What is deferred compensation

Deferred compensation is an arrangement in which an employee’s compensation, such as base salary, bonuses, or other forms of remuneration, is postponed to a future date instead of being paid immediately. 

As a compensation management technique, deferred compensation allows employees to delay receiving a portion of their compensation, usually in exchange for other benefits, such as tax advantages or the promise of a larger payout in the future.

Deferred compensation usually accumulates over time and is paid in a lump sum. Employers often establish deferred compensation plans for high-level executives and highly compensated employees. 

These plans may take many forms, such as Roth 401(k) plans, stock option plans, or non-qualified deferred compensation plans. The terms of these plans may vary widely and be subject to local restrictions and regulations.

One of the primary benefits of deferred compensation plans is that they allow employees to save for retirement and defer select income taxes. 

How deferred compensation works

A deferred compensation plan allows employees to delay receiving a portion of their compensation until a future date, usually retirement. The employee and employer agree on the plan’s terms, which typically include how much compensation will be deferred, when it will be paid out, and any conditions or restrictions that may apply.

Employees may choose to participate in a deferred compensation plan for various reasons, including tax benefits, retirement savings plans, and the ability to defer income until they are in a lower tax bracket (and pay a lower tax rate). The employee’s deferred income is not eligible to be taxed until the funds are received. 

These plans allow for tax-deferred asset growth without contribution limits. While the employee does not pay employment tax on deferred income, it’s important to note that they do pay Social Security and Medicare taxes at the time of deferral. The specific details of the deferred compensation plan depend on the type of plan established by the employer. 

Qualified vs. non-qualified deferred compensation plans

Most deferred compensation plans fall into one of two categories: qualified and non-qualified deferred compensation plans. Essentially, the main differences are the legal and regulatory requirements they are subject to, the types of benefits they provide, and their associated risks.

Qualified deferred compensation plans

Qualified plans, such as 401(k) plans, are subject to the Employee Retirement Income Security Act (ERISA) and other regulations. These plans are designed to provide retirement benefits to employees and are subject to specific contribution limits, vesting requirements, and distribution rules. 

Contributions to these plans are made pre-tax, meaning they are tax-deductible for the employer and not subject to income taxes for the employee until distributions are made. 

Non-qualified deferred compensation plans

Non-qualified plans, on the other hand, are not subject to the same legal and regulatory requirements as qualified plans. Also referred to as Section 409A, golden handcuffs, or NQDC plans, these plans are typically offered to highly compensated employees. They often provide additional retirement benefits beyond those offered by qualified plans. 

Non-qualified plans are more flexible, allowing for a broader range of contribution and distribution options. However, they are also riskier, as ERISA does not protect the deferred compensation and is subject to the employer’s financial health and ability to pay.

Types of deferred compensation plans

There are several different types of deferred compensation plans, each with unique features and benefits, including retirement plans, pension plans, and stock option plans. The following deferred compensation plans should be considered in compensation planning.

401(k) plans

A 401(k) plan can become a type of salary reduction arrangement where employees can elect to have a portion of their salary withheld from their paycheck and contributed to the plan on a pre-tax basis. This means the money is not subject to income taxes when deferred, which can provide immediate tax savings. Traditional IRA is another common tax-deferred retirement account.

Excess benefit plans

A salary excess benefit plan is a type of non-qualified deferred compensation plan that allows high earners to defer a portion of their income above the limit set by the IRS for qualified retirement plans, such as 401(k) plans. These plans are not subject to the same tax and regulatory requirements as qualified plans, so they offer more flexibility in plan design and contribution limits.

Supplemental Executive Retirement Plans (SERPs)

Supplemental Executive Retirement Plans (SERPs) are a type of non-qualified deferred compensation plan where companies choose to contribute funds into a supplemental retirement fund for employees to access upon retirement.

Stock option plans

Stock option plans allow employees to purchase company stock at a specific price in the future. With this plan, the company provides employees with a financial incentive to help the company succeed.

Phantom stock plans

Phantom stock plans give employees the right to receive a cash payment equal to the increase in the value of the company’s stock over a certain period. With this option, employees benefit from the company’s growth without owning stock.

Restricted Stock Units (RSUs)

With RSUs, employees can receive company stock at a future date, subject to specific vesting requirements. Similar to other stock options, RSUs can be used to incentivize employees to stay with the company for a longer period of time.

Cash balance plans

As a hybrid retirement plan, cash balance plans combine features of traditionally defined benefit and contribution plans. They allow employees to accumulate a retirement benefit based on a predetermined formula, and the benefit is typically expressed as a hypothetical account balance.

Bonus deferral plans

Bonus deferral plans are another type of deferred compensation plan, allowing employees to defer any bonuses they receive until a future date (and defer the tax on their bonus until they receive it).