What Is a Deferred Salary and How Does It Work?
Learn about deferred salary: how postponing earnings can shape your financial strategy, future income, and long-term planning.
Deferred salary is an arrangement where an employee agrees to receive a portion of their current income at a later date. This allows individuals to postpone the receipt of earnings, often until retirement or another specified future event. It represents a formal agreement between an employer and an employee to delay compensation.
Defining Deferred Salary
Deferred salary involves an agreement where an employee chooses to have a portion of their compensation set aside for payment in a future tax year. Employers utilize these arrangements to retain key talent and incentivize long-term performance, creating a vested interest for employees in the company’s sustained success. Employees often engage in these agreements for personal tax planning, aiming to receive income when they anticipate being in a lower tax bracket, or to save for retirement.
Types of Deferred Compensation Plans
Non-Qualified Deferred Compensation (NQDC) plans are the most common vehicle for deferring salary, representing a contractual agreement between an employer and an employee. These plans operate outside the regulations of the Employee Retirement Income Security Act (ERISA), which governs qualified plans like 401(k)s. The absence of ERISA oversight provides flexibility in plan design, allowing employers to tailor arrangements for specific employees, often highly compensated individuals. NQDC plans can offer more generous deferral limits compared to qualified plans.
However, this flexibility also introduces risks, as NQDC plans are typically unfunded and unsecured promises to pay in the future. While NQDC plans are the primary focus for salary deferral, other forms of deferred compensation exist, generally involving an employee’s election to defer a portion of their salary or bonus. These arrangements are typically designed to attract and retain executives by offering benefits beyond traditional, qualified retirement plans.
Tax Treatment
Federal income tax is typically imposed on the employee when the compensation is actually received, not when it is earned or deferred. This allows individuals to potentially defer income tax to a future year when their income, and thus their marginal tax rate, may be lower. For employers, the deferred compensation generally becomes a deductible expense in the tax year the employee includes the income in their taxable income.
Payroll taxes, specifically FICA taxes (Social Security and Medicare), usually follow a different timing rule. FICA taxes are generally due at the time the compensation is deferred or when the employee’s right to the deferred amount becomes vested and is no longer subject to a substantial risk of forfeiture. For example, if an employee defers a salary portion in 2025 that vests immediately, FICA taxes are generally due in 2025, even if the income tax is not due until the payout in 2035.
Key Considerations for Participants
Deferred amounts typically represent an unsecured promise from the employer, meaning the deferred funds are generally subject to the claims of the company’s general creditors. This introduces a risk that if the company faces severe financial distress or bankruptcy, the employee could potentially lose their deferred compensation.
Once an election to defer salary is made, it is often irrevocable or subject to strict rules regarding changes. Internal Revenue Code Section 409A governs non-qualified deferred compensation plans and imposes strict requirements on the timing of deferral elections and distributions. Participants must review the agreed-upon payout schedule and conditions, such as payment upon separation from service, reaching a specific age, or a fixed calendar date. Deferred salary might not count towards calculations for other employer-sponsored benefits, such as 401(k) contributions or Social Security earnings in the year it is deferred, potentially affecting future benefit accruals.