What is Deferred Compensation?

Deferred compensation refers to an agreement where some part of an employee’s earnings are held back and paid at a future date instead of being given when the earnings are made. 

This strategy is often used as a part of an overall compensation package, particularly for high-earning employees or executives. It can be an effective tool for both employee retention and tax planning. 

What are the Types of Deferred Compensation?

Deferred compensation plans are of two types, namely qualified and non-qualified. They are designed to allow employees to earn wages, bonuses, or other compensation in one year but receive the earnings in a future year, providing potential tax and retirement benefits. 

1. Qualified Deferred Compensation Plans

Qualified plans are those that comply with the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. 

They offer tax benefits to participants and must be made available to all employees of a company, ensuring nondiscrimination. Contributions to these plans are typically tax-deductible for the employer, and tax-deferred for the employee. 

The funds grow tax-free until they are withdrawn, usually at retirement when the participant may be in a lower tax bracket.

Examples 

• 401(k) Plans, perhaps the most well-known type of deferred compensation plan, allows employees to defer a portion of their salary, which is invested based on the employee’s selections. Employers may match contributions to a certain percentage.
• 403(b) Plans are similar to 401(k) plans but specifically for employees of public schools, certain non-profits, and some ministers.
• 457 Plans offered by state and local government entities, as well as certain non-profits, allowing employees to defer compensation.
• Traditional Pension Plans that provide a defined benefit to retirees, calculated based on factors like years of service and salary history.

2. Non-Qualified Deferred Compensation Plans (NQDC)

Non-qualified deferred compensation plans are not subject to the same ERISA regulations as qualified plans. This means they can be more flexible but also come with higher risks. 

NQDCs are often targeted at executives or highly compensated employees to provide benefits beyond those allowed in qualified plans.

Examples 

• Deferred Savings Plans allow employees to defer a portion of their salary or bonuses to a future date, often with employer matching contributions.
• Supplemental Executive Retirement Plans (SERPs) provide retirement benefits to selected executives above and beyond those covered by the company’s standard retirement plans.
• Executive Bonus Plans involve the employer paying life insurance premiums on behalf of the employee, who is the policy owner. The cash value of these policies can be accessed by the employee at a later date as deferred compensation.
• Phantom Stock Plans give employees the right to receive bonuses equivalent to the value of the company’s stock, without actually giving them the stock or equity stake.

A Glance at the Benefits of Deferred Compensation

Deferred compensation plans offer a unique blend of advantages that can be appealing to both employers and employees. It can also serve as a strategic tool for financial planning and benefit optimization. 

Let us understand how deferred compensation creates a win-win scenario for the workplace ecosystem.

Enhanced Financial Planning and Flexibility

One of the striking benefits of deferred compensation is the enhanced financial planning and flexibility it offers. By deferring part of their income, employees can plan for large future financial needs more effectively, whether that’s retirement, education funds, or big-ticket purchases. 

Such flexibility in planning allows individuals to tailor their compensation in a way that best suits their personal and family needs over time.

Tax Advantages

Deferred compensation plans come with significant tax advantages that benefit both sides of the employment equation. 

For employees, deferring income to a future date often means that the income will be taxed at a lower rate, especially if they fall into a lower tax bracket upon retirement. The deferral of taxes on this income can also mean that the investment grows tax-deferred over time. This can significantly increase the value of the savings due to compounding.

Employers also stand to gain from tax-related benefits. Contributions made to qualified plans are generally deductible when made, which can reduce the taxable income of the business. 

This dual advantage helps make deferred compensation plans an attractive component of a comprehensive compensation strategy.

Attracting and Retaining Talent

In a competitive job market, attracting and retaining top talent is a priority for employers. Deferred compensation plans can be a main ingredient of an attractive benefits package that sets a company apart. 

For high-earning employees or individuals in executive positions, the prospect of tax-efficient savings and retirement benefits can be a powerful incentive to join or stay with a company.

For employees, the promise of future financial stability and the perception of being valued highly by their employer can enhance job satisfaction and loyalty. In this way, deferred compensation acts as a tool for career engagement and motivation.

Risk Management and Cost Control

From an employer’s perspective, deferred compensation plans can also offer a degree of risk management and cost control. 

Companies can better control their money by delaying some salary payments until their financial situation is stronger. Also, although non-qualified deferred compensation plans may not save as much in taxes as qualified plans, they give companies more freedom to decide which key employees to offer these plans to, focusing on those who are crucial for the business’s success.

What You Need to Consider?

• The plan must clearly define when payouts will occur, such as at retirement, upon reaching a specific age, or at predetermined dates.
• Besides retirement, plans can define other events that trigger a payout, like disability, death, or a change in control of the company.
• Employees typically must decide to defer compensation before earning it, often in the previous year.
• NQDC plans, while less regulated than qualified plans, still must comply with specific IRS rules, particularly those outlined in Section 409A of the Internal Revenue Code to avoid penalties.
• Plans may offer various investment options where the deferred funds can be allocated, affecting the growth of the deferred amount.

Get Reliable Expert Assistance With All of Your Payroll Management Needs

Deferred compensation is a complex but potentially rewarding strategy that can benefit both employers and employees. 

However, it’s critical for both parties to understand the terms, benefits, and risks involved. Employees considering deferred compensation should also consult with a financial advisor or tax professional to ensure that this approach aligns with their overall financial and retirement planning strategy.

To best manage your payroll, partner with the leading talent acquisition and payroll management company, Tarmack. Our comprehensive suite of HR solutions helps businesses not just streamline their recruitment process but also hire and retain the best professionals across geographies with proven talent management strategies. Here’s how you can get started!