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Dictionary

Understanding Deferred Compensation

Deferred compensation is an arrangement by which a portion of an employee's income is set aside, to be paid out at a later date. This financial term is commonly used in the context of retirement or executive compensation plans, allowing the employee to receive benefits upon meeting a specific condition – often retirement or leaving the company. In this guide, the concept behind deferred compensation will be explored, including its advantages, disadvantages, and common forms.

Why Choose Deferred Compensation?

Deferred compensation can be an attractive option for employees and employers alike. The primary benefit, from an employee's perspective, is that income can be deferred until later, when the individual might be in a lower tax bracket. This is a key tax planning strategy that allows individuals to save and invest money more effectively over time.

On the employer side, offering deferred compensation plans can be beneficial for retaining key employees, as it acts as an incentive for employees to stay with the company until the deferred income can be distributed. The company's cash flow can also be better managed, as the funds aren't paid out immediately but rather at a later time. This enables the company to invest in business development or expansion projects.

Types of Deferred Compensation Plans

There are several types of deferred compensation plans available for employers and employees to choose from. Two of the most common forms are non-qualified deferred compensation (NQDC) plans and qualified deferred compensation plans.

Non-Qualified Deferred Compensation (NQDC) Plans:

NQDC plans are typically offered to a select group of employees, such as executives or other highly compensated individuals. These plans are called "non-qualified" because they do not receive the same tax treatment as qualified plans, which are subject to specific regulations set forth by the IRS.

With an NQDC plan, employees can defer a portion of their income to be paid out at a later date, potentially when they are in a lower tax bracket. There is a considerable amount of flexibility in designing NQDC plans, allowing employers to structure them in a way that best meets their needs and objectives. The plan can include vesting schedules, choosing the timing and form of distributions, and specifics regarding events that trigger distributions, such as retirement, separation from service, or change in control of the company.

It is important to note that although NQDC plans can provide tax advantages to employees, these plans carry risks due to the fact they're considered unsecured obligations of the employer. If the company goes bankrupt, deferred compensation assets may be at risk.

Qualified Deferred Compensation Plans:

Qualified deferred compensation plans, such as 401(k)s and 403(b)s, have specific requirements and regulations laid down by the IRS. They must be made available to all employees who meet specific eligibility criteria, and contribution limits are set by the government.

Like NQDC plans, employees can defer a portion of their income into a qualified plan, potentially reducing their taxable income for the year in which the deferral is made. The funds in these accounts also typically grow on a tax-deferred basis. Upon withdrawal, the contributions and growth in the accounts will be taxed at the employee's income tax rate.

The Pros and Cons of Deferred Compensation

There are both advantages and disadvantages associated with deferred compensation plans, which should be considered before deciding whether to participate in one.

Advantages of Deferred Compensation:

  • Income and tax deferral – By deferring income from a higher tax year, employees may potentially pay less tax on the compensation received at a later date.
  • Flexible plan design – Employers can tailor the plan to meet specific objectives and needs.
  • Incentive for employee retention – As deferred compensation plans can tie distributions to factors such as length of service or continued employment, they can encourage key employees to stay with the company.

Disadvantages of Deferred Compensation:

  • Employers' financial risk – As previously mentioned, funds in NQDC plans are considered unsecured assets, so employees may lose their deferred compensation should the company go bankrupt.
  • Limited liquidity – Deferred compensation plans typically limit the ability to access funds until specific events occur or conditions are met, which can create difficulty for those who need the money earlier.
  • Changes in tax rates or legislation – If tax rates or regulations change, the benefits of deferred compensation may be reduced or eliminated.

Conclusion

Deferred compensation is an important financial concept that offers potential benefits and risks for both employees and employers. When carefully considered and structured, these plans can be an effective tool for tax planning, talent retention, and retirement planning. Understanding the nuances and implications of deferred compensation can assist individuals in making informed decisions about whether participating in such a plan is the right choice for them.

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