What is Deferred Compensation?

Deferred compensation is a financial arrangement where an employee earns income now but receives it at a later date. This can include portions of salary, bonuses, or other forms of compensation that are set aside and distributed in the future. The primary purpose of these plans is to provide a way for individuals to save for retirement or other long-term goals while potentially reducing their current taxable income.

Here’s how it works: when you participate in a deferred compensation plan, you agree to defer a portion of your income until a specified time in the future. This could be upon retirement, after a certain number of years with the company, or under specific conditions like disability. The types of income that can be deferred include regular salary, annual bonuses, performance-related commissions, and even stock options.

Types of Deferred Compensation Plans

Deferred compensation plans come in two main categories: qualified deferred compensation plans and non-qualified deferred compensation (NQDC) plans.

Qualified Deferred Compensation Plans

These plans are governed by the Employee Retirement Income Security Act (ERISA) and IRS regulations. Examples include 401(k), 403(b), and 457 plans. The benefits of these plans include tax-free growth of the funds, protection from creditors, and specific contribution limits that are set by law. For instance, in a 401(k) plan, contributions are made before taxes, reducing your current taxable income.

Non-Qualified Deferred Compensation (NQDC) Plans

NQDC plans are not subject to ERISA regulations and offer more flexibility. They are often used for high-income earners because they do not have annual contribution limits like qualified plans do. However, these plans come with risks such as less legal protection and the potential loss of deferred compensation if the company goes bankrupt.

How Deferred Compensation Works

Enrolling in a deferred compensation plan involves defining how much of your income you want to defer and over what period. Here’s a step-by-step look:

• Enrollment Process: You decide how much of your income to defer each year and specify when you want to receive the funds.

• Investment Options: The deferred funds are typically invested in various assets such as stocks, bonds, or mutual funds. Over time, these investments grow based on their performance.

• Distribution Options: When it’s time to receive your deferred compensation, you can choose between a lump sum or installments. The timing can be tied to specific events like retirement or disability.

Tax Benefits of Deferred Compensation

One of the most appealing aspects of deferred compensation is its tax benefits.

• Deferred Taxes: By deferring income until later years when you might be in a lower tax bracket (e.g., during retirement), you can reduce your overall tax liability.

• Tax-Deferred Growth: The investments within your deferred compensation plan grow without being subject to immediate taxes. You only pay taxes when you receive the distributions.

• Example Scenarios: High-income earners can particularly benefit from these plans by reducing their current taxable income and potentially lowering their taxes in retirement.

Benefits of Deferred Compensation

Deferred compensation offers several benefits for both employees and employers.

Financial Forecasting

These plans help you plan for future financial goals more effectively by setting aside funds that will be available when you need them most.

Increased Value

The long-term investment of your deferred funds can result in higher returns compared to short-term savings strategies.

Employer Benefits

Employers can attract and retain top talent by offering these plans as part of their compensation package. Additionally, deferred compensation can improve cash flow for the company since payments are made in the future.

Employee Benefits

Employees benefit from tax advantages, financial security, and customized plans that fit their individual needs. These plans also provide peace of mind knowing that there is a dedicated fund for retirement or other significant life events.

Drawbacks of Deferred Compensation

While deferred compensation plans offer many advantages, there are also some drawbacks to consider:

• Restricted Access: One of the main drawbacks is that you cannot access these funds immediately without potential penalties for early withdrawal.

• Reduced Protections: Non-qualified plans lack the same legal protections as qualified plans, making them riskier if the company faces financial difficulties.

• Risk of Company Insolvency: If the company goes bankrupt before distributing your deferred compensation, there is a risk that you might lose some or all of these funds.

Examples of Deferred Compensation Plans

Here are some common examples:

• Retirement Plans: Pensions, 457 plans, and other retirement-focused deferred compensation plans are designed specifically for saving for post-work life.

• Bonus Deferral Plans: These allow employees to defer annual bonuses or performance-related commissions until a later date.

• Severance Packages: Deferred severance payments can provide financial security during transitions between jobs.