How to Set Up a Deferred Compensation Plan

Deferred compensation refers to an arrangement where an employee or executive agrees to receive a portion of their salary or bonus at a later date, typically upon retirement, termination, or another specified event. This approach allows individuals to postpone the taxation of income until it is received, potentially at a time when they are in a lower tax bracket. For employers, these plans serve as a valuable tool for attracting, retaining, and incentivizing key talent by offering benefits beyond standard compensation. Establishing such a plan requires careful consideration and planning to ensure it aligns with both organizational goals and regulatory compliance.

Choosing Your Deferred Compensation Plan Type

Establishing a deferred compensation plan begins with selecting the appropriate type, distinguishing between qualified and non-qualified plans. Qualified plans, such as 401(k) plans or profit-sharing plans, adhere to Internal Revenue Code (IRC) and Employee Retirement Income Security Act of 1974 (ERISA) guidelines. These plans offer significant tax advantages, including tax-deductible employer contributions and tax-deferred growth on investments for participants. They are subject to non-discrimination rules, benefiting a broad base of employees, not just highly compensated individuals.

Qualified plan contributions are limited by annual IRS ceilings. For instance, in 2025, the 401(k) elective deferral limit is $23,000, with a $7,500 catch-up for those aged 50 and over. Combined employer and employee deferrals are also subject to overall limits, such as $69,000 in 2025. These plans offer participants a range of investment options, with assets held in a trust for the exclusive benefit of employees.

Non-qualified deferred compensation (NQDC) plans, conversely, do not meet ERISA or IRC requirements, allowing for greater flexibility in their design. Examples include Supplemental Executive Retirement Plans (SERPs), Executive Bonus Plans, and salary deferral plans for a select group of management or highly compensated employees. These plans are not subject to the same non-discrimination rules or contribution limits as qualified plans, making them ideal for providing substantial benefits to a select group.

While NQDC plans offer design flexibility, they involve different tax treatments. Employee deferrals and employer contributions are not tax-deductible until the participant receives compensation. Participants do not pay income tax on the deferred amounts until they are distributed, but the employer holds the assets, and the employee is an unsecured creditor until distribution. Thus, deferred funds are subject to claims of the employer’s general creditors in bankruptcy, a risk absent in qualified plans.

Key Design Elements of Your Plan

Once a plan type is selected, the next step involves defining its design elements, which dictate how it operates and who benefits. Eligibility criteria determine which employees can participate. For qualified plans, eligibility rules are often broad to meet non-discrimination requirements, while non-qualified plans can be highly selective, targeting specific executives or management teams. This decision directly impacts the plan’s cost and its effectiveness in achieving retention goals.

The contribution structure outlines how funds are added to the plan. This can include employee salary deferrals, where a portion of compensation is set aside, or employer contributions, which may be discretionary, matching, or profit-sharing based. For example, an employer might match employee deferrals in a qualified plan or make a fixed annual contribution to a non-qualified plan. The chosen structure influences both the employer’s financial commitment and the participant’s incentive to join.

Vesting schedules determine when participants gain full, non-forfeitable ownership of the contributions made to their deferred compensation accounts. Common vesting options include:
Immediate vesting, where ownership is granted immediately.
Graded vesting, where ownership increases incrementally over time (e.g., 20% per year over five years).
Cliff vesting, where full ownership is granted only after a specific period (e.g., three years of service).
A well-designed vesting schedule can encourage employee longevity and retention.

Distribution triggers specify events for deferred compensation payout. These events include retirement, termination, disability, death, or company change of control. Non-qualified plans also allow for distributions upon a specified date or a fixed schedule, offering additional flexibility. Defining these triggers is important for compliance with tax regulations, especially for non-qualified plans.

Finally, the funding mechanism addresses how the deferred compensation obligation will be financed and secured. For qualified plans, assets are held in a separate trust, protecting them from the employer’s creditors. For non-qualified plans, common methods include:
Holding funds in the company’s general assets.
Using a rabbi trust, where funds are set aside but remain subject to the employer’s creditors.
Corporate-owned life insurance (COLI) to informally fund the obligation.
The choice of funding mechanism impacts both the security of the deferred funds for the participant and the tax implications for the employer.

Understanding Legal and Regulatory Requirements

Navigating the legal and regulatory landscape is a step in establishing a deferred compensation plan, as compliance dictates legality and tax treatment. Qualified plans are primarily governed by ERISA, which imposes requirements regarding reporting, disclosure, and fiduciary duties. ERISA mandates that plan fiduciaries act solely in the best interest of plan participants and beneficiaries, diversifying investments to minimize risk. Plans must also adhere to specific participation and vesting rules, ensuring broad employee coverage and fair access to benefits.

Beyond ERISA, qualified plans must comply with various sections of the IRC. These sections dictate contribution limits, non-discrimination testing to prevent disproportionate benefits for highly compensated employees, and rules for employer contributions’ tax-deductibility. For instance, Section 401(a) outlines the general requirements for qualified plans, while Section 415 sets the maximum contribution limits. Failure to meet these requirements can result in disqualification of the plan, leading to adverse tax consequences for both the employer and participants.

Non-qualified deferred compensation plans, while exempt from most ERISA provisions, are primarily governed by Section 409A. This section imposes rules on deferral election timing, distribution triggers, and prohibitions against accelerating or delaying payments. For example, deferral elections must be made in the year prior to service performance, and distribution events must be clearly defined and limited to specific circumstances like separation from service, death, disability, or change of control.

Non-compliance with Section 409A can lead to penalties, including immediate taxation of deferred amounts, an additional 20% excise tax, and interest. Adherence to Section 409A is important for non-qualified plans. Beyond federal regulations, some state laws may also apply, particularly regarding contract law principles that govern the agreement between the employer and the employee for NQDC plans.

Formalizing Your Plan Documentation and Filings

Formalizing a deferred compensation plan involves documentation and proper governmental filings, transforming design decisions into legal instruments. The primary document is the Plan Document or Agreement, which outlines plan features. This includes provisions on eligibility, contribution formulas, vesting schedules, and distribution events. For qualified plans, this document also names fiduciaries and their responsibilities, while for non-qualified plans, it specifies the funding mechanism and the rights of participants as unsecured creditors.

If the plan utilizes a trust, such as a rabbi trust or qualified plan trust, a separate Trust Agreement must be drafted. It details trustee duties, assets, and distribution conditions. For qualified plans, a Summary Plan Description (SPD) is also mandatory; this plain-language document explains plan provisions, participant rights, and claims procedures, ensuring employees understand their benefits. For non-qualified plans, clear employee communications, though not formally an SPD, are equally important.

Several IRS forms are required during the setup phase. An EIN is necessary if a new trust entity is established. Qualified plans may file for a determination letter using the Form 5300 series, an optional step to obtain IRS approval. Additionally, initial Form 5500 series filings are required for qualified plans with 100 or more participants, reporting on financial condition and operations to the DOL and IRS.

Once all documents are drafted, a review and approval process occurs. This involves internal legal counsel, external benefits attorneys, and management to ensure accuracy and compliance. For many plans, especially those impacting executive compensation, a formal board resolution is necessary to authorize establishment. Finally, required forms are submitted to authorities like the IRS or DOL. Participants are then notified of the plan’s establishment and eligibility.

Managing Your Plan After Setup

Effective management of a deferred compensation plan extends well beyond its initial setup, requiring continuous administrative and compliance oversight. Accurate recordkeeping is important, requiring accurate participant records. This includes tracking individual contributions and deferrals, monitoring investment performance (if applicable), and documenting all plan distributions. Records are important for tax reporting, audits, and accurate benefit calculations over time.

Ongoing reporting requirements are also a responsibility. For qualified plans, annual Form 5500 series filings are mandatory, providing information on financial status, investments, and operations to the DOL and IRS. For non-qualified plans, tax reporting involves issuing W-2 forms for deferred wages or 1099-NEC forms for independent contractors, ensuring proper income recognition and withholding in the year of distribution. These filings must be timely to avoid penalties.

Continuous compliance monitoring is important to ensure the plan remains in adherence with all applicable laws and regulations, including ERISA (for qualified plans) and Section 409A (for non-qualified plans). Regular reviews of operations, elections, and distribution triggers against legal standards help identify and rectify issues, preventing non-compliance. This proactive approach minimizes the risk of costly penalties and adverse tax consequences.

Distribution processes must be clearly defined and consistently followed according to plan terms. This involves verifying qualifying distribution events (e.g., retirement or termination), calculating payouts, and ensuring timely payments. Adhering to the plan’s distribution schedule is important for maintaining participant confidence and avoiding regulatory issues.

Finally, plan documents may require amendments over time due to changes in regulations, business needs, or participant demographics. New IRS guidance or legislative changes might necessitate updates to contribution or distribution rules. Employers should have a clear process for reviewing the plan document periodically, annually, and making necessary amendments, which often require formal approval and communication to participants.