W2 Deferred Compensation: How to Report It on Your Tax Return

Deferred compensation is a key aspect of financial planning for many employees, allowing them to delay income and potentially reduce their immediate tax burden. Properly reporting deferred compensation on your tax return is critical for compliance with IRS regulations and optimizing tax outcomes.

Locating Deferred Compensation Figures

On your W2 form, deferred compensation figures are typically found in Box 12, alongside a code that specifies the type of plan. For example, code D refers to elective deferrals to a 401(k) plan, while code Z indicates income from a nonqualified deferred compensation plan that fails to meet Section 409A requirements of the Internal Revenue Code. These codes are essential for accurate tax reporting.

For nonqualified deferred compensation plans, reported amounts may involve income subject to a substantial risk of forfeiture, meaning the income is not fully vested and could be forfeited if certain conditions are unmet. The IRS requires such income to be reported in the year it becomes vested, adding complexity to tax timing. This is especially relevant for executives and high-income earners who frequently participate in these plans.

Deferred compensation impacts taxable income differently depending on the plan type. Deferrals to qualified plans like 401(k)s reduce taxable income in the deferral year, while nonqualified plans may not offer immediate tax benefits, potentially increasing tax liabilities when the income is eventually received. Understanding this distinction is critical for tax planning and can influence decisions about participating in deferred compensation arrangements.

Plan Classifications and Reporting Differences

Deferred compensation plans fall into two main categories: qualified and nonqualified. Qualified plans, such as 401(k)s, comply with IRS guidelines, offering tax-deferred growth where contributions and earnings are taxed only upon withdrawal. These plans are subject to annual contribution limits—$23,000 for 2024, with an additional $7,500 catch-up contribution for those 50 and older.

Nonqualified deferred compensation (NQDC) plans, on the other hand, are not bound by the same IRS restrictions. Typically used to provide supplemental retirement benefits to key employees, these plans allow for greater flexibility, such as deferring amounts beyond qualified plan limits. However, they are subject to stricter rules under Section 409A of the Internal Revenue Code, which governs the timing of deferrals and distributions. Non-compliance can result in severe penalties, including a 20% additional tax on top of regular income taxes.

Reporting requirements differ significantly between these plan types. Contributions to qualified plans are reflected on the W2 form and reduce taxable income for the year. For NQDC plans, income is reported when it becomes vested or distributed, rather than at the time of deferral. This reporting complexity requires employers to ensure accuracy while enabling employees to understand the tax implications of their plans.

Withholding Rules for Salary Deferrals

Tax withholding for salary deferrals requires precision. When employees defer part of their salary into a retirement plan, employers adjust withholding based on the remaining wages, following IRS regulations outlined in Section 3402 of the Internal Revenue Code. Proper calculations help avoid underpayment or overpayment of taxes.

Deferrals into qualified plans, such as 401(k)s, reduce taxable income for federal income tax purposes but do not affect Social Security and Medicare taxes. These taxes are calculated on the full salary amount before deferrals. Employers must configure payroll systems to handle these calculations accurately, while employees should consider how deferrals affect their take-home pay and future tax obligations.

For nonqualified deferred compensation plans, withholding rules are more complex. Income from these plans is subject to withholding when it is no longer at risk of forfeiture and becomes vested. Employers must track vesting schedules carefully and adjust withholding accordingly to comply with IRS guidelines and avoid penalties.

Adjustments if W2 Is Incorrect

Errors on a W2 form, particularly involving deferred compensation, can complicate tax filings. If you notice inaccuracies, such as incorrect amounts or codes, contact your employer’s payroll department to request a corrected W2, known as a W2c.

If the employer is unresponsive, you can file your tax return using Form 4852, a substitute for a corrected W2. This form requires detailed explanations of the discrepancies and how you determined the correct amounts. Maintaining thorough documentation of all communications with your employer and supporting evidence is essential in case the IRS questions your filing.