When Is Deferred Compensation Worth It?

Deferred compensation represents an agreement between an employee and an employer to pay a portion of the employee’s earnings at a later date. This arrangement typically involves postponing current salary, bonuses, or other compensation, paid out at a specified future date or upon a predetermined event like retirement or termination of employment. Non-qualified deferred compensation (NQDC) plans are a common type offered by employers. These plans fall outside the regulations of the Employee Retirement Income Security Act (ERISA), which governs qualified plans like 401(k)s.

Unlike qualified plans, NQDC plans do not receive the same tax-advantaged status or federal protections. This provides employers flexibility in designing them, often for highly compensated employees. In a NQDC plan, the employee elects to defer income, and the employer holds these funds, typically as a bookkeeping entry or through an informal funding mechanism. The deferred amounts generally remain part of the company’s general assets, making the employee an unsecured creditor of the employer.

The employee makes an election to defer a percentage or fixed amount of compensation before it is earned. This election usually occurs during an annual enrollment period for the following year’s compensation. The deferred funds are then credited to an account, which may track returns as if invested in hypothetical options. These are not actual investments held in a separate trust for the employee’s benefit, but rather a measurement of the growth of the employer’s promise to pay.

Taxation and Growth Potential

NQDC defers income tax on compensation and its earnings until the funds are received by the employee. This means deferred amounts and any credited growth are not subject to federal income tax in the year earned or accumulated. Participants often aim to receive these funds during retirement or another period when they anticipate being in a lower income tax bracket, potentially reducing their overall tax burden.

While income tax is deferred, federal payroll taxes, specifically Social Security and Medicare taxes (FICA), are generally due at the earlier of when services are performed or when the employee’s right to the deferred compensation becomes nonforfeitable. FICA taxes are typically paid in the year compensation is earned and vested, even though income tax is postponed. The ability for the deferred funds to grow without immediate income tax significantly enhances compounding over time. This tax-deferred growth can lead to a larger accumulation of wealth compared to an equivalent amount of currently taxed income invested in a taxable account.

The rules governing NQDC plans are outlined in Internal Revenue Code Section 409A. Payments from an NQDC plan must generally occur only upon specific events, such as separation from service, disability, death, a specified time or schedule, or a change in company ownership. If a plan fails to comply with Section 409A, the deferred amounts can become immediately taxable to the employee, along with a 20% penalty tax and interest charges.

The growth within an NQDC plan is often tied to an investment vehicle, even if the funds are not physically segregated. For instance, a plan might mirror the performance of a stock market index or a selection of mutual funds. Although the employee bears the investment risk associated with these hypothetical investments, the income tax on any gains realized within the plan is deferred until the distribution event. This allows the entire amount, including the notional earnings, to compound without being reduced by annual income taxes until the specified payout date.

Key Considerations Before Committing

Before electing to participate in a deferred compensation plan, individuals should carefully evaluate several factors beyond the tax advantages. A fundamental aspect of non-qualified deferred compensation (NQDC) is that it constitutes an unsecured promise from the employer. This means that the employee becomes a general creditor of the company, and the deferred funds are typically not held in a separate trust for the employee’s exclusive benefit. Instead, these amounts remain part of the employer’s general assets and are subject to the claims of the company’s other creditors.

This structure introduces the risk of not receiving the deferred compensation if the employer faces financial distress, insolvency, or bankruptcy. While some employers may use informal funding mechanisms, such as a rabbi trust, to set aside assets for future payment, these assets are still subject to the claims of the employer’s general creditors. Therefore, assessing the employer’s financial stability and long-term viability is a significant consideration before committing to deferring income. The potential for complete loss of the deferred funds exists if the company’s financial health deteriorates.

Another consideration is the lack of immediate access to the deferred funds. Once compensation is deferred, it is generally inaccessible until a predetermined payout event, which is strictly governed by Section 409A. Unlike some qualified retirement plans, NQDC plans typically do not permit early withdrawals or loans. Attempting to access funds outside the pre-established distribution schedule can trigger severe penalties, including immediate taxation of all deferred amounts, a 20% penalty, and interest charges.

Changes in personal financial circumstances or tax laws between the time of deferral and the payout date also warrant careful thought. An individual’s financial needs might evolve unexpectedly, making the deferred funds less suitable for future liquidity requirements. Similarly, shifts in tax policy could alter the anticipated tax benefit of receiving income in a lower tax bracket years down the line. It is important to consider how deferred compensation fits into an overall financial plan, including existing retirement savings, emergency funds, and other investment goals, to ensure it aligns with personal risk tolerance and liquidity needs.