The basics of deferred compensation plans
For most people, it’s difficult to imagine not collecting all of the income they’ve earned, when they earn it. But for highly compensated individuals, sometimes it’s better to defer their income into the future rather than collect it now.
A deferred compensation plan is an arrangement in which an employee, typically an executive or other high-earning individual, earns income from an employer one year, but collects it in a future year.
Deferred compensation plans are often used as supplemental retirement plans. The employer sets aside earned income, then pays it out during the employee’s retirement. Unlike other types of qualified retirement plans, there are no caps on the amount of contributions made to a deferred compensation plan.
This can benefit high-earning employees who already contribute the maximum allowed amount to their IRAs and 401(k)s, but need to save more in order to maintain their lifestyles in retirement.
For example, an executive who currently earns $500,000 can only save $18,000 in a 401(k) during the current tax year, the same as an employee who makes $50,000. That’s less than 4 percent the employee is setting aside for retirement. At that rate, he or she would not be able to save enough to replace the bulk of their working income with retirement income.
Deferred compensation can also be used to offset current tax obligations since the employee does not pay tax on the income until he or she receives it.
Employers use these plans as a way of providing extra compensation to key employees without having to provide the benefit to all employees. Deferred compensation plans do not have the same non-discrimination rules as qualified retirement plans that must be offered to all full-time workers.
The most common deferred compensation plan is a Non-Qualified Deferred Compensation (NQDC) plan, also known as a 409A plan after the section of the tax code that governs them.
To be an IRS approved NQDC, the plan must be in writing, and it must state the triggering event that will result in future payment. The IRS allows six triggering events:
A fixed date
Separation from employment, such as termination or retirement
Change in company ownership
Violating any of the rules on NQDCs will result in having to pay the immediate income taxes owed on the deferred compensation plus a tax penalty.
Other restrictions on NQDC plans are the inability to loan yourself money from the plan or to roll the money into an IRA or other retirement accounts.
NQDC plans come in two types: elective and non-elective. In an elective arrangement, the employee chooses to receive less of his or her current salary and any bonus compensation until a future year. Non-elective plans allow the employer to fund the future benefit without reducing the employee’s salary or bonus incentive payments. The latter is often used to retain key people.
Employers can impose certain restrictions on NQDC, such as forbidding the employee to work at a competitor.
One of the risks of deferred compensation for employees is not getting paid. Companies do not segregate deferred compensation funds; they remain in the company’s general assets. Therefore they could be lost if the company’s finances take a downturn.
If the company declares bankruptcy, the employee who is still owed deferred compensation will have to stand in line with other creditors before getting paid and will probably not receive all that is owed if he or she receives any amount at all.
Another risk is losing the potential rate of return of investing the funds received today versus the rate of return offered in the deferred plan. The employee may be able to earn a greater rate of return on the after-tax amount without deferral than what is paid under the deferred compensation plan. Some NQDCs pay a fixed rate of interest, while others offer the same investment choices as those in the company 401(k) plan.