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What is deferred compensation?

Types of deferred compensation

Advantages and disadvantages of deferred compensation

What’s the difference between a 401(k) and a deferred compensation plan?

The bottom line

LearnWealth & IncomeUnderstanding a Deferred Compensation Plan: Types and Examples

Understanding a Deferred Compensation Plan: Types and Examples

Oct 14, 2022


7 min read

Having confidence in the financial security of the employer is key because it can financial insolvency could mean the deferred compensation never gets paid.

Employers use deferred compensation as an incentive to retain employees they value the most, especially those who earn high salaries. Deferred compensation has enticing tax advantages, and some plan types can circumvent the contribution and income limits that traditional retirement savings plans have.

What is deferred compensation?

Deferred compensation is a portion of an employee’s salary an employer pays at a later time. That compensation can be a contribution to a retirement plan or pension or it can be in the form of  stock options or restricted shares. One example of a deferred compensation plan is a traditional 401(k), but the term more commonly refers to a separate agreement that supplements a 401(k). Using deferred compensation, for example, a high-salaried executive might reduce taxable income and save more than the maximum allowable annual contribution to a 401(k).  

The deferred payouts are usually made to the employee when they retire or after a specified number of years. If deferred compensation were to be paid out in a lump sum, it could put the recipient in a higher tax bracket. To avoid that scenario, employees could elect to schedule payouts over time. 

There are several types of deferred compensation plans, and each comes with different policies. Some plans let recipients make withdrawals for major life situations like purchasing a new home, rather than waiting until they retire or terminate their employment. 

Usually, income tax on deferred compensation is postponed until they receive the money, usually in retirement. The exception is for Roth IRAs because contributions are made to those accounts after taxes have already been paid.  

The benefit of deferred taxes is that employees may find themselves in a lower tax bracket after they retire. If that’s the case, the tax rate they pay on deferred compensation will be lower than if they had received the full compensation during their working years. Another plus is that deferred compensation may push an employee to a lower tax bracket during their working years, too.

Let’s say an executive is making $225,000 per year at age 55 and is in the 35% tax bracket. The executive agrees to let the company defer 20% of salary ($45,000) for 10 years. The deferral reduces the taxable salary to $180,000, which puts the executive in the lower 32% tax bracket while employed. If the executive retires at age 64 and goes to an even lower tax bracket, the deferred compensation received the next year would be subject to lower tax rates. 

Types of deferred compensation

There are two broad categories used to classify types of deferred compensation plans: qualified deferred compensation and non-qualified deferred compensation.

Qualified deferred compensation

Qualified deferred compensation plans include well-known retirement plans such as 401(k) plans and 403(b) plans. This type of compensation is covered by the Employee Retirement Income Security Act (ERISA). In case a company that offers one of these plans goes bankrupt, creditors can’t seize the money that would go into an employee’s qualified deferred compensation plan. 

By law, qualified deferred compensation must be nondiscriminatory, meaning any employee can receive it from a company that offers such a plan. It is also subject to plan contribution limits—in 2022, this is $20,500 per year for employees. Employees over age 50 can add $6,500 to that in catch-up contributions.

Non-qualified deferred compensation

Non-qualified deferred compensation is sometimes known as a 409(a) plan or more colloquially, “golden handcuffs.” Depending on the agreement, non-qualified deferred compensation can come in the form of stocks, options, savings plans, or Supplemental Executive Retirement Plans (SERPs), which don't have the maximum annual contributions or income eligibility limits of a 401(k). 

Depending on the agreement, payouts can be delivered at a fixed date, when the employee retires, when company ownership changes, or when the employee experiences a disability, emergency, or death. Taking the payout in the form of early distributions might trigger hefty IRS penalties, though.

Unlike qualified deferred compensation, non-qualified deferred compensation doesn’t have to be offered to every employee across the board. Employers usually use it to lock-in high-value employees earning higher salaries. 

Also unlike qualified deferred compensation, non-qualified deferred compensation can be offered to independent contractors who wouldn’t be eligible for a qualified plan.

Non-qualified compensation plans tend to be more flexible, but that also means they can be riskier. There are fewer laws and regulations with non-qualified deferred compensation plans than with qualified deferred compensation plans. That means each agreement might come with conditions that could allow the employer to rescind the deferred compensation, if, for example, the employee were fired or joined a competitor. 

Despite the risks, highly compensated employees might choose non-qualified deferred compensation because it reduces taxes and circumvents the contribution limits of a qualified retirement plan like a 401(k). 

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Advantages and disadvantages of deferred compensation

The pros and cons of deferred compensation vary depending on the type of agreement. 

Potential benefits of deferred compensation

  • No contribution limits to retirement plans

    . Non-qualified deferred compensation essentially circumvents contribution limits and income limits of a 401(k), allowing high earners to supersize the amount they save for retirement. 

  • Tax-deferred growth

    . Although take-home pay is less, the deferred money will be invested and can grow on a pretax basis until retirement. 

  • Lower taxable income

    . The IRS doesn’t recognize deferred compensation until distributions begin, at which point the money becomes taxable income. Usually these distributions are taken in retirement, when the retiree’s tax bracket is lower than when they were working. The recipient, however, must still pay Social Security and Medicare taxes on deferred income. 

  • Distribution requirements

    . In a nonqualified plan, the retiree would not be forced to take minimum distributions at age 70 ½ as they would in a 401(k). Instead, they might take distributions in a lump sum or as annual installments. However, the distribution schedule must be agreed to in advance, and generally, early withdrawals from non-qualified plans are not an option, though they are with qualified plans. 

Potential disadvantages of deferred compensation

  • Possibility of income loss

    . With non-qualified deferred compensation, if the company goes bankrupt, deferred salary might never be paid out, and funds could be seized by creditors. In fact, some employees might take early withdrawals as a defensive strategy when they have doubts about the company’s financial solvency. Might the company renege on their promise to pay the deferred compensation? In this scenario, the employee could withdraw the money early, pay taxes, and reinvest it elsewhere. 

  • No roll over options

    . Non-qualified deferred compensation can’t be rolled over into an IRA or other retirement plan because they aren’t covered by ERISA standards, whereas qualified plans like 401(k) plans do permit such rollovers.

  • No borrowing options

    . Whereas qualified plans permit taking a short-term loan from your 401(k), there is no way to borrow from a non-qualified plan, because the money isn’t exactly the employee’s yet; it remains in the company’s coffers until the distribution is received. 

  • Lack of liquidity.

    Because nonqualified deferred compensation typically can’t be accessed until the agreed upon distribution date, an individual may have to wait many years before they can access the funds. 

  • Limited investment opportunities

    . The value of deferred compensation in the form of investments or stock options can move up or down over time. Employees might have some flexibility in managing investment options, but the range of options will be limited, because they are pre-selected by the employer. 

What’s the difference between a 401(k) and a deferred compensation plan?

A 401(k) is a qualified deferred compensation plan—one of two types. If an employee maxes out 401(k) contributions and wants to save more for retirement, a non-qualified deferred compensation agreement would let them take their retirement savings further. 

Non-qualified deferred compensation plans don’t have as many formal regulations as 401(k) plans. As such, they aren’t as secure, either, because the compensation in a non-qualified plan is not protected from creditors if the company goes bankrupt. 

The bottom line

Deferred compensation offers an important means for retirement planning. Both qualified plans like 401(k) and 403(b), and non-qualified plans can feature tax advantages. Non-qualified deferred compensation plans offer a way around contribution and income limits of qualified plans, but they can be riskier. Having confidence in the financial security of the employer is key, because financial insolvency could mean the deferred compensation never gets paid.

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