How Does Deferred Compensation Work?
In a deferred compensation plan, employees agree to delay a portion of their income, usually until retirement, thus reducing their current taxable income. This deferred income is then invested by the employer in a tax-deferred account, allowing it to grow over time. Upon retirement or reaching a specific date, employees can start withdrawing from their deferred compensation plan, paying taxes at that point.
Here’s an example to illustrate how deferred compensation works:
A high-level executive at a tech company earns an annual salary of $250,000. To reduce their taxable income now and prepare for retirement, the executive and their employer agree to defer 10% of their salary ($25,000) annually into a Nonqualified Deferred Compensation (NQDC) Plan.
The deferred funds are invested by their employer in one of several investment options, allowing them to grow tax-free over time. By the time the tech executive retires, their deferred compensation, with accumulated interest and investment gains, has grown to $350,000.
After the executive retires, they begin receiving their deferred compensation in installments. Since their retirement income is likely lower than their working income, they pay taxes on the deferred compensation at a lower tax rate, helping them keep more of their money.
Types Of Deferred Compensation Plans
Deferred compensation plans come in several types, each with unique structures, benefits, and regulations. Each type of deferred compensation plan serves different needs, with varying degrees of flexibility, tax advantages, and protections. Employers often choose plans based on company size, employee roles, and organizational goals. Here are the primary types of deferred compensation plans in the U.S. :
| Types Of Deferred Compensation Plans |
Description |
| Qualified Deferred Compensation Plans |
These include retirement savings plans such as 401(k)s, which are governed by the Employee Retirement Income Security Act (ERISA). Contributions to qualified plans are tax-deferred, often matched by employers, and protected by federal regulations. These plans also allow employee contributions up to annual limits set by the IRS. |
| Nonqualified Deferred Compensation (NQDC) Plans |
Common among executives and high-earning employees, NQDC plans allow employees to defer more income than what is allowed in a qualified plan. However, these plans are not protected under ERISA, meaning funds could be at risk if the employer faces financial issues. They also have fewer restrictions on contribution limits and withdrawals. |
| 457 Deferred Compensation Plans |
Primarily offered to state and local government employees, 457 plans allow for pre-tax contributions and tax-deferred growth. These plans share some similarities with 401(k)s but allow penalty-free withdrawals before retirement age under certain conditions, making them flexible for public-sector employees. |
| Supplemental Executive Retirement Plans (SERPs) |
Designed to supplement other retirement benefits, SERPs are employer-funded and offered to executives to provide additional retirement income. SERPs are typically nonqualified, meaning they lack the ERISA protections of 401(k) plans. |
What Is The Difference Between Deferred Compensation vs. Other Retirement Plans?
Retirement plans like 401(k)s, IRAs, and pensions are types of deferred compensation. These types of plans fall under Qualified Deferred Compensation Plans. These plans are designed for broad employee access and are regulated under tax and labor laws, encouraging retirement savings for most workers with tax benefits.
Deferred Compensation typically includes non-qualified plans where employees (often executives) defer a portion of their income to be received in the future, outside of strict government regulations. Common examples include non-qualified deferred compensation (NQDC) plans, often reserved for higher earners.
The Benefits Of Deferred Compensation For Employers
When used strategically, deferred compensation can act as a tool for employers to build a committed workforce, manage expenses, and provide tailored benefits for top talent. Here are some of the advantages deferred compensation plans can offer employers:
| Benefit |
Description |
| Talent Attraction and Retention |
Deferred compensation plans, particularly for executives and key employees, make companies more competitive by offering attractive benefits, helping to recruit and retain top talent. |
| Cost-Efficiency |
Unlike traditional retirement plans (such as 401(k) matching), deferred compensation plans often do not require immediate cash outlay, allowing employers to manage cash flow more effectively. |
| Tax Advantages |
Employers may receive tax benefits by deducting deferred compensation expenses when payments are made, typically at retirement, rather than when contributions are initially deferred. |
| Enhanced Employee Loyalty |
Deferred compensation plans often require employees to remain with the company for a specific period (vesting), increasing employee loyalty and reducing turnover among key personnel. |
| Customization for High-earners |
These plans offer flexibility in compensation structure, enabling employers to provide additional benefits to high earners who have exhausted traditional retirement plans. |
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