asked Questions

Is Deferred Compensation a Good Idea?

It all depends. 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 without the limits imposed by a 401(k) or IRA.

What Are the Benefits of a Deferred Compensation Plan?

Aside from no contribution limits, these plans offer tax-deferred growth and a tax deduction in the period that the contributions are made. This means that if you retire with a lower tax bracket, or in a state that does not levy income tax, you can greatly benefit in the future.

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

Deferred compensation plans are more informal and less secure than 401(k) plans as a result. 401(k) plans are highly regulated and are sponsored by an employer. Deferred compensation is simply a plan in which an employee defers accepting a part of his compensation until a specified future date. 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 company an individual is employed by is considered very financially solid.

How Is a Deferred Compensation Paid Out?

The distribution date, which may be at retirement or after a specified number of years, must be designated at the time the plan is set up and cannot be changed. It is generally advantageous for the employee to defer compensation to avoid having all of the deferred income distributed at the same time, as this typically results in the employee receiving enough money to put them in the highest possible tax bracket for that year. Note that distributions cannot be rolled into a qualified retirement plan.

How Does Deferred Compensation Affect Your Taxes?

Those making contributions to a plan enjoy a tax deduction in that year, which can help one also avoid alternative minimum tax (AMT). The funds then grow tax-deferred until withdrawals are made at retirement. If you retire in a lower tax bracket or lower-tax jurisdiction you will benefit from the tax deferral upon retirement.