What Is a Deferred Compensation Plan?

A deferred compensation plan is an agreement between an employer and an employee to pay a portion of the employee’s compensation at a future date or upon a specified event. This arrangement allows individuals to postpone receiving income until a later time, often during retirement or a period of lower income. The primary purpose is to help employees manage tax liabilities and save for long-term goals. Employers also use these plans to attract, retain, and motivate key talent.

How Deferred Compensation Works

Deferred compensation delays the receipt of income. Employees typically elect to defer a portion of their current compensation, such as salary, bonuses, or commissions, before it is earned, following regulatory timelines.

The employer holds these deferred amounts, tracking them in a bookkeeping account. This account may grow based on a predetermined rate of return or a specified investment benchmark. Employees do not control these investments, as the funds remain employer assets.

Payment of these deferred funds is delayed until a future date or a triggering event in the deferral agreement. Common events include retirement, termination of employment, or a pre-determined calendar date. This delay means employees do not have current access to the funds, postponing the income tax obligation.

This mechanism allows employees to defer taxation, potentially moving income into a lower tax bracket. For employers, it creates a future payment commitment, often tied to continued service. This deferral of income receipt impacts when the compensation is recognized for tax purposes.

Common Features of Deferred Compensation Plans

Deferred compensation plans include several common features. Vesting determines when an employee gains an irreversible right to deferred funds. “Cliff vesting” means an employee becomes 100% vested after a specific period, like three years. “Graded vesting” means ownership accrues gradually, for example, 20% per year over five years.

Distribution events are specific occurrences or dates that trigger payment of deferred compensation. These events are defined within the plan agreement to ensure compliance with tax regulations. Common triggers include retirement, separation from service, disability, death, a change in company control, or a pre-specified future date.

The funding status of a deferred compensation plan is an important distinction, impacting the security of the employee’s deferred funds. “Unfunded plans” are merely an employer’s promise to pay, with no assets specifically set aside or protected. The employee is a general creditor, meaning their claim is equal to other unsecured creditors if the company faces financial distress or bankruptcy.

Employers may informally set aside assets for future payment obligations, leading to “informally funded plans.” A common method is a “rabbi trust,” where assets are placed in an irrevocable trust for future distribution. Companies might also use corporate-owned life insurance (COLI) policies, owning the policy and using its cash value to offset future liabilities. Despite these methods, assets in a rabbi trust or COLI remain subject to the employer’s general creditors, maintaining “unfunded” status for tax purposes and offering no protection against insolvency.

Income tax on deferred compensation is generally deferred until the compensation is received by the employee. For non-qualified plans, however, Social Security (FICA) and Medicare taxes may apply earlier, often when the right to the deferred compensation becomes vested.

Distinguishing Between Plan Types

Deferred compensation plans fall into two categories: qualified and non-qualified. Qualified plans meet stringent requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (IRC). Their qualified status means they are subject to extensive rules designed to protect participants and ensure broad employee coverage through non-discrimination rules.

These plans benefit from immediate tax deductions for employer contributions and allow for tax-deferred growth on investments. Funds are generally held in a trust, providing security and subjecting the plan to ERISA’s fiduciary duties. They are also subject to annual IRS contribution limits, which vary each year, such as the 401(k) elective deferral limit of $23,000 for 2024 for those under age 50.

Common qualified plans include 401(k)s, which are defined contribution plans allowing pre-tax salary contributions. 403(b) plans are available to employees of tax-exempt organizations and public schools, operating like 401(k)s. Traditional defined benefit pension plans also fall under the qualified umbrella.

Non-qualified deferred compensation (NQDC) plans do not meet IRS and ERISA qualification rules. This means they are not subject to most ERISA provisions, resulting in fewer employee protections compared to qualified plans. NQDC plans are typically offered to a select group of management or highly compensated employees, allowing employers to tailor benefits.

For NQDC plans, the employer’s tax deduction is generally delayed until the employee receives payment, aligning with income recognition. These plans are largely governed by Internal Revenue Code Section 409A, enacted to prevent constructive receipt of income and ensure tax compliance. Section 409A imposes strict rules on deferral elections and distributions, penalizing non-compliant plans with immediate taxation and potential penalties.

Examples of non-qualified plans include Supplemental Executive Retirement Plans (SERPs), which provide additional retirement benefits beyond qualified plan limits. Phantom stock plans grant employees the right to a cash payment equal to the value of company shares, without actual ownership. Stock appreciation rights (SARs) allow employees to receive a payment equal to the increase in value of a company’s stock over a set period. Deferred bonus plans allow the postponement of bonus payments.