What Is a Deferred Compensation Plan?

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What Is a Deferred Compensation Plan?

Deferred compensation is the process of reserving a portion of an employee’s compensation to be distributed at a later date. These deferred compensation payments are usually in pension plans, retirement plans, or stock options. The taxes on deferred compensation plans are not paid until the distribution is made. Deferred compensation plans are also known as DCPs, or sometimes elective deferral programs (EDPs).

401(k) vs. Deferred Compensation Plan?

A 401(k) plan is a form of retirement savings plan tightly regulated and sponsored by an employer, often with matching contribution. Deferred compensation is a strategy in which an individual employee saves for future costs by deferring a portion of their income to a later date, usually after retirement. Deferred compensation schemes are less stringent than typical 401(k) plans, but they are also less secure. 

What is the purpose of a deferred compensation plan?

A deferred compensation plan may be used when an employee wants to access deferred tax benefits because income tax on the compensation is deferred until it is paid out, usually at the end of employment or retirement. The employee can often benefit from a lower tax bracket in retirement, lowering the income tax they would be obligated to pay on the compensation. Employees who expect to be in a higher tax bracket than when they retire may choose a Roth 401(k). A Roth 401(k) retirement plan requires employees to pay taxes when the compensation is earned. 

Types of Deferred Compensation: 

Deferred compensation plans can be split into two types, qualified and non-qualified. Usually, deferred compensation plans refer to non-qualified plans, but the phrase is often used for retirement savings plans. Qualified and non-qualified deferred compensation plans are very different in terms of legal requirements, employment requirements, design, and scope.  

Qualified Deferred Compensation Programs: 

These include 401(k) and 403(b) plans, which are pension plans authorized by the Employee Retirement Income Security Act (ERISA). A corporation that has implemented 401(k) plans or 403(b) plans must make it available to all employees, except for independent contractors. Qualifying delayed compensation is set aside for the sole benefit of the recipients, which means creditors can’t access the funds in bankruptcy. There is a cap on contributions to this type of retirement account by law. 

Non-Qualified Deferred Compensation Programs: 

NQDCs, also known as golden handcuffs, is a 409(a) plan that offers employees the opportunity to attract and retain talent compared to other plans. This plan can be beneficial to employers looking to reward employees who they consider top performers. Contributions to this plan are not capped. NQDCs are often considered more versatile than other qualified plans despite their restrictions. A non-compete clause, for example, might be included in an NQDC.

When is compensation paid? 

Compensation under an NQDC or qualified deferred compensation plan can be given:

  • Upon retirement
  • A set date 
  • Employee death/incapacity – paid to a designated beneficiary
  • Emergency (under strict requirements) 
  • When a change in ownership occurs 
  • Other circumstances such as children’s college 

When can the employer keep the qualified deferred compensation plan? 

  • Violation of a non-compete clause 
  • Employee dismissal 
  • Employee violation of contract 
  • Company bankruptcy

Benefits of Non-Qualified Deferred Compensation Plans: 

NQDC plans are beneficial to employees because they offer the opportunity to invest for retirement while simultaneously reducing their tax burden. However, executives who are well compensated may only invest a small portion of their actual salary into a qualified deferred compensation plan. In contrast, NQDC plans do not have this limitation on contribution requirements.

Drawbacks of NQDC plans: 

Creditors can access NQDC plans if your company goes bankrupt, as these do not have the same safeguards as qualified plans or 401(k) retirement plans. This might make NQDCs an unwise choice for employees whose payout date is years away or whose companies are in a questionable financial state.

What are “top hat plans”?

Stock or options, deferred savings plans, and supplemental executive retirement plans (SERPs), sometimes known as “top hat plans,” are also examples of NQDCs. SERPs that provide additional perks to senior executives, such as personalized retirement plans, have been under fire in recent years. The use of excess/restoration plans is also permitted. Severance and change-of-control incentives are being used to address pay-for-non-performance problems.

Advantages of Deferred Compensation

There are no contribution limits in a deferred compensation plan, and they offer tax-deferred growth for employees looking to save money for retirement. Because there are fewer limits placed on deferred compensation plans compared to 401(k)s or IRAs, employees can defer up to all of their yearly bonuses as retirement income. Deferred compensation plans can often be utilized in conjunction with traditional 401(k) plans to increase your deferred income for retirement. 

Disadvantages of Deferred Compensation

There are fewer protections for employees in a deferred compensation plan than a 401(k). In a deferred compensation plan, the employee may lose some or all of their compensation if their company declares bankruptcy or is dismissed. Unlike an IRA or 401(k), which offers some options for early distributions, the money is more stringently held until retirement in a deferred compensation plan.

Another drawback is that there is no way to borrow against this money, and employees may be left with limited investment options like exclusive company stock. You cannot roll over deferred compensation funds into an IRA.  

Utilizing an employer-matched 401(k) will often give your retirement income the best bang for its buck. However, some highly compensated employees may want to set aside a more significant portion of their income in a deferred compensation plan to save for retirement, children’s college, or other expenses without the restrictions of other retirement plans. 

  • No contribution limitations
  • Tax-deferred growth
  • Tax credit in the year the contributions are made.

Receiving Deferred Compensation

Employees can receive their deferred compensation payout usually after a predetermined length of time, upon retirement, or another set circumstance. You cannot modify the payout date once it has been set. 

In Conclusion

Deferred contribution plans can benefit employees looking to defer taxes on income in the years they are made, which might help you avoid paying higher taxes so long as you expect to be in a lower tax bracket in the future. These deferred compensation plans vary by company, so carefully consider the plan terms, advantages, and disadvantages before electing to contribute to a deferred compensation plan.