How Is Deferred Compensation Paid Out?

Deferred compensation is an agreement between an employer and an employee to pay a portion of compensation at a future date. This arrangement is commonly extended to executives and other highly compensated employees as a benefit. Its primary purpose is to allow individuals to defer income, often until their tax rate might be lower, such as retirement. These plans are distinct from qualified retirement plans like 401(k)s, as they typically lack the same contribution limits and regulatory oversight under the Employee Retirement Income Security Act (ERISA).

Events Triggering Payouts

Deferred compensation payouts are initiated by specific events or conditions outlined in the plan agreement. These events are defined to ensure compliance with Internal Revenue Code Section 409A, which regulates nonqualified deferred compensation. A common trigger is a separation from service, occurring when an employee leaves the company, including retirement, resignation, or termination. A “separation from service” under Section 409A is generally considered to have occurred when the employer and employee reasonably anticipate that the employee will perform no further services, or that the level of services will permanently decrease to 20% or less of the services provided over the preceding 36 months.

Another trigger is a fixed date or a predetermined schedule for payouts. This allows employees to plan income streams for specific financial goals, such as a child’s college expenses or a bridge to retirement. For example, a plan might stipulate payments to begin on a participant’s 60th birthday or in five annual installments.

Payouts can also be triggered by a change in company control, such as a merger, acquisition, or a significant change in ownership. Section 409A provides specific definitions for what constitutes a “change in ownership or effective control” or a “change in the ownership of a substantial portion of the assets” of a corporation for these purposes. An employee’s disability or death are also permissible events that can trigger distributions. In limited circumstances, an unforeseeable emergency experienced by the employee may also allow for a payout.

Distribution Options

Upon a triggering event, deferred compensation can be distributed through various methods elected by the employee. A common option is a lump-sum payment, where the entire deferred amount is paid as a single sum. This provides immediate access to funds, which can be beneficial for large purchases or investments, but it can also result in a significant tax liability in the year of receipt, potentially pushing the recipient into a higher income tax bracket.

Alternatively, employees can elect to receive deferred compensation in installments. These payments are typically made over a predetermined period, such as 5, 10, or 15 years. Spreading out payments can help manage the tax burden by distributing income over multiple tax years, potentially lowering overall tax liability if the recipient’s income fluctuates or is lower in subsequent years. The remaining balance often continues to grow tax-deferred until each installment is paid. Some plans may even structure payments to resemble an annuity, providing a stable income stream over a longer duration, sometimes for the recipient’s lifetime.

Employee elections regarding the time and form of payment are subject to strict rules under Section 409A. An initial election to defer compensation and choose a distribution method must generally be made before the year in which services are performed. Once made, these elections are typically irrevocable. Section 409A permits subsequent changes to distribution elections under specific conditions. A new election cannot become effective for at least 12 months after it is made, and if the change relates to a fixed-time payment, the election must be made at least 12 months before the originally scheduled payment date. Furthermore, any change must defer the payment for a minimum of five additional years, unless the distribution is due to death, disability, or an unforeseeable emergency.

Tax Treatment of Distributions

The tax treatment of nonqualified deferred compensation (NQDC) distributions is an important aspect for recipients. Unlike qualified retirement plans, NQDC is generally taxed as ordinary income when actually received by the employee, or when it is made available without substantial risk of forfeiture. Distributions are subject to federal income taxes at the recipient’s regular income tax rates in the year of receipt. State and local income taxes may also apply, depending on the recipient’s state of residence.

For Federal Insurance Contributions Act (FICA) taxes, which include Social Security and Medicare taxes, a “special timing rule” applies to NQDC. FICA taxes are typically imposed at the earlier of when services are performed or when the deferred compensation is no longer subject to a substantial risk of forfeiture. This often means FICA taxes are due on deferred amounts before the actual income is paid out.

Employers are generally required to withhold applicable income tax and FICA/Medicare taxes from deferred compensation payouts. Distributed amounts are reported on Form W-2, with nonqualified deferred compensation distributions potentially appearing in Box 11 and Section 409A deferrals in Box 12 with Code Y.

Compliance with Section 409A is crucial, as non-compliance can lead to severe penalties for the recipient. If a deferred compensation plan fails to meet Section 409A requirements, all deferred compensation for current and prior taxable years becomes immediately taxable to the employee, regardless of whether it has been paid. In addition to immediate income inclusion, the employee may face a 20% excise tax on the deferred amount and an interest penalty accruing from the date the compensation should have been included in income. These penalties are imposed on the recipient, not the employer, highlighting the importance of proper plan design and administration.