Definition: Deferred compensation is a portion of an employee’s income set aside to be paid out later, typically as part of a long-term financial or retirement plan.
This arrangement is common in executive compensation packages but can also be found in other employment contexts. The primary purpose is to defer tax liability and to provide long-term financial benefits or retirement income.
Key aspects of deferred compensation:
- Types of Plans: Deferred compensation can come in two main types:
- Qualified Deferred Compensation Plans, like 401(k) plans, which are subject to Employee Retirement Income Security Act (ERISA) guidelines and offer tax benefits to both employers and employees.
- Non-Qualified Deferred Compensation Plans (NQDC), which are more flexible but do not provide the same tax advantages as qualified plans and are typically offered to executives or high-earning employees.
- Tax Benefits: One of the primary advantages is the deferral of taxes. Employees are not taxed on this income until it is disbursed, potentially putting them in a lower tax bracket upon retirement or later in life.
- Timing of Payouts: The timing of deferred compensation payouts is agreed upon in advance and can be scheduled for specific dates, retirement, or other significant life events.
- Investment Growth: Deferred funds are often invested, allowing potential growth over time. The specific investment options depend on the plan’s structure.
- Risk of Forfeiture: In non-qualified plans, there’s a risk of forfeiture if the company faces financial difficulties, as these plans are often unsecured.
- Customization: Non-qualified plans, in particular, offer a high degree of customization to meet the employer’s and employee’s specific financial planning and compensation needs.
Pros and cons of deferred compensation
Pros of deferred compensation:
- Attract and Retain Talent: Deferred compensation can be a powerful tool in attracting and retaining key employees, especially executives and high-performers, as it adds an attractive component to the overall compensation package.
- Tax Benefits: Employers can benefit from tax advantages, as contributions to qualified deferred compensation plans are typically tax-deductible when they are made.
- Improved Cash Flow: Since the compensation is deferred, employers can maintain better immediate cash flow for business operations. The funds that would have been paid as immediate compensation can be used for other investments or business needs.
- Performance Incentive: Deferred compensation can be structured to align with company performance goals, serving as an incentive for employees to contribute to the company’s long-term success.
- Cost-Effective: Compared to immediate raises or bonuses, deferred compensation can be a more cost-effective way to reward employees, particularly in terms of managing current payroll expenses.
Cons of deferred compensation for employers:
- Administrative Complexity: Setting up and managing deferred compensation plans, especially non-qualified plans, can be administratively complex and may require legal and financial expertise.
- Financial Obligation: The company incurs a long-term financial obligation. This can be a concern if future cash flow becomes restricted or if there are significant changes in the financial health of the business.
- Tax Implications: There are specific IRS rules and regulations governing deferred compensation, and non-compliance can lead to penalties. The tax benefits are also contingent on continued adherence to these rules.
- Employee Turnover Risks: If the deferred compensation is a significant part of the remuneration package, high turnover rates could lead to early disbursement of these funds, impacting financial planning.
- Risk of Forfeiture in NQDC Plans: In non-qualified deferred compensation plans, there’s a risk that employees might lose their deferred compensation if the company faces bankruptcy or financial insolvency, as these plans are often unsecured.
Types of deferred compensation
1. Qualified Deferred Compensation Plans:
Qualified plans are those that comply with the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. They offer tax benefits and are available to all eligible employees.
Examples:
- 401(k) Plans: Allow employees to defer a portion of their salary, with potential employer matching contributions.
- 403(b) Plans: Similar to 401(k)s but for employees of non-profit organizations and public schools.
- 457 Plans: Available for government and certain non-profit employees, allowing them to defer compensation.
- Pension Plans: Traditional retirement plans where factors like salary history and duration of employment determine benefits.
Contributions are made pre-tax, reducing current taxable income. Taxes are paid upon withdrawal, potentially at a lower rate in retirement.
2. Non-Qualified Deferred Compensation Plans (NQDC):
NQDC plans do not have to comply with most ERISA provisions. They are more flexible but come with fewer tax benefits and are often offered selectively to executives or higher-paid employees.
Examples:
- Deferred Savings Plans: Allow executives to defer a portion of their salary or bonuses.
- Supplemental Executive Retirement Plans (SERPs): Employer-funded plans that promise to pay executives certain benefits upon retirement.
- Phantom Stock Plans: Provide benefits based on the value of the company’s stock, but without actually granting stock.
Taxes on the deferred income are delayed until distribution, but contributions are not tax-deductible for the employer until paid out.
Funds in NQDC plans are not protected in the event of company bankruptcy and may be at risk.
FAQ
How does deferred compensation benefit employees?
The primary benefit for employees is the deferral of taxes on the income until a later date, usually upon retirement, which could potentially place them in a lower tax bracket. It also helps in long-term financial planning and savings.
Are there risks associated with non-qualified deferred compensation plans?
Yes, in non-qualified plans, the deferred funds are not protected if the company faces bankruptcy or financial difficulties, as they are typically considered unsecured company obligations.
Can employers match contributions in deferred compensation plans?
Yes, employers can match employee contributions in qualified plans like 401(k)s, but matching policies vary among organizations.
When can employees access funds in a deferred compensation plan?
Fund access typically occurs upon retirement, but specific terms can vary based on the plan. Some plans may allow earlier access under certain circumstances like financial hardship, but often with penalties.
How are deferred compensation plans taxed?
Contributions are made pre-tax for qualified plans, and income tax is paid upon withdrawal. For non-qualified plans, taxes are deferred until the funds are distributed, but employers cannot deduct their contribution until it is paid out.
Can deferred compensation be rolled over into an IRA or other retirement plans?
Qualified deferred compensation like 401(k)s can often be rolled over into an IRA or other qualified retirement plans. However, non-qualified plan balances generally cannot be rolled over.
Is there a limit to how much an employee can defer?
For qualified plans, the IRS sets annual contribution limits. Non-qualified plans do not have these limits, but deferral amounts are typically agreed upon in the employment contract or plan documents.
What happens to deferred compensation if an employee leaves the company?
The handling of deferred compensation after an employee leaves depends on the plan’s terms. Sometimes, they may receive a lump-sum payment, or the plan may continue until the predetermined distribution date.