In today’s competitive job market, employers may offer an array of benefits to attract and retain top talent. One such option is “deferred compensation“, which is a portion of an employee’s compensation that is paid at a later date. Some employers may also utilize “deferred executive compensation” which is more specifically tailored for key individuals within an organization. Because taxes on this income are usually postponed until the income is actually paid, deferred compensation is an appealing option for many employees. Deferred compensation can come in many forms including retirement plans, stock options, and pension plans.
Types of Deferred Compensation Plans
There are two main types of deferred compensation: qualified and non-qualified. The main difference between these two types of plans is how they are taxed by the Internal Revenue Service, but they also can be distinguished by what type of law governs them and how employers choose to utilize them.
Qualified Deferred Compensation
Qualified deferred compensation plans can include a variety of different retirement and pension plans. They are governed by the Employee Retirement Income Security Act (ERISA), and include 401(k), 403(b) and 457 plans. These plans have the benefit of growing tax-free, with employees paying no taxes on the income gains until the money is dispersed. Further tax deferral is often possible by rolling over a qualified plan into an Individual Retirement Account (IRA) or another qualified plan. For many employees, this reduces their tax burden, as they will typically draw on these funds after retirement when they are in a lower income bracket.
Because these plans are governed by federal law, they do have some restrictions. Highly-paid employees may be barred from participating in the plan, and contributions are capped. Additionally, because these plans are intended for retirement, there are significant penalties for early withdrawal of funds. When a company offers a qualifying deferred compensation plan, it must be offered to all of its employees, with the exception of independent contractors. Importantly, because qualifying deferred compensation plans are made for the sole benefit of the recipients, they are protected in the event the employer declares bankruptcy. Creditors cannot access these funds. This makes qualified deferred compensation plans a low risk option for most employees.
Non-qualified Deferred Compensation
Non-qualifying deferred compensation (NQDC) plans are contractual agreements between employers and employees. Known as 409(a) plans, these deferred compensation plans are often used to attract and retain particularly valuable, highly-compensated employees. They can take many different forms, including stock or stock options, deferred savings plans, and supplemental executive retirement plans (SERPs).
The tax treatment of NQDC plans varies based on the type of compensation, because taxes are paid on these accounts when the income is realized by the employee. Because NQDC plans are contractual in nature, they are far more flexible than qualified plans. They can be offered to both employees and to independent contractors.
There are no contribution limits, and the parties may negotiate different restrictions or incentives. This could include a non-compete clause, or a clause that requires the employee to forfeit the compensation if he is fired or goes to work for a competitor. This type of provision has earned NQDC plans the nickname “golden handcuffs” because employees are often required to stay with the company for a set period of time in order to receive the compensation.
How the Process Works
Generally, deferred compensation is paid when the employee retires, although the payout can begin when other triggering events occur (including a change in ownership of the company, on a fixed date, or upon death, disability, or in a clearly defined emergency). There may be heavy tax penalties for early distribution of these plans. For employers, NQDC plans may be a way to postpone paying the full compensation for an expensive employee. For employees, NQDC plans may help to reduce tax burdens and to save for retirement. This is particularly important for highly compensated employees whose contributions to qualified plans would be capped by law.
However, unlike qualified plans, NQDC plans are not made for the sole benefit of the recipient; if a company goes bankrupt, the funds could be seized by creditors. This makes NQDC plans risky in situations where distributions don’t begin for a long time, or where a company is not in a strong financial position.
Contact the Business Benefits Group Today!
No matter which form a plan takes, deferred compensation is often favorable to employees, who can often lower their tax burden by delaying compensation until they are in a lower tax bracket. Many factors should be considered when deciding whether a deferred compensation plan is right for your organization, including the type of deferred compensation plan, future retirement needs, anticipated tax rates, and projected income.
Call or contact us online to speak with the experienced benefits consultants at the Business Benefits Group for more information on our full service offerings. Our highly knowledgeable industry professionals can provide competent assistance in deciding whether deferred compensation would be a smart choice for your business.