Is Deferred Compensation a Good Idea?

Deferred compensation is a financial arrangement where an employee agrees to receive a portion of their earnings at a future date, rather than when the income is initially earned. The primary intent is to delay income recognition for various financial planning objectives, allowing for a structured approach to managing income streams over an extended period.

Understanding Deferred Compensation

Deferred compensation is an agreement between an employer and an employee to pay a portion of current earnings at a later time, often upon retirement or separation from service. This arrangement can be broadly categorized into qualified and non-qualified plans. Qualified plans, such as 401(k)s and traditional pensions, adhere to strict Internal Revenue Service (IRS) regulations and are generally covered by the Employee Retirement Income Security Act (ERISA), which establishes minimum standards for retirement and health plans.

Non-qualified deferred compensation (NQDC) plans do not fall under ERISA’s protections and are often offered to a select group of management or highly compensated employees. These contractual agreements allow for greater flexibility in design and do not have the same contribution limits as qualified plans. In an NQDC arrangement, an employee defers a specific amount or percentage of compensation, and a deferral schedule outlines when and how funds will be paid out. The deferred funds generally remain assets of the employer until distributed, meaning they are subject to the claims of the employer’s general creditors.

Tax Implications of Deferred Compensation

The tax treatment of deferred compensation is a primary consideration. A central principle allowing for tax deferral is the “constructive receipt” doctrine. This doctrine holds that income is taxable when made available to a taxpayer without substantial limitations or restrictions, even if not physically received. Properly structured plans avoid constructive receipt, meaning income is not taxed until actually paid out. This allows for income to be taxed at a lower individual income tax bracket if an individual anticipates being in a reduced tax bracket during retirement or distribution.

While income tax is deferred, deferred compensation is generally subject to Federal Insurance Contributions Act (FICA) taxes, including Social Security and Medicare taxes, at an earlier point. For NQDC plans, FICA taxes are typically applied at the later of when services are performed or when the deferred amount is no longer subject to a substantial risk of forfeiture, such as upon vesting. This is known as the “special timing rule” for FICA purposes. Once FICA taxes are accounted for under this rule, neither that amount nor any subsequent earnings are subject to FICA taxes again upon distribution, under the “non-duplication rule.”

Assessing Individual Suitability

Evaluating whether deferred compensation aligns with one’s financial strategy involves reviewing personal circumstances and plan terms. Consider how deferring income fits into your broader financial goals, such as long-term wealth accumulation or specific financial milestones. The illiquid nature of deferred compensation means it typically cannot be accessed before the predetermined distribution date, impacting immediate cash flow.

Your current and projected tax situation warrants careful analysis. If you are in a high tax bracket during your earning years and anticipate a lower tax bracket in retirement, deferring income may reduce your overall tax liability. Understanding the employer’s financial health and stability is also important, particularly for non-qualified plans where deferred funds remain an unsecured asset of the company. In the event of employer financial distress or bankruptcy, these funds may be at risk as participants are considered general creditors.

Reviewing the vesting schedule associated with deferred compensation is another important step. Vesting schedules define when an employee gains full ownership of the deferred funds. These can range from immediate vesting to “cliff vesting,” where full ownership occurs after a specific period, or “graded vesting,” where a percentage vests incrementally over time. Forfeiture risk exists if an employee leaves the company before the deferred compensation is fully vested.

Deferred Compensation and Other Retirement Options

Deferred compensation plans function differently from common retirement savings vehicles like 401(k)s, Individual Retirement Accounts (IRAs), and traditional pensions. These conventional options often have specific contribution limits set by the IRS.

Deferred compensation, especially non-qualified plans, typically does not have statutory contribution limits, allowing individuals to defer larger amounts of income than permitted in qualified plans. Qualified plans generally offer tax advantages such as pre-tax contributions and tax-deferred growth, similar to deferred compensation, but also provide robust legal protections under ERISA. Funds in qualified plans are typically held in separate trusts, shielding them from the employer’s creditors. In contrast, non-qualified deferred compensation is generally considered an unsecured promise from the employer, meaning funds are not held in a separate protected account.

While 401(k)s and IRAs often offer portability, allowing funds to be rolled over to other retirement accounts when changing employers, non-qualified deferred compensation plans generally lack this feature. This means deferred funds remain tied to the original employer until distribution, which can affect financial flexibility during career transitions. Deferred compensation can complement other retirement savings by providing an additional avenue for high-income earners to defer taxes on compensation beyond the limits of traditional retirement plans.