Are Deferred Compensation Plans a Good Idea?

Deferred compensation plans represent a financial arrangement where an individual postpones receiving a portion of their income until a later date. These arrangements can be particularly appealing for those aiming to optimize their future tax situation or enhance their long-term savings. Understanding their structure and how they integrate with an individual’s broader financial objectives is important.

Defining Deferred Compensation Plans

Deferred compensation plans are typically categorized into two main types: qualified and non-qualified plans. Qualified plans, such as 401(k)s and pension plans, adhere to strict federal regulations under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC), offering specific tax benefits and protections for a broad base of employees. These plans are subject to contribution limits and non-discrimination rules, ensuring widespread employee participation.

In contrast, non-qualified deferred compensation (NQDC) plans are contractual agreements between an employer and an employee, falling outside most ERISA regulations. This distinction means NQDC plans offer greater flexibility in design and can be selectively offered to a limited group of employees, often executives or highly compensated individuals. NQDC plans allow participants to defer significant amounts of income, often exceeding the contribution limits of qualified plans. The core nature of an NQDC plan is that it is an employer’s unsecured promise to pay a future benefit.

Operational Mechanics of Deferred Compensation

NQDC plans begin with the employee’s election to defer income. This election typically must be made before the calendar year in which the compensation is earned to ensure tax deferral. The types of compensation that can be deferred include base salary, bonuses, and sometimes even stock-based awards. These deferrals are recorded in a notional account, which may grow based on a fixed rate or chosen investment options, similar to a 401(k).

NQDC plans involve vesting schedules, which determine when an employee’s right to deferred funds becomes non-forfeitable. Until vested, the deferred compensation can be subject to forfeiture if specific conditions, such as continued employment for a defined period, are not met. The plan document also outlines specific distribution triggers, which dictate when the deferred compensation will be paid out. Common triggers include separation from service (such as retirement), disability, death, or a specified future date.

NQDC plans are “unfunded” for tax purposes, meaning deferred amounts generally remain assets of the employer until distributed. This means the employee is an unsecured creditor of the employer, relying on the company’s financial stability for future payment. While employers may informally set aside assets, such as through a “rabbi trust,” these assets remain subject to the claims of the employer’s general creditors, distinguishing NQDC from qualified plans where assets are held in a separate trust for the employee’s sole benefit.

Tax Implications of Deferred Compensation

A key benefit of non-qualified deferred compensation is income tax deferral; tax is generally not due until compensation is received. This allows the deferred income, and any notional earnings on it, to grow on a tax-deferred basis, potentially shifting income to a period when the employee may be in a lower tax bracket, such as retirement. To maintain this tax-deferred status, NQDC plans must be carefully structured to avoid the “constructive receipt” doctrine. Constructive receipt occurs if income is made available to a taxpayer without substantial limitations or restrictions, even if not physically received, which would trigger immediate taxation. Plans are designed so that the employee does not have an unrestricted right to the funds before the agreed-upon distribution event.

While income tax is deferred, Federal Insurance Contributions Act (FICA) taxes—Social Security and Medicare—are generally due earlier. These employment taxes are typically assessed at the later of when the services creating the right to the deferred amount are performed, or when the right to the amount is no longer subject to a substantial risk of forfeiture (i.e., when it vests). This is known as the “special timing rule” for FICA taxation of NQDC. Consequently, employees may owe FICA taxes on deferred compensation years before they actually receive the income.

Upon distribution, the deferred compensation is typically taxed as ordinary income. This includes both the original deferred amount and any accumulated notional earnings. State income tax considerations also apply, as the deferred income will be subject to state taxes in the year of distribution, based on the tax laws of the state where the recipient resides at that time. Once FICA taxes have been paid on deferred compensation, the same amounts are generally not subject to FICA taxes again upon distribution, preventing double taxation.

Factors for Individual Assessment

Participation in a non-qualified deferred compensation plan involves several factors beyond immediate tax deferral. The employer’s financial health is a primary consideration, as NQDC plans represent an unsecured promise to pay. If the employer faces financial difficulties or bankruptcy, the deferred funds may be at risk, as employees become general creditors alongside other company obligations. This contrasts with qualified plans, where assets are held in a protected trust, generally safe from the employer’s creditors.

Limited liquidity and control over deferred funds is another important aspect. Once an election to defer is made, it is generally irrevocable, and access to the funds is restricted until a pre-determined distribution event. This lack of immediate access means individuals must ensure they have sufficient current liquidity to meet financial obligations without relying on the deferred income. The vesting schedule also warrants attention, as unvested amounts can be forfeited if employment conditions are not met, such as leaving the company before the vesting period concludes.

Individuals should also consider their anticipated future tax rates. While deferring income may be advantageous if one expects to be in a lower tax bracket in retirement, a rise in future tax rates could diminish the benefit. Aligning the deferral strategy with long-term financial planning goals, including expected income streams and expenses in retirement, is important. The investment options offered within the NQDC plan should also align with an individual’s risk tolerance and overall investment strategy, as the notional growth of deferred funds depends on these choices.