Deferred Compensation Definition: What It Means and How It Works

Deferred compensation is an integral part of many employee benefit packages, enabling individuals to plan their financial future by postponing income to a later date. This arrangement benefits both employees and employers by offering flexibility in managing tax liabilities and retirement planning.

Eligibility Requirements

Eligibility for deferred compensation plans depends on the type of plan and employer policies. Nonqualified deferred compensation (NQDC) plans are typically designed for key executives or highly compensated employees. Governed by Section 409A of the Internal Revenue Code, these plans do not need to be offered to all employees but must adhere to specific timing and distribution rules.

Qualified deferred compensation plans, such as 401(k) plans, are subject to the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. These regulations require inclusivity, ensuring such plans are available to a broad group of employees. Employers must conduct annual tests, like the Actual Deferral Percentage (ADP) test, to confirm compliance and prevent benefits from disproportionately favoring higher-paid employees.

Types of Plans

Deferred compensation plans are classified into nonqualified and qualified plans, each governed by distinct regulatory frameworks.

Nonqualified Plans

NQDC plans provide flexibility in deferring income, mainly benefiting executives and high earners. These plans are not bound by the same regulatory requirements as qualified plans, allowing employers to customize them for specific individuals or groups. Under Section 409A, NQDC plans must follow rules about deferral elections and distribution timing. For instance, deferral elections generally need to be made before the year the services are performed. While NQDC plans offer tax deferral benefits, they carry risks, as deferred amounts are unsecured liabilities of the employer. In cases of bankruptcy, participants may not receive their funds.

Qualified Plans

Qualified deferred compensation plans, including 401(k) and 403(b) plans, must meet ERISA and Internal Revenue Code requirements to offer tax advantages. These plans are inclusive, adhering to nondiscrimination rules, and often feature employer matching contributions to boost retirement savings. Contributions are tax-deferred, meaning taxes are paid upon distribution, which can be advantageous for those in higher tax brackets. However, these plans are subject to annual contribution limits—$22,500 for individuals under 50 in 2023, with an additional $7,500 catch-up contribution for those 50 and older.

Vesting Periods

Vesting periods determine when employees gain full ownership of employer-promised benefits. In qualified plans like 401(k)s, vesting schedules encourage employee retention. Employers may use a cliff vesting schedule, where employees become fully vested after a specific period, or a graded vesting schedule, which gradually increases the vested percentage over time. For instance, a graded schedule might vest 20% after two years, reaching 100% after six years.

In nonqualified plans, vesting terms are more flexible and often negotiated between the executive and employer. This allows for customized arrangements aligned with strategic goals. However, the lack of statutory protection in nonqualified plans means employees must assess their employer’s financial stability when considering these arrangements.

Vesting also affects tax planning. Vested amounts are typically taxable in the year they become non-forfeitable, requiring strategic planning to manage tax liabilities, particularly for individuals with significant deferred compensation.

Distribution Methods

Distribution methods dictate how and when employees receive their deferred compensation. Options often include lump-sum payments or periodic installments. Lump-sum distributions provide immediate access to funds but can lead to substantial tax liabilities. Periodic installments spread the tax burden over several years, potentially reducing the overall tax impact by keeping the recipient in a lower tax bracket.

Distribution timing is influenced by life events such as retirement, reaching a certain age, or meeting service requirements. For qualified plans, required minimum distributions (RMDs) must begin at age 73 under Internal Revenue Code Section 401(a)(9). Nonqualified plans allow more flexibility in timing, though they are still subject to Section 409A rules, which require predetermined and strictly adhered-to distribution events.

Tax Treatments

Tax treatment is a defining feature of deferred compensation plans, enabling participants to manage taxable income strategically. However, the tax implications differ between nonqualified and qualified plans.

For qualified plans, employee contributions are tax-deferred, reducing taxable income in the year of contribution. Employers benefit from deductible contributions as a business expense. Taxes on contributions and investment earnings are deferred until distribution, when they are taxed as ordinary income. Qualified plans also allow rollovers into other tax-advantaged accounts without immediate tax consequences, as permitted under Internal Revenue Code Section 402. However, early withdrawals before age 59½ incur a 10% penalty in addition to regular income tax, barring specific exceptions.

Nonqualified plans lack the same tax deferral advantages for employers. Contributions are not deductible until the employee recognizes the income, typically upon distribution. Employees are taxed on deferred amounts only when paid out but must comply with stringent Section 409A rules. Non-compliance can lead to immediate taxation of deferred amounts, a 20% additional tax, and interest penalties. Participants must carefully weigh the tax implications of their deferral elections, especially considering potential changes in tax laws or brackets.