how deferred compensation works
an employee may negotiate for deferred compensation because it offers immediate tax benefits in many cases the taxes due on the income is deferred until the compensation is paid out often when the employee reaches retirement age 23 if employees expect to be in a lower tax bracket when retiring they have a chance to reduce their tax burden roth 401 k s are an exception as they require the employee to pay taxes on income as it is earned the balance in a roth account is however normally tax free when it is withdrawn 4 it can be a better option for people who expect to be in a higher tax bracket when they retire types of deferred compensationthere are two broad categories of deferred compensation qualified and non qualified these differ in their legal treatment and the purpose they serve qualified deferred compensation plans are governed by the employee retirement income security act erisa a key set of federal regulations for retirement plans 5 they include 401 k plans and many 403 b plans 67funds in qualified deferred compensation plans are for the sole benefit of their recipients creditors cannot access the funds if the company goes bankrupt contributions to the plans are capped by law 8non qualified deferred compensation nqdc plans are contractual agreements between employers and participants also known as 409 a plans or in some cases golden handcuffs nqdcs take different forms including bonus plans equity stock arrangements and supplemental executive retirement plans serps otherwise known as top hat plans 910nqdc plans have no caps on contributions and are typically offered only to top level employees and key talent that the company wants to retain independent contractors are eligible for nqdc plans 11 this isn t the case with qualified deferred compensation plans compensation is usually paid out when the employee retires although there can be provisions for earlier payouts in case of certain events like a change in ownership of the company or a strictly defined emergency depending on the terms of the contract deferred compensation might be canceled by the company if the employee is fired defects to a competitor or otherwise forfeits the benefit from the participant s perspective nqdc plans offer a reduced tax burden and a retirement savings bonus this is especially valued by highly compensated employees because qualified 401 k plans have annual contribution limits 12on the downside the money in nqdc plans does not have the same protection as a 401 k balance if the company goes bankrupt creditors can seize funds from nqdc plans 10for some companies nqdc plans are a way to hire expensive talent without having to pay their full compensation immediately meaning they can postpone funding the obligations that approach however can be a gamble for the employee the employee pays social security and medicare taxes on the deferred income at the time of the deferral but does not pay income tax on it until the funds are actually received 13deferred compensation vs 401 k a deferred compensation plan is generally an addition to a company 401 k plan and may be offered only to a few executives and other key employees as an incentive generally those employees participate in both plans they max out their contributions to the company 401 k while enjoying the bonus of a deferred compensation plan that said a 401 k plan that includes a matching contribution from an employer is technically a form of deferred compensation it s part of a regular salary that is payable only after the employee leaves the company or retires much like a type of non qualified deferred compensation called a golden parachute which is reserved for highly compensated employees 9however the 401 k is a qualified plan meaning the employer must stick to federal regulations that ensure the integrity of such plans non qualifying plans are less regulated advantages of deferred compensationunlike 401 k s or individual retirement accounts iras there are no contribution limits to a deferred compensation plan an eligible employee can for example earmark an annual bonus as retirement savings the money in both of these plans can grow tax free until it is withdrawn the big exception is the roth 401 k or roth ira where contributions are taxed when they are made and no further taxes are due on withdrawals 147the absence of contribution limits can add a great deal of value to a deferred compensation plan for a highly paid employee the plans also offer tax deferred growth and a tax deduction for the period that the contributions are made no limits on contributionstax deferred asset growthcurrent period tax deductionbalances are not protected in case of company bankruptcythe money is not available until retirementno way to borrow against balancethere are however some drawbacks disadvantages of deferred compensationwith a deferred compensation plan you are effectively a creditor of the company lending the company the salary you have deferred if the company declares bankruptcy in the future you can lose some or all of this money 1even if the company remains solid your money is locked up in many cases until retirement meaning that you cannot access it easily depending on the plan s structure you also may find yourself with limited investment options it may include only the company s stock for example unlike with a 401 k plan when funds are received from a deferred compensation plan they cannot be rolled over into an ira account 15