What Is Deferred Pay? How It Works and Its Tax Treatment
Unpack the concept of deferred pay, understanding why compensation is sometimes received later and its broader financial impact.
Deferred pay is a financial arrangement where an employee earns compensation in one period but receives payment for it in a future period. This approach involves a formal agreement between an employer and an employee to delay the distribution of a portion of earnings.
This compensation strategy allows for various long-term objectives, such as incentivizing sustained performance and aiding in an individual’s financial planning. It can help align an employee’s interests with the long-term success of the company. Companies often utilize deferred pay to attract and retain experienced talent by offering future financial security.
Understanding Deferred Pay
Deferred pay represents an agreement to postpone the receipt of compensation that has already been earned, distinguishing it from immediate wages. The employee has a right to the compensation, but its actual distribution is scheduled for a later date or upon the occurrence of a specific event. The core purpose is to provide a future financial benefit rather than an immediate one.
From an employer’s perspective, deferred pay arrangements serve as a tool for employee retention and to incentivize long-term performance. These plans can help align the financial goals of employees with the strategic objectives of the company over an extended period. For employees, deferring income offers potential financial planning benefits, such as receiving funds during retirement when they might be in a lower tax bracket.
Different Forms of Deferred Compensation
Non-Qualified Deferred Compensation (NQDC) plans are contractual agreements between an employer and employee, designed for highly compensated employees or executives. These plans generally fall outside the regulations of the Employee Retirement Income Security Act (ERISA), offering greater flexibility in design.
Equity-based compensation also functions as a form of deferred pay, tying an employee’s future compensation to company stock performance. Examples include stock options, such as non-qualified stock options (NSOs) and incentive stock options (ISOs), and restricted stock units (RSUs). The value or shares are realized at a later date, often contingent on a vesting schedule.
Qualified retirement plans, such as 401(k)s and traditional pension plans, represent another category of deferred compensation. These plans adhere to federal regulations, including ERISA, and offer broad participation to employees. Unlike NQDC plans, assets in qualified plans are held in a trust, separate from the employer’s general assets, providing protection for participants.
Mechanics of Deferred Pay Arrangements
Employees elect to defer a portion of their current compensation, such as salary or bonuses, through a written agreement. This agreement specifies the amount to be deferred and outlines the conditions and schedule for future payouts.
Vesting schedules define when an employee gains full ownership rights to the deferred compensation. Vesting can occur over time, such as a four-year period, or upon meeting performance conditions. Until fully vested, deferred amounts may be subject to forfeiture if the employee leaves the company or fails to meet certain criteria.
Payouts from deferred compensation plans are triggered by predefined events. Common triggers include separation from service, such as retirement or termination, a specified future date, or a change in control of the company. Other events like disability or an unforeseeable emergency can also initiate distributions.
For non-qualified deferred compensation plans, deferred funds remain assets of the employer and are subject to the claims of the employer’s general creditors. In the event of the employer’s bankruptcy or insolvency, employees may risk losing their deferred compensation. In contrast, qualified plans hold assets in a separate trust, offering protection from the employer’s creditors.
Tax Treatment of Deferred Pay
The tax treatment of deferred pay follows the principle that income is taxed when it is received or constructively received by the employee. Constructive receipt means income is considered taxable even if not physically in hand, provided it is credited to an account, set apart, or made available without substantial restrictions. This doctrine prevents taxpayers from deliberately delaying income receipt to control the tax year.
Non-Qualified Deferred Compensation (NQDC) plans are subject to rules under Internal Revenue Code Section 409A. Failure to comply with this section can result in severe penalties for the employee, including immediate taxation of all deferred amounts, an additional 20% excise tax, and penalty interest. While income tax on NQDC is deferred until distribution, FICA (Social Security and Medicare) taxes are due at the time of deferral, even before the income is received.
For qualified retirement plans like 401(k)s, contributions and earnings grow tax-deferred until withdrawal in retirement. Distributions are then taxed as ordinary income. Equity-based compensation has varying tax implications depending on the type. Restricted Stock Units (RSUs) are taxed as ordinary income at vesting, and any subsequent appreciation is subject to capital gains tax upon sale.
Non-qualified stock options (NSOs) are taxed when exercised, with the difference between the fair market value and the exercise price treated as ordinary income. Any further gain upon sale is subject to capital gains tax. Incentive stock options (ISOs) receive more favorable tax treatment; they are not taxed at grant or exercise for regular income tax purposes, though they may trigger the alternative minimum tax (AMT). If ISOs meet specific holding period requirements, the gain from their sale is taxed at the lower capital gains rates.