Deferred compensation is a tax-favored plan allowing an employee to defer a portion of their salary in exchange for a promise from the employer to pay that amount in the future. This arrangement offers the potential for tax benefits, as the deferred income is typically not taxed until it is received by the employee, which is usually during retirement when they may be in a lower tax bracket.
Types of Deferred Compensation Plans
Non-Qualified Deferred Compensation (NQDC)
Non-Qualified Deferred Compensation plans are more flexible and less regulated compared to qualified plans, such as 401(k)s. They do not have to adhere to ERISA requirements, making them attractive for high earners. Common examples include:
- Elective Deferral Plans: Employees choose to defer a portion of their current salary.
- Supplemental Executive Retirement Plans (SERPs): Employers provide additional retirement benefits to select employees.
Qualified Deferred Compensation
Qualified deferred compensation plans comply with ERISA standards and provide tax benefits for both employees and employers. Examples include:
- 401(k) Plans: Employers and employees contribute, and taxes on the earnings are deferred until withdrawal.
- 403(b) Plans: Similar to 401(k)s, but for employees of non-profits and public schools.
Historical Context of Deferred Compensation
Deferred compensation plans have evolved over the decades, especially with changes in tax laws and regulations. The emergence of the Employee Retirement Income Security Act (ERISA) in 1974 established standards that qualified plans must meet, promoting security and fairness in employee retirement savings.
Applicability and Benefits
Deferred compensation plans are particularly beneficial for:
- Employees seeking to save more for retirement beyond traditional plans.
- Employers looking to attract and retain top talent by providing customized retirement benefits.
Tax Considerations
Deferred compensation plans offer significant tax advantages. Since the deferred income is not taxed until it is actually received, it can reduce the taxpayer’s income in high-earning years and potentially fall into a lower tax bracket upon retirement.
Risks and Special Considerations
- Employer Solvency: In non-qualified plans, the employee’s deferred compensation is considered an unsecured liability of the employer.
- Regulatory Compliance: For qualified plans, adhering to ERISA and IRS regulations is mandatory.
Examples
Scenario 1: High-Earning Executive
An executive opts to defer $50,000 of their $250,000 salary into a non-qualified deferred compensation plan, reducing their immediate taxable income. Upon retirement, they receive distributions from the deferred amount, which is taxed at potentially lower rates.
Scenario 2: Public School Teacher
A teacher participates in a 403(b) plan, contributing a portion of their salary to grow tax-deferred until retirement.
Comparisons
| Aspect | Qualified Deferred Compensation | Non-Qualified Deferred Compensation |
|---|---|---|
| Regulations | Strict ERISA compliance | More flexible, no ERISA adherence |
| Tax Benefits | Immediate tax deduction | Deferred tax until distribution |
| Risk | Lower risk, employer holds funds | Higher risk, dependent on employer solvency |
Related Terms
- 401(k) Plan: A retirement savings plan allowing employees to contribute a portion of their salary, with some employers matching contributions.
- 403(b) Plan: Similar to a 401(k) but for employees of non-profits and public schools.
- ERISA: The Employee Retirement Income Security Act regulates the standards for qualified retirement plans.
FAQs
What is deferred compensation?
How is deferred compensation taxed?
What are the risks of deferred compensation?
Summary
Deferred compensation plans serve as powerful tools for employees seeking to manage tax liabilities and save for the future, and for employers aiming to attract and maintain valuable talent. Understanding the different types, benefits, and potential risks is essential for making the most out of these arrangements.
References
- IRS. “Retirement Topics - Nonqualified Deferred Compensation. Link”.
- Employee Benefits Security Administration (EBSA). “ERISA Overview. Link”.
By comprehensively addressing deferred compensation, employees and employers can make informed decisions to benefit their financial future.
