What Is Deferred Compensation?
Deferred compensation is an arrangement in which an employee or service provider receives a portion of their earned wages, bonuses, or other forms of remuneration at a later date than when it was earned. This financial mechanism falls under the broader category of executive compensation and retirement planning, primarily used to provide tax advantages or incentivize key personnel. While technically any delay in payment constitutes deferred compensation, the term most commonly refers to non-qualified plans that offer flexibility beyond traditional retirement plans regulated by the Employee Retirement Income Security Act (ERISA).
The core principle of deferred compensation involves an agreement where an employee postpones the receipt of certain earnings, thereby deferring the associated income tax until the funds are actually received in a future tax year47. This strategic deferral can be appealing to high-income individuals who anticipate being in a lower tax bracket during retirement or at the time of payout.
History and Origin
The concept of deferring compensation, particularly for retirement, has roots in various forms, including traditional pensions and early savings arrangements. In the United States, significant developments occurred with the introduction of specific tax code provisions. For instance, the Revenue Act of 1978 introduced Section 401(k), which allowed employees to choose to receive a portion of income as deferred compensation, establishing tax structures around it46. While Section 401(k) plans became widely adopted as qualified retirement plans, the legislative framework also paved the way for non-qualified deferred compensation arrangements, often designed to supplement the more restrictive qualified plans for highly compensated employees. These non-qualified plans gained prominence as a flexible tool for employers to attract and retain top talent by offering additional tax advantages and savings opportunities44, 45.
Key Takeaways
- Deferred compensation allows an employee to delay receiving a portion of their pay until a future date, often post-retirement.
- The primary benefit is typically the deferral of income tax until the compensation is paid out.
- Non-qualified deferred compensation plans are not subject to the same strict ERISA regulations as qualified plans, offering greater flexibility in design and eligibility43.
- A significant risk for employees is that non-qualified deferred compensation may be subject to the employer's creditors if the company faces financial distress or bankruptcy41, 42.
- These arrangements are commonly used as a tool for attracting and retaining highly compensated employees and executives40.
Interpreting Deferred Compensation
Interpreting deferred compensation primarily involves understanding its tax implications and the associated risks. For the employee, the key benefit is the deferral of taxable income to a later date. This can be advantageous if the individual expects to be in a lower tax bracket at the time of distribution, potentially reducing their overall tax burden. However, careful financial planning is essential, as future tax rates are uncertain.
From the employer's perspective, deferred compensation is a valuable tool for talent management. It allows companies to provide competitive compensation packages, particularly for executives, without immediate cash outflow and often with the added benefit of retaining key personnel due to vesting schedules39. The company typically cannot deduct the deferred amounts as an expense until they are paid to the employee38.
Hypothetical Example
Consider Sarah, a highly compensated executive at Tech Innovate Inc. She earns an annual salary of $500,000 and typically receives a $100,000 annual bonus payments. Tech Innovate offers a non-qualified deferred compensation plan. Sarah, anticipating that her income will be lower in retirement, elects to defer 50% of her annual bonus, or $50,000, into this plan for five years.
For the current year, Sarah receives $500,000 in salary and $50,000 of her bonus, totaling $550,000, which is currently taxable. The deferred $50,000 is not taxed in the current year. This amount, along with any hypothetical earnings, will accumulate within the plan, typically based on an investment crediting rate specified by the company.
Upon her agreed-upon retirement date in five years, Sarah will begin to receive her deferred compensation, along with any growth. If the plan specifies a lump-sum payout, she would receive the accumulated $250,000 (five years of $50,000 deferrals) plus earnings at that time, and this entire amount would then become subject to income tax. This illustrates how deferred compensation can help manage an individual's tax liability over time.
Practical Applications
Deferred compensation plans are widely used in various financial contexts, primarily for high-earning individuals and corporate executives. One significant application is in providing supplemental retirement benefits beyond the limits of traditional defined contribution plans like 401(k)s or defined benefit plans36, 37. Employers often use these plans to attract and retain key talent by offering additional tax-advantaged savings opportunities that align with their overall wealth management strategies35.
Another practical application is in structuring equity awards, such as stock options or restricted stock units, where the payout or vesting might be tied to future events or performance metrics, effectively deferring the income34. Companies also utilize deferred compensation arrangements to align executive incentives with long-term corporate goals. For example, a significant portion of an executive's compensation might be tied to performance over several years, with the payout deferred until those targets are met, fostering greater loyalty and commitment33. The Internal Revenue Service (IRS) provides detailed guidance on the rules governing non-qualified deferred compensation plans under Section 409A of the Internal Revenue Code, which dictate the timing of deferral elections and distributions to ensure compliance and maintain tax-deferred status [3, 5, 9, irl.gov].
Limitations and Criticisms
Despite their advantages, deferred compensation plans, particularly non-qualified ones, come with notable limitations and criticisms. A primary concern for employees is the "unfunded" nature of many non-qualified plans. This means the deferred amounts are typically not held in a separate trust but remain part of the employer's general assets, making the employee an unsecured creditors of the company32. Consequently, if the employer experiences financial distress, bankruptcy, or insolvency, the employee risks losing some or all of their deferred compensation29, 30, 31. Unlike qualified plans, which are protected by ERISA, non-qualified plans lack these protections28. This inherent risk means that careful due diligence on the employer's financial health is a critical component of personal risk management for participants27.
Another criticism revolves around the lack of portability. If an employee leaves the company before the agreed-upon payout date or triggering event, they may forfeit some or all of their deferred benefits, a feature sometimes referred to as "golden handcuffs"25, 26. Furthermore, while tax deferral is a significant benefit, the employee does not have immediate access to the funds, which can be a drawback if liquidity is needed for unforeseen circumstances24. Tax laws, such as Section 409A, impose strict rules on election, distribution, and funding, and failure to comply can result in immediate taxation and significant penalties for the employee, not the employer22, 23. Additionally, for the employer, deductions for deferred compensation are generally not available until the employee recognizes the income, which can impact the company's current tax planning20, 21.
Deferred Compensation vs. Qualified Retirement Plan
Deferred compensation is often contrasted with a qualified retirement plan, such as a 401(k) or 403(b). The fundamental difference lies in their regulatory framework and tax treatment.
| Feature | Deferred Compensation (Non-Qualified) | Qualified Retirement Plan (e.g., 401(k)) |
|---|---|---|
| Regulation | Not subject to most ERISA rules; governed by IRS Section 409A | Governed by ERISA and specific IRS codes (e.g., 401(k)) |
| Eligibility | Highly compensated employees, executives, select groups19 | Broadly available to most employees; non-discrimination rules apply18 |
| Contribution Limits | Generally no IRS-imposed limits, customizable16, 17 | Strict annual contribution limits set by IRS |
| Asset Protection | Unfunded; subject to employer's general creditors in bankruptcy14, 15 | Assets held in a separate trust; protected from employer's creditors12, 13 |
| Employer Deduction | Employer deducts when employee receives income10, 11 | Employer deducts contributions when made9 |
| Portability | Often limited; may be forfeited upon leaving7, 8 | Generally portable (e.g., rollovers to IRAs)6 |
Confusion often arises because both types of plans involve delaying the receipt of income, leading to tax advantages. However, qualified plans are designed with broader employee participation and robust asset protection in mind, while non-qualified deferred compensation offers greater flexibility for employers to tailor benefits for a select group, albeit with increased risk to the employee's deferred funds.
FAQs
Is deferred compensation considered taxable income?
Deferred compensation is not considered taxable income for the employee until the funds are actually received in a future tax year, assuming the plan complies with IRS Section 409A rules [2, 8, irl.gov].
Who typically uses deferred compensation?
Deferred compensation plans are primarily offered to and used by highly compensated employees, executives, and other key personnel within a company, as they allow for deferrals beyond the limits of qualified retirement plans5.
Are deferred compensation plans protected in bankruptcy?
No, non-qualified deferred compensation plans are generally not protected in the event of the employer's bankruptcy. The deferred funds are typically part of the company's general assets and are subject to the claims of the employer's unsecured creditors3, 4.
Can I take a loan from a deferred compensation plan?
Unlike some qualified retirement plans, employees generally cannot take loans from non-qualified deferred compensation plans. These plans also typically do not allow for rollovers into an IRA or other tax-deferred retirement vehicle upon distribution2.
What are FICA taxes in relation to deferred compensation?
FICA taxes (Social Security and Medicare taxes) on deferred compensation are typically due at the earlier of when the services are performed or when there is no longer a substantial risk of forfeiture regarding the employee's right to the deferred amounts1. This is different from income tax, which is deferred until actual receipt.