What Happens to Deferred Compensation If I Quit?

Deferred compensation represents an agreement where an employee postpones receiving a portion of their current income until a future date. This arrangement often includes salary, bonuses, or commissions that are set aside for later payout. Companies typically use these plans to incentivize and retain key employees, particularly at executive levels. Understanding how these funds are treated upon a voluntary departure from employment is important for individuals participating in such arrangements.

Understanding Your Deferred Compensation Plan

Reviewing your employer’s official plan documents is essential to understanding your deferred compensation plan. These documents detail the terms and conditions governing your deferred funds, outlining what you are entitled to if you leave your job.

Many deferred compensation arrangements are non-qualified deferred compensation (NQDC) plans. Unlike qualified plans like 401(k)s, NQDC plans are not subject to strict Employee Retirement Income Security Act (ERISA) rules and are based on a contractual promise from the employer to pay you in the future. Equity-based compensation, such as Restricted Stock Units (RSUs) or stock options, is another common form. These have deferred payout schedules tied to future events or employment milestones.

A vesting schedule dictates when you gain a right to deferred funds. “Cliff vesting” means you become 100% vested on a specific date after a certain employment period, such as three or five years. “Graded vesting” allows you to become vested incrementally over time, for example, 20% each year over five years. Any portion of your deferred compensation not yet vested when you quit is generally forfeited.

Deferred compensation payouts are also tied to specific events or conditions, known as payout triggers. While retirement or a fixed future date are common triggers, termination of employment, including voluntary resignation, is often another. It is important to identify how different types of termination are defined within your plan documents, as this can affect your entitlement. For example, resigning voluntarily may be treated differently than an involuntary termination without cause, which might preserve your right to vested amounts. Some plans may include forfeiture clauses that can negate vested amounts under specific conditions, such as violating a non-compete agreement or being terminated for cause.

Distribution and Taxation Upon Quitting

Once you have determined your vested amount of deferred compensation after quitting, the method and timing of its distribution are governed by your plan’s terms. Common distribution methods include a single lump-sum payment or installment payments spread out over several years, such as five or ten years. Some plans may offer you a choice between these methods, while others may prescribe a specific approach. Your plan documents will specify these options, and any election you make must generally be irrevocable and made in advance of the payout event.

Internal Revenue Code Section 409A influences the timing of payouts, setting rules for non-qualified deferred compensation plans to avoid adverse tax consequences. Payments are typically made on a fixed date or schedule, upon separation from service, or at a change in company control. For “specified employees,” such as highly compensated officers, Section 409A mandates a six-month delay after separation from service before NQDC payments can be made. This delay helps ensure compliance.

When deferred compensation is finally distributed, it is generally taxed as ordinary income in the year you receive it. This means the amount will be added to your other taxable income, such as wages, and taxed at your marginal income tax rate. For example, if you receive a $100,000 deferred compensation payout, it will be treated similarly to receiving an additional $100,000 in salary for that tax year. This income is subject to federal income tax withholding, and potentially state and local income taxes, depending on where you reside at the time of distribution.

Regarding FICA taxes, which include Social Security and Medicare, the rules for NQDC can be distinct. FICA taxes are typically applied at the time the deferred compensation vests or when it is no longer subject to a substantial risk of forfeiture, even if the money has not yet been paid out. This means you might have paid FICA taxes on the deferred amount in a prior year, even though you are only receiving the income now. For equity-based deferred compensation, FICA taxes are usually applied at the time of exercise or settlement.

Non-qualified deferred compensation plans that fail to comply with Section 409A can result in severe tax penalties for the employee, even if the non-compliance was an employer error. If a plan is found to be non-compliant, all deferred amounts for current and prior years become immediately taxable to the employee. Additionally, a 20% excise tax is imposed on the deferred amount, along with interest penalties from the date the amount should have been included in income. While these penalties are primarily aimed at employers, they directly impact the employee’s net payout.

Navigating the Process After Quitting

Before quitting, review all your deferred compensation and equity award agreements. This allows you to confirm your understanding of vesting schedules, payout terms, and any post-employment obligations like non-compete or confidentiality agreements. Knowing these details helps you plan for your financial future and avoid unexpected forfeitures.

After you have decided to leave your employment, communicating with your former employer’s Human Resources or benefits department is an important step. You should contact them to confirm the status of your deferred compensation, including any vested amounts and the anticipated payout schedule. This communication also provides an opportunity to ensure your contact information, including your mailing address and bank account details for direct deposit, is current for future distributions and tax documentation.

Understanding the logistical aspects of receiving your payouts is important. Inquire about the specific distribution method, such as direct deposit or physical check, and the exact timeline for your first payment. If your plan offered various options, confirm your elected choice and when funds will be disbursed based on your separation date. Some plans may require specific forms or updated information to initiate the payout process.

Upon receiving your deferred compensation payouts, it is important to retain all related tax documentation. Your former employer will issue relevant tax forms, such as a W-2 or a 1099-MISC, depending on the nature of the compensation and how it was treated for tax purposes. These forms are necessary for accurately filing your income taxes in the year of receipt. Given the complexities of deferred compensation taxation, consulting with a qualified tax professional is often beneficial to ensure proper reporting and to understand any specific implications for your individual financial situation.