Deferred Compensation is a financial agreement where deferment is made on a certain part of an employee’s income so that payment is received some time in the future. One of the main benefits of deferred payment is that tax is also deferred to the future point at which the income is actually paid. Typical examples include retirement plans, pensions and employee stock and shares pensions.
Deferred Compensation is only available to employees of public bodies and employees can choose to opt in to Deferred Compensation due to the likely tax benefits they’ll receive. Usually, income tax isn’t payable until the time for payment of the compensation arrives, which is usually upon retirement. In a situation where an employee is in a lower bracket of tax after retiring than when the compensation was initially earned, their tax burden can be reduced, with the exception of the Roth 401(k) retirement plan, which requires tax to be paid based on the time the income was actually earned. This is a better choice for employees who are likely to be in a higher tax bracket after retirement as they’re able to pay the tax based on their lower liability when the income was earned.
There are 2 different types of Deferred Compensation, namely Qualified Deferred Compensation and Non-qualified Deferred Compensation (NQDC), both very different in their legal applications and purposes. “Deferred compensation” is a term that’s sometimes taken to mean non-qualified plans but, technically, it covers both qualified and non-qualified plans.
All plans are normally instigated by the Board of Directors, drafted by lawyers, and recorded in the Board minutes with clear and detailed parameters set.
Qualified Deferred Compensation consists of pension plans that come under the Employee Retirement Income Security Act 1974. (ERISA). This Act has many rules, one of which regulates the amount of qualifying employee income. The tax benefits in qualifying plans were designed to help lower-to-middle income earners to accumulate savings. If a company has a qualified plan in place, this must be available to everyone in the company in direct employment (i.e. not contractors). There’s protection with Qualifying Deferred Compensation as the fund is set up for the sole benefit of its recipients. This means that, if the employer goes into debt, any creditors are unable to access the funds. There’s also a cap to the plan that’s determined by law.
NQDCs take different forms, including stocks and shares, deferred savings plans and supplemental executive retirement plans (SERPs). There are two main types of NQDC plans which are elective and non-elective. In an elective NQDC plan, employees can decide to receive a lower salary and bonus payout than they normally would and defer the receipt of this compensation to a future date. Non-elective NQDC plans are where the source of funding for the benefits comes from the employer and the current salary of employees isn’t reduced to fund future payouts from the plan. Non-elective NQDC plans can also give employers a means of attracting and retaining key employees. They’re frequently known as 409(a) plans and sometimes, in jest, as “golden handcuffs”, and can be offered to a select few employees in preference to others in the company with no limits on the contributions that can be made. Some employers use these as a means of tempting and recruiting the best staff available on the jobs market with the benefit of being able to defer their full compensation to a later date. This has all kinds of benefits for the company including cashflow and accounting advantages.
Companies may also offer Deferred Compensation benefits to independent contractors as well as employees. Any employer contributions made are tax deductible to the plan as soon they’re made but not taxable to individuals until they’re withdrawn. Usually, compensation’s paid out when the individual retires, but it can be instigated in the following circumstances:
The company could hold on to the compensation if the employee’s dismissed, leaves to work for a competitor, or forfeits the benefit in some other way. It’s important for the employee to be aware that triggering an early payment of an NQDC can lead to a heavier tax liability.
NQDC plans offer the employee the chance to have a reduced tax liability and to accumulate savings for their retirement. With many retirement schemes, there are limits to contributions so the top echelons of company executives might only be able to pay a small percentage of their salary into their plan. NQDC plans, however, aren’t included in these restrictions, but they aren’t without risks and don’t have the same protection as qualified plans. This is because, if the company becomes insolvent, the funds from NQDC plans can be claimed by creditors to offset the debts. So NQDCs are a higher risk option for those employees who are expecting payments well into the future, especially if their company’s financial position either is, or might become, uncertain.
They may be more suitable, however, for employees likely to be in a higher tax bracket upon retirement and would prefer to pay taxes calculated against their current income level. Other factors that could influence their decision are legal and tax rate changes. It goes without saying that investors should always consult a financial advisor before embarking on decisions based on their tax situation.