Is Deferred Compensation a Retirement Plan?

While many use deferred compensation plans to save for retirement, they are not “retirement plans” in the same way as a 401(k). The differences in their structure affect an individual’s financial security and tax planning. The regulatory framework, security of the funds, and the rules for taxation and distributions separate these two types of arrangements. A deferred compensation plan’s utility and risks can only be assessed by comparing it to a traditional retirement plan, as they represent a different approach to saving for the future.

The Framework of Qualified Retirement Plans

Qualified retirement plans, such as 401(k)s, 403(b)s, and traditional pension plans, are defined by their adherence to the Employee Retirement Income Security Act of 1974 (ERISA). This federal law was established to protect employee retirement savings by setting minimum standards for most voluntarily established retirement plans in private industry. A central protection under ERISA is the requirement that plan assets be held in a trust, separate from the employer’s general assets. This segregation of funds ensures that the money you save for retirement cannot be claimed by your employer’s creditors in the event of business difficulties or bankruptcy.

ERISA also imposes non-discrimination rules. These rules require that the plan be offered to a broad base of employees, not just executives or highly compensated individuals. The Internal Revenue Service (IRS) also sets annual limits on how much an individual and an employer can contribute to these plans.

Defining Non-Qualified Deferred Compensation Plans

In contrast, a Non-Qualified Deferred Compensation (NQDC) plan is a contractual agreement between an employer and an employee to pay a portion of their compensation at a future date. These are often used to provide additional retirement savings for key executives and other highly compensated employees who may have reached the contribution limits of their qualified plans. The term “non-qualified” signifies that these plans do not meet the requirements of ERISA.

By operating outside of the ERISA framework, employers gain flexibility and are not bound by non-discrimination rules. This allows them to be selective and offer these plans exclusively to a select group of management or highly compensated employees. This structure allows for a high degree of customization, but this flexibility comes at the cost of the protections and security that are hallmarks of qualified retirement plans.

Key Distinctions in Funding and Security

The most significant difference between qualified and non-qualified plans lies in how they are funded and the security provided to the employee. Most NQDC plans are considered “unfunded,” meaning the compensation you defer is not set aside in a separate, protected account. Instead, it remains a general asset of the company, and the plan represents an unsecured promise from your employer to pay you in the future. This creates the primary risk associated with NQDC plans: if the employer experiences financial distress or files for bankruptcy, the employee becomes a general unsecured creditor. In a bankruptcy proceeding, there is a risk that the employee could lose their entire deferred compensation.

Some employers use a vehicle known as a “rabbi trust” to hold assets intended to pay for NQDC benefits. While this provides some assurance that the funds are available, a rabbi trust is still subject to the claims of the employer’s creditors in the event of insolvency. This stands in contrast to a qualified plan, where your retirement savings are held in a legally protected trust.

Taxation and Distribution Differences

The tax treatment and distribution rules for NQDC plans are also different from those of qualified plans. A unique aspect of NQDC taxation involves the timing of payroll taxes (FICA) versus income taxes. For NQDC plans, FICA taxes for Social Security and Medicare are due when the services are performed or when the compensation vests. This means an employee might pay FICA taxes on deferred money years before they actually receive it. Federal and state income taxes, however, are deferred until the employee receives the cash distribution from the plan.

This deferral is governed by the rules of Internal Revenue Code Section 409A. Section 409A imposes requirements on when and how distributions can be made.

An employee must make an irrevocable election regarding the timing and form of their payments before the compensation is earned. Changing this election is highly restricted; for instance, a subsequent deferral must be made at least 12 months before the original payment date and must postpone the payment for at least five years. This inflexibility is a major difference from 401(k) plans, which offer more options for withdrawals and rollovers.