Deferred Compensation

What is Deferred Compensation?

The deferred compensation plan is a crucial term in the world of financial planning and employee benefits.

This term refers to a prearranged agreement between an employer and an employee in which a portion of the employee's income is set aside to be paid out at a later date, usually after retirement, rather than at the time it's earned.

The crux of a deferred compensation plan is its basis in deferred tax principles. According to income tax laws, taxes are generally applied to earned income in the year it's received.

However, by pushing back the date when the income is officially 'received,' a deferred compensation plan essentially delays the associated tax payment. This strategy can offer considerable benefits, depending on an individual's financial situation and future tax rates.

Types of Deferred Compensation Plans

Qualified Deferred Compensation Plans

• 401(k) Plans: This is one of the most common types of employer-sponsored retirement accounts. Contributions are typically made pre-tax, reducing the taxable income for the year of the contribution.
• Individual Retirement Accounts (IRAs): These are personal retirement savings accounts that offer tax advantages for retirement savings. Depending on the type of IRA (Traditional or Roth), contributions may be tax-deductible, and/or distributions may be tax-free.
• Defined Benefit Plans and Defined Contribution Plans: Both are types of qualified retirement plans that provide tax advantages. Defined Benefit Plans provide a fixed, pre-established benefit for employees at retirement, while in Defined Contribution Plans, the employer, the employee, or both contribute to the employee's individual account under the plan.
• Employee Stock Ownership Plans (ESOPs): These are qualified deferred compensation plans where a company contributes its own stock or cash to buy such stock to an employee's trust-established plan. The plan may be leveraged with loans.

Non-Qualified Deferred Compensation Plans (NQDC)

• Deferred Compensation Plans for Executives: These plans are often used to incentivize executives by tying a portion of their compensation to the performance of the company.
• Stock Option Plans: These plans allow employees to purchase company stock at a predetermined price at a future date. This can be a powerful incentive if the company's stock price rises significantly.
• Savings Plans: These are similar to 401(k) plans, but they are non-qualified. Employees can contribute a portion of their salary, and some employers will match a portion of the contribution. Information on these plans can vary and is often provided directly by the employer.
• Supplemental Executive Retirement Plan (SERP): This is a non-qualified retirement plan for key company employees, such as executives, that provides benefits above and beyond those covered in other retirement plans. Information on these plans can vary and is often provided directly by the employer.
• 457 Plans: These plans are available to state and local government employees and some non-governmental employees. Similar to 401(k) plans, they allow employees to contribute a portion of their salary pre-tax. However, unlike 401(k) plans, there is no 10% penalty for withdrawal before the age of 59 and a half.
• Excess Benefit Plans: These plans provide benefits in excess of the limits imposed on qualified plans like a 401(k). They are often used in conjunction with a qualified plan. Information on these plans can vary and is often provided directly by the employer.

Please note that while I have provided links to official sources where available, the detailed guidelines and specifics for non-qualified plans such as Savings Plans, SERPs, and Excess Benefit Plans often depend on the individual company's policies. It is always advisable to consult with a financial advisor or the HR department for more specific information.

How Does a Deferred Compensation Plan Work?

Process and Mechanisms

When an employee opts to participate in a deferred compensation plan, they agree to defer a portion of their income into the plan. The funds in a deferred compensation plan are often invested in a variety of ways, offering a range of investment options to the participating employees. As the earnings grow within this plan, they do so on a tax-deferred basis, only attracting taxation upon distribution.

Employee Retirement Income Security Act (ERISA)

ERISA plays a significant role in the management of deferred compensation plans, particularly qualified plans like 401(k)s. The law sets forth standards that plans must follow to ensure they are managed in the best interests of the participants. However, non-qualified deferred compensation plans are not subject to ERISA guidelines, which means they offer more flexibility but come with a higher risk, particularly if the company goes bankrupt.

Role of Employers and Employees

It's critical to note that funds held within a non-qualified deferred compensation plan technically remain within the employer's control. In the unfortunate event that a company goes bankrupt, the employees might lose the funds deferred within their NQDC plan. This risk is something employees must carefully consider when deciding whether to participate in a deferred compensation plan.

When can Employees Access Deferred Compensation?

Deferred compensation is typically designed to be paid out at retirement or another predetermined future date. This is strategic, as the aim is to take advantage of potentially being in a lower tax bracket during retirement, which can lead to substantial tax savings.

Who can Benefit from Deferred Compensation?

Deferred compensation is a financial tool that can serve as a powerful lever for both employers and employees under the right circumstances.

Advantages for Employees

For high-income employees who anticipate being in a lower tax bracket upon retirement, deferred compensation can be a very beneficial strategy. The income deferred, along with any earnings from investments made within the plan, grow tax-deferred until they are distributed. This can substantially enhance an individual's retirement savings.

Advantages for Employers

From an employer's perspective, offering a deferred compensation plan can be a strategic tool for attracting and retaining top talent. Since the actual compensation is deferred, there is no immediate cash outflow for the company, making it a cost-effective strategy in the short term.

What are the Potential Risks or Drawbacks of Deferred Compensation?

While deferred compensation can offer significant benefits, it also comes with potential risks and drawbacks. These risks are distinct for employees and employers.

Taxation Issues

If not handled correctly, deferred compensation can lead to unexpected tax liabilities. For example, if the IRS determines that an employee has control over the assets in a non-qualified deferred compensation plan, they could levy taxes immediately, even if the employee hasn't received the funds.

Bankruptcy Risks

Since assets in a non-qualified deferred compensation plan technically belong to the employer, they are vulnerable if the employer faces bankruptcy or other financial difficulties. In such a case, deferred compensation assets could be used to pay off the company's creditors.

How to Set Up a Deferred Compensation Plan?

Setting up a deferred compensation plan requires careful thought and planning. It's important to understand the steps involved and the potential challenges along the way.

Steps for Employers

An employer interested in setting up a deferred compensation plan should start by consulting with a tax professional or financial advisor. These professionals can provide guidance on the legal and tax implications of these plans and help determine the best structure for the plan.

Steps for Employees

For employees, the first step in setting up a deferred compensation plan is understanding the potential benefits and risks. They should consult with a financial advisor to determine whether a deferred compensation plan aligns with their overall retirement savings goals.

Related: Compensation, Workers' Compensation