What Is Deferred Pay and How Does It Work?

Deferred pay is a financial arrangement where an individual earns compensation in one period but receives it at a future date. It can be a useful tool for both employers and employees in long-term financial planning.

Defining Deferred Pay

Deferred pay is a contractual agreement between an employer and an employee to postpone the payment of earned income until a later time, such as a future tax year or upon a specified event. It can include salary, bonuses, or other forms of compensation.

For employers, offering deferred pay can be a strategy for employee retention, especially for key personnel, by creating “golden handcuffs” that incentivize long-term commitment. For employees, the motivation often involves long-term financial planning, such as saving for retirement or other significant life events. It can also align an employee’s financial interests with the company’s long-term performance objectives.

How Deferred Pay Works

The mechanics of deferred pay involve a formal agreement between the employer and employee that outlines the terms of the deferral. This agreement typically specifies the amount of compensation to be deferred, the schedule for future payments, and the specific events that will trigger the payout. These payout triggers commonly include retirement, separation from service, a fixed future date, disability, death, or a change in company ownership.

Vesting refers to the point at which an employee gains full ownership rights to deferred funds. For employer contributions, a vesting schedule might be in place, meaning the employee only fully owns the deferred compensation after remaining with the company for a certain period, for example, three to five years. If an employee leaves before meeting the vesting requirements, they may forfeit some or all of the unvested employer contributions. The deferred funds are typically held by the employer or placed in a trust, such as a Rabbi Trust, which remains subject to the company’s creditors.

Common Forms of Deferred Pay

Deferred pay manifests in various structures, broadly categorized as qualified or non-qualified plans. Qualified deferred compensation plans, such as 401(k)s and pension plans, adhere to strict federal regulations, including those set forth by the Employee Retirement Income Security Act of 1974. These plans often have contribution limits set by the Internal Revenue Service and generally require broad employee participation, meaning they are available to all eligible employees. Contributions to qualified plans are typically made with pre-tax dollars and grow tax-deferred.

Non-Qualified Deferred Compensation (NQDC) plans, by contrast, are not subject to ERISA regulations and offer greater flexibility in design and eligibility. These plans are often reserved for highly compensated employees or executives and do not have the same contribution limits as qualified plans. Examples of NQDC plans include supplemental executive retirement plans (SERPs), deferred bonus plans, and salary reduction arrangements where employees defer a portion of their current income. Stock-based compensation, such as Restricted Stock Units (RSUs) or stock options, can also function as deferred pay when their payout or vesting is tied to future events or continued employment.

Tax Treatment of Deferred Pay

For income tax purposes, the general rule is that deferred compensation is not taxed until it is actually received by the employee, rather than when it is earned. This deferral of income tax can be advantageous if an employee expects to be in a lower tax bracket during retirement or when the deferred funds are distributed. The funds within the deferred compensation arrangement can grow on a tax-deferred basis until the payout occurs.

While income tax is deferred, Federal Insurance Contributions Act (FICA) taxes (Social Security and Medicare) generally apply earlier for non-qualified deferred compensation. Under a “special timing rule,” FICA taxes are typically due when the right to the deferred amount is no longer subject to a substantial risk of forfeiture, such as at vesting, or when the services are performed, whichever is later. This means FICA taxes may be withheld and paid before the income itself is distributed. Once FICA taxes have been applied under this rule, those amounts, and reasonable earnings on them, are not subject to FICA taxes again upon distribution. For employers, the deferred compensation generally becomes a deductible expense for income tax purposes when it is paid to the employee.