What Are Deferred Compensation Plans?

Deferred compensation plans are arrangements where an employee agrees to receive a portion of their current earnings at a future date. This strategy involves delaying the receipt of income, allowing individuals to manage their tax liabilities and save for specific future needs. These plans are designed to help employees accumulate wealth over time, often for retirement.

Understanding Deferred Compensation

Deferred compensation represents an agreement between an employer and an employee to pay a portion of the employee’s earnings at a later time. For employers, offering these plans can attract and retain highly skilled talent, particularly for executive and key personnel roles. These plans often incentivize long-term commitment by tying deferred payments to continued employment or specific performance achievements.

From an employee’s perspective, a primary benefit is tax deferral. By delaying income receipt, individuals can postpone income taxes until a future date, often when they anticipate being in a lower tax bracket, such as during retirement. This deferral allows the compensation to potentially grow tax-free until it is distributed. These plans also serve as a structured savings mechanism, aiding in long-term financial planning for retirement or other significant future expenses.

Types of Deferred Compensation Plans

Deferred compensation plans generally fall into two main categories: qualified and non-qualified plans. Each has distinct characteristics and regulatory frameworks. Qualified plans adhere to specific requirements set forth by the Internal Revenue Service (IRS) and the Employee Retirement Income Security Act (ERISA). These plans benefit from favorable tax treatment and are subject to rules regarding contribution limits, participation, and non-discrimination.

Common examples of qualified plans include 401(k) plans, prevalent in the private sector, and 403(b) plans, typically offered by public schools and non-profit organizations. For 2024, the employee contribution limit for 401(k) and 403(b) plans is $23,000, with an additional catch-up contribution of $7,500 allowed for those age 50 and over. Another type is the 457(b) plan, available to governmental and certain non-governmental tax-exempt entities. These plans are often designed to ensure broad employee participation and generally provide immediate tax deductibility for employer contributions.

In contrast, non-qualified deferred compensation plans do not meet the extensive requirements of ERISA, offering greater flexibility in their design and who can participate. Employers frequently use these plans to provide benefits to highly compensated employees or executives, as they are exempt from many non-discrimination rules. Examples include Deferred Compensation Agreements (DCA), Supplemental Executive Retirement Plans (SERP), Phantom Stock, and Stock Appreciation Rights (SARs). These arrangements allow for deferrals beyond qualified plan limits and are governed by Internal Revenue Code Section 409A, which dictates the timing of deferrals and distributions.

Key Features of Deferred Compensation Plans

Deferred compensation plans incorporate several operational features that dictate how and when funds are accumulated and disbursed.

Deferral Election

Deferral election is a primary feature, where employees formally choose to set aside a portion of their salary, bonuses, or other compensation for future payment. These elections are generally irrevocable once made for a given year, typically requiring the decision to be finalized before the year in which services are performed.

Vesting

Vesting determines when an employee gains full ownership rights to the deferred funds. Employee contributions are always immediately vested. Employer contributions may be subject to a vesting schedule, such as cliff vesting, where 100% ownership is granted after a specific period, or graded vesting, which provides increasing ownership percentages over several years.

Distribution Triggers

Distribution triggers specify the predetermined events that will cause the deferred compensation to be paid out. These commonly include retirement, termination of employment, disability, or death. Plans may also specify a particular future date for distribution, allowing for strategic financial planning.

Funding

The funding of deferred compensation plans varies by plan type. Qualified plans typically involve setting aside assets in a trust, separate from the employer’s general assets, offering security for employees. For non-qualified plans, the employer’s promise to pay is often “unfunded” and “unsecured.” This means funds remain part of the company’s general assets and are subject to claims of the employer’s general creditors in the event of insolvency.

Taxation of Deferred Compensation

Taxation of deferred compensation depends on whether the plan is qualified or non-qualified. The benefit of these plans is the deferral of income tax, allowing deferred amounts and associated earnings to grow until received by the employee.

For qualified plans, employee contributions made on a pre-tax basis and employer contributions are not subject to income tax when contributed. Instead, these amounts are taxed as ordinary income when distributed, typically during retirement. Early withdrawals before age 59½ may be subject to a 10% penalty tax, in addition to regular income tax. Roth 401(k) plans allow for after-tax contributions, and qualified distributions are generally tax-free.

Employers contributing to qualified plans can deduct their contributions in the year they are made.

Non-qualified deferred compensation plans have a different tax treatment. For employees, compensation is not subject to income tax until actually received or “made available,” provided the plan complies with Section 409A. Failure to comply with Section 409A can result in immediate taxation of all vested deferred amounts, a 20% additional federal penalty tax, and interest charges. When distributions are made from a compliant non-qualified plan, they are taxed as ordinary income to the employee.

From the employer’s perspective, contributions to non-qualified plans are not tax-deductible until the employee receives the compensation.

Deferred compensation, whether qualified or non-qualified, is subject to FICA taxes at the earlier of when services are performed or when compensation is no longer subject to a substantial risk of forfeiture, such as when it vests. This “special timing rule” for FICA taxes can result in payroll taxes being due well before income tax is paid.