Deferred Compensation

Deferred compensation is an arrangement where an employee elects to receive a portion of their earnings at a later date, typically after retirement, rather than in the current pay period. This strategy helps employees manage their tax obligations, allowing them to defer income taxes until the funds are actually received. Deferred compensation plans are often offered by employers to provide additional retirement savings options beyond traditional pension or 401(k) plans.

Key Features

• Tax Deferral: One of the main advantages of deferred compensation is the ability to delay tax payments until the funds are distributed. By postponing taxes, employees can reduce their current taxable income, potentially lowering their immediate tax liability and taking advantage of lower tax rates during retirement.
• Voluntary Participation: Employees typically choose to participate in a deferred compensation plan, and the contributions are deducted from their salary before taxes. The employer may also match a portion of the employee’s deferrals.
• Retirement Savings: Deferred compensation plans serve as a way to accumulate additional funds for retirement. Since the contributions grow tax-deferred, the balance can accumulate over time, providing a substantial benefit upon retirement.

Types of Deferred Compensation Plans

• Qualified Plans (e.g., 457(b) Plan): These plans adhere to IRS rules and are subject to contribution limits. The 457(b) plan, for example, is often available to government employees and certain non-profit sector workers. Contributions are made pre-tax, and the earnings grow tax-deferred until withdrawal.
• Non-Qualified Plans: Unlike qualified plans, non-qualified deferred compensation (NQDC) plans do not have the same contribution limits or regulatory restrictions. These are often used to provide additional retirement savings options for highly compensated employees. However, non-qualified plans do carry certain risks, such as potential forfeiture of benefits if the employee leaves the company early.

Benefits

• Retirement Planning: Deferred compensation provides a strategic way for employees to save more for retirement, especially for those who have already maximized other retirement plan contributions.
• Employer Attraction: Offering deferred compensation as part of the benefits package can make an employer more attractive to top talent, particularly in industries where retirement savings can be a significant concern.
• Control Over Timing: Employees can typically decide when they want to access their deferred compensation, which provides flexibility in managing income during retirement or other financial goals.

Considerations

• Risk of Forfeiture: In some non-qualified plans, employees risk losing their deferred compensation if they leave the company or fail to meet other specified conditions.
• Creditor Risk: Non-qualified plans are considered part of the employer’s assets and may be subject to claims by creditors in the event of the company’s financial difficulties.
• Tax Implications: While tax deferral is a benefit, employees should be aware of the tax implications when they eventually withdraw the funds, as they will be taxed as ordinary income upon receipt.