What is deferred compensation?
Deferred compensation is part of an employee’s compensation that is set aside for payment at a later date. In most cases, taxes on this income are deferred until paid. Forms of deferred compensation include pension plans, pension plans and stock option plans.
Operation of deferred compensation
An employee can opt for deferred compensation because it offers potential tax benefits. In most cases, income tax is deferred until payment of the indemnity, usually upon the employee’s retirement. If the employee expects to be in a lower tax bracket after retirement from the date he originally received the allowance, he has a chance to reduce his tax burden.
The Roth 401 (k) is an exception, requiring the employee to pay income taxes when earned. However, they may be preferable for employees who expect to be in a higher tax bracket when they retire and therefore would prefer to pay taxes in their current lower tax bracket. There are many other factors that influence this decision, such as changes to the law. In 2019, the highest federal tax rate was 37% – just over half of what it was in 1975. Investors should consult a financial adviser before making decisions based on tax considerations.
Key points to remember
- Deferred compensation plans are an incentive that employers use to retain key employees.
- Deferred compensation can be qualified or unskilled.
- The attractiveness of deferred compensation depends on the employee’s personal tax situation.
Types of deferred compensation
There are two main categories of deferred compensation, qualified and unskilled. These differ considerably in their legal treatment and, from the employer’s point of view, for the purpose they serve. Deferred compensation is often used to designate unqualified plans, but the term technically covers both.
Qualified deferred compensation plans
Eligible deferred compensation plans are pension plans governed by the Employee Retirement Income Security Act (ERISA), including plans 401 (k), 403 (b) and 457 plans. A company that has such a plan in place must offer it to all employees, but not to independent contractors. Eligible deferred compensation is compensated for the sole benefit of its beneficiaries, which means that creditors cannot access the funds if the company does not pay its debts. Contributions to these plans are capped by law.
Ineligible deferred compensation plans
Unqualified Deferred Compensation Plans (NQDC), also known as 409 (a) plans and “golden handcuffs”, provide employers with a way to attract and retain particularly valuable employees because they do not have to be offered to all employees and have no cap 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, which means they can defer funding for these bonds. This approach, however, can be a gamble.
Deferred compensation plans that are not eligible from an employee perspective
NQDCs are contractual agreements between employers and employees, so that even though their possibilities are limited by laws and regulations, they are more flexible than qualified plans. For example, an NQDC may include a non-compete clause.
Compensation is generally paid when the employee retires, although payment may also begin on a fixed date, in the event of a change in business owner, or due to disability, death or an emergency (strictly defined). Depending on the terms of the contract, a deferred indemnity may be retained by the company in the event of dismissal, failure of a competitor or loss of the advantage. Early distributions on NQDC plans trigger heavy IRS penalties.
From an employee’s point of view, NQDC plans offer the possibility of reducing the tax burden and a way to save for retirement. Due to contribution limits, highly paid executives can only invest tiny portions of their income in qualified plans; NQDC plans do not have this drawback. On the other hand, there is a risk that if the business goes bankrupt, creditors will seize funds for NQDC plans, as these do not have the same protections as qualified plans. This can make NQDCs a risky option for employees whose distributions begin years later, or whose businesses are in poor financial condition.
NQDCs take different forms, including stocks or options, deferred savings plans and supplemental retirement plans for managers (SERP), otherwise known as “high-end plans”.