Do You Pay Taxes on Deferred Compensation?

Yes, you pay taxes on deferred compensation, but the primary issue is not if you pay, but when. Deferred compensation is an arrangement where an employee earns compensation in one year but receives the payment in a future year. This strategy allows for the postponement of income tax until the money is paid out, often during retirement when an individual may be in a lower tax bracket.

The rules governing this tax deferral are precise and depend heavily on the type of plan involved. While the concept seems straightforward, the execution involves a complex interplay of tax types, timing rules, and regulatory requirements, where missteps can lead to significant tax consequences.

The Two Main Categories of Deferred Compensation

Deferred compensation arrangements fall into two broad categories: qualified and non-qualified plans. Qualified plans are the more common type and include familiar retirement vehicles like 401(k)s and 403(b)s. These plans are governed by the Employee Retirement Income Security Act (ERISA), which provides protections for employees.

Funds in a qualified plan must be held in a trust, separate from the employer’s assets, which shields the money from the company’s creditors. These plans must be offered to a broad base of employees.

In contrast, non-qualified deferred compensation (NQDC) plans are designed for key executives and highly compensated employees. These are contractual agreements where an employer promises to pay compensation in the future. Unlike qualified plans, NQDC plans are unfunded promises, meaning the assets remain part of the company’s general funds and are subject to the claims of its creditors. This structure is less secure for the employee but provides greater flexibility for the employer in designing the plan to attract and retain top talent.

Timing of FICA and Income Taxes for Non-Qualified Plans

A complex aspect of NQDC plans is the different timing for employment taxes and income taxes. For these plans, Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare, are handled differently than federal and state income taxes. This split-timing rule means taxes can be paid on money long before the employee receives it in cash. The distinction hinges on two concepts: “substantial risk of forfeiture” for FICA and “constructive receipt” for income tax.

FICA taxes are due at the later of two dates: when the services are performed, or when the compensation is no longer subject to a “substantial risk of forfeiture.” A substantial risk of forfeiture means the employee’s right to the money is conditioned on performing future services or meeting specific performance goals, which is commonly known as vesting. Once the money is vested, it becomes taxable for FICA purposes, even if the payout is scheduled for years later. The amount subject to FICA includes the original deferred amount plus any earnings accrued up to the vesting date.

For example, if an executive is granted $100,000 in deferred compensation in 2025 that vests in 2030, the FICA taxes on that amount are due in 2030. The employer will withhold the employee’s share of these taxes from their regular salary that year. Once FICA is paid on an amount, neither that principal nor any future earnings on it are subject to FICA again when distributed. This “non-duplication rule” prevents double taxation for FICA.

Federal and state income taxes are due only when the compensation is actually or constructively received. Constructive receipt occurs when funds are made available to the employee without substantial limitations or restrictions. For a properly structured NQDC plan, this does not happen until the pre-determined payment date, such as upon retirement or at a specified future date.

Continuing the example, while FICA taxes were paid in 2030, the income tax on the $100,000 plus all accumulated earnings is not due until it is paid out, perhaps in 2040. At that point, the full distribution is reported as ordinary income.

Key Rules for Tax Deferral Under Section 409A

To successfully defer income tax, NQDC plans must comply with the regulations in Internal Revenue Code Section 409A. This law imposes a rigid framework on NQDC plans, and failure to adhere to its rules can have severe financial consequences for the employee. Section 409A focuses on the timing of deferral elections and distributions.

A primary requirement is that an employee’s election to defer compensation must be made in writing during the calendar year before the year in which the services are performed. For instance, to defer a bonus earned in 2026, the employee must make that irrevocable election by December 31, 2025. This rule prevents employees from using hindsight to defer income.

Section 409A also strictly limits when deferred funds can be paid out. Payments can only be made upon the occurrence of one of six specific events:

• Separation from service
• A date specified at the time of deferral
• Death
• Disability
• An unforeseeable emergency
• A change in control of the company

The plan must specify the payment timing and form at the time of the initial deferral election, and these choices are difficult to change. For certain “specified employees” of public companies, payments triggered by a separation from service must be delayed for six months. The law also contains an anti-acceleration rule, which prohibits speeding up the payment of deferred amounts.

If a plan fails to comply with Section 409A, all compensation deferred under that plan for the current and all preceding years becomes immediately taxable. In addition, the employee is subject to a 20% federal penalty tax on the entire deferred amount, plus interest.

Reporting Deferred Compensation on Tax Forms

The tax timing rules for NQDC plans are reflected in specific boxes on an employee’s annual Form W-2. When NQDC vests and becomes subject to FICA taxes, the vested amount is included in Box 3 (Social Security wages), up to the annual wage base limit, and Box 5 (Medicare wages), which has no limit. This occurs in the year of vesting, even though no cash has been paid. The employer withholds the FICA taxes from the employee’s other cash wages paid during that year.

When the deferred compensation is eventually paid out, the full distribution is reported in Box 1 (Wages, tips, other compensation) and is subject to income tax withholding. The same amount is also reported in Box 11 (Nonqualified plans), which serves as an informational flag for the IRS.

The W-2 also uses codes in Box 12 to provide details. Code Y shows the amount of compensation an employee chose to defer during the current year. Code Z is used to report income under a plan that has failed to comply with Section 409A regulations.