Deferred compensation is when a portion of an employee's income is paid out at a later date, usually to provide tax advantages or retirement plans.
How deferred compensation works
When an employee enrolls in a deferred compensation program, it allows them to delay receiving a portion of their compensation until later—usually when they retire. “Deferred comp,” as these plans are sometimes called, can be offered as part of an employee benefits package. The employee and the employer must agree on the terms of the plan, including how much to defer, when it will be paid out to them, and any other terms and conditions of the plan.
There are many different types of deferred compensation plans. Retirement savings plans are the most common, but they also exist to fund pensions, stock options, and other investment options for employees. They can offer employees tax benefits because the compensation allocated to the deferral program is often tax-deferred, meaning it isn’t taxed until it’s paid out. If the employee expects to be in a lower tax bracket at retirement age (or whenever they start making withdrawals on their deferred compensation), this could mean paying less income tax overall.
Deferred compensation vs. 401(k) vs. IRA
A deferred compensation plan is generally offered in addition to other retirement accounts, like 401(k)s and IRAs—not as a replacement. It may also only be offered to high-earning executives who tend to max out their contributions to their other retirement accounts, or whose retirement income needs aren’t met by the traditional offerings of the Social Security retirement system and typical retirement savings plans.
There are a few different types of deferred compensation plans, similar to how there are different types of 401(k) and IRA plans that have different regulations, tax structures, and IRS rules.
You may be familiar with Roth and traditional IRA accounts: A Roth IRA is subject to different contribution limits than a traditional IRA—and contributions are made “after-tax,” meaning they’re taxed at the time they’re paid into the account and then can be withdrawn tax-free. Different types of deferred compensation plans are distinct in similar ways (more on this in the next section).
Types of deferred compensation
There are two broad categories of deferred compensation plans: qualified and non-qualified.
Qualified deferred compensation plans
Qualified deferred compensation plans are specifically designed for retirement plans. They’re subject to the Employee Retirement Income Security Act (ERISA) and other regulations, including contribution limits, vesting requirements, and distribution rules. Contributions made to qualified deferred compensation plans are pre-tax, which means taxes are paid when the money is withdrawn.
Non-qualified deferred compensation plans
Non-qualified deferred compensation plans aren’t subject to the same legal and regulatory requirements as qualified plans. These plans are designed for highly compensated employees, and may be referred to as Section 409A, golden handcuffs, or NQDC plans. A non-qualified plan may even be offered in addition to a qualified plan.
While non-qualified plans are more flexible, with no contribution limits or rules about vesting or distribution, they also carry more risk, since they aren’t protected by ERISA and can be impacted by the employer’s financial health and ability to pay.
Pros and cons of deferred compensation plans
Pros of deferred compensation
Cons of deferred compensation
Better financial future: Deferred compensation plans can empower employees to take control of their financial wellness by providing a structured way to save for the future.
Potential risk: Non-qualified deferred compensation plans are subject to the financial health of the employer, meaning the funds may be at risk if the company faces financial difficulties or bankruptcy.
Tax benefits: Contributions are made with pre-tax dollars, which can lower an employee's current taxable income and defer taxes until the income is received, often at retirement when they may be in a lower tax bracket.
Complexity and administrative burden: Setting up and maintaining deferred compensation plans can be complex and requires careful compliance with various tax and regulatory requirements, increasing the administrative burden for employers.
More retirement savings: Deferred compensation plans allow employees to save more for retirement beyond the limits of traditional retirement accounts like 401(k)s and IRAs, especially beneficial for employees who need to catch up on retirement savings.
Lack of portability: Deferred compensation plans are often tied to the employer and unable to rollover, so if an employee leaves the company, they may lose their benefits.
Flexible payroll deductions: Employees can choose the amount to defer from their payroll, providing flexibility to manage their current and future financial needs.
Frequently asked questions about deferred compensation plans
Still have questions about deferred compensation plans? Learn more in the FAQs below.
Who can establish a deferred compensation plan?
Deferred compensation plans can be established by all kinds of employers. Both qualified and non-qualified plans can be set up depending on the employer’s and their employees’ needs.
How is deferred compensation paid out?
Deferred compensation is typically paid out according to the terms specified in the plan agreement. Since deferred compensation is often used as a retirement solution, payout options can include lump-sum distributions or periodic payments over a set period, such as monthly or annually. The timing and form of payouts can be tailored to meet the employee’s financial needs and goals.
How does deferred compensation affect your taxes?
Deferred compensation affects taxes by allowing employees to defer a portion of their income, reducing their current taxable income. Taxes are not paid on the deferred amounts until they are received, which can result in tax savings if the employee is in a lower tax bracket upon receiving the deferred income.
What is an IRC 457(b) deferred compensation plan?
An IRC 457(b) deferred compensation plan is a type of non-qualified retirement plan available to state employees, county and local government workers, and certain non-governmental, tax-exempt organizations. These plans allow participants to defer a portion of their salary into the plan, where it grows tax-deferred until withdrawal. The IRS sets specific limits on contributions to 457(b) plans, and these plans offer similar tax benefits to other deferred compensation plans, helping employees save for retirement.
Disclaimer: Rippling and its affiliates do not provide tax, accounting, or legal advice. This material has been prepared for informational purposes only, and is not intended to provide or be relied on for tax, accounting, or legal advice. You should consult your own tax, accounting, and legal advisors before engaging in any related activities or transactions.