Takeaways
- Deferred compensation is a portion of earnings you set aside for a future date.
- Companies offer deferred compensation plans to encourage regular savings.
- Deferred compensation plans have two categories: qualified and non-qualified.
- ERISA regulates qualified plans, including 401(k), 403(b), and 457(b) plans.
- Non-qualified plans are available to executives and are not protected from insolvency.
What Is Deferred Compensation?
Deferred compensation is a financial arrangement in which a portion of an employee’s earnings is set aside to be paid out later. It allows employees to delay receiving part of their salary or bonus, often until retirement. Deferred compensation is a savings strategy that provides employees with potential tax benefits and long-term financial security.
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How Deferred Compensation Works
Deferred compensation allows employees to postpone a portion of their income to a future date, usually after they leave the company or retire. These earnings can be invested, and sometimes, your employer may match a portion of your compensation you elect to defer, like in a retirement plan.
The deferred funds are typically not taxed until paid out, which can be advantageous for employees who anticipate being in a lower tax bracket in future years. Stashing savings in a 401(k) or Traditional IRA is a smart strategy that can lower your taxes. Depending on the plan type, your funds can be invested in various assets such as stocks, bonds, mutual funds, and index funds, hopefully growing over time.
The payout schedule for deferred compensation varies depending on the plan. Some plans allow employees to choose their distribution schedule, while others have a fixed timeline. Payments may be received as a lump sum or in installments over a specified period. However, like with all investing, there are risks. Enrolled employees could lose deferred earnings if the investments in your plan decline in value over time or the company faces financial difficulties, particularly with non-qualified plans.
Read Also: What Is Discretionary Income?
Types of Deferred Compensation
There are two primary types of deferred compensation plans: qualified and non-qualified. Each has different rules, benefits, and risks.
Qualified Deferred Compensation Plans
Qualified deferred compensation plans are regulated under the Employee Retirement Income Security Act (ERISA) and offer employee protections.[1] The most common type of qualified plan is a 401(k) plan, where employees contribute pre-tax earnings, and employers may provide matching contributions.
According to the U.S. Bureau of Labor Statistics, 91% of companies with 500 or more workers have access to defined benefit pension or contribution retirement plans.[2] Other examples include 403(b) plans for non-profit organizations and 457(b) plans for government employees.
Key parts of qualified plans include:
- Contributions are subject to IRS limits.
- Funds are protected from employer bankruptcy.
- Taxes are deferred until funds are withdrawn, typically in retirement.
- Withdrawals before age 59½ may incur penalties.
Non-Qualified Deferred Compensation (NQDC) Plans
Non-qualified deferred compensation plans are designed for executives and high-earning employees who want to postpone a more significant portion of their income beyond the limits imposed by qualified plans. These plans do not follow the same ERISA regulations, making them more flexible but riskier.
The main characteristics of NQDC plans include the following:
- Contributions are not subject to IRS limits, allowing higher deferrals.
- Funds are not protected from employer insolvency.
- Taxes are deferred until distribution, but early withdrawal rules vary.
- Payouts are usually predetermined and may be subject to company conditions.
Because NQDC plans carry a higher risk, participants must carefully evaluate their employer’s financial stability before deferring a significant portion of their earnings.
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Why Companies Use Deferred Comp
Companies offer deferred compensation for several strategic reasons.
First, these plans help attract and retain top talent, particularly executives and high earners looking for tax-efficient ways to manage their income.
Deferred compensation also benefits employers by managing payroll costs and cash flow. By delaying part of an employee’s compensation, companies can allocate resources more efficiently while offering competitive compensation packages.
From a tax perspective, businesses may benefit from deductions on deferred compensation payouts when they are distributed to employees. However, the tax treatment varies depending on the plan type and structure.
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Pros of Deferred Comp
- Tax Deferral Benefits: Employees can defer income to a future date when they may be in a lower tax bracket. (Read about 5 Amazing Savings Habits to Start Now).
- Potential for Investment Growth: Deferred funds can be invested, allowing earnings to grow over time. (Read about Compound Interest).
- Flexibility in Payout Options: Employees may choose lump-sum payments or installment distributions. (Read about Investing in Annuities).
- Attractive for High Earners: Non-qualified plans allow executives to defer more significant portions of their salary beyond IRS limits. (Read about Retirement 101).
- Retention and Incentive Tool: This tool helps companies retain key employees by offering long-term financial benefits. (Read about 7 Non-Cash Ways to Get Compensated).
Cons of Deferred Comp
- Risk of Employer Insolvency: Non-qualified plans are not protected, meaning employees could lose deferred earnings if the company fails. (Read about how the Federal Deposit Insurance Corporation protects your savings).
- Limited Access to Funds: Deferred income is not easily accessible and may be subject to strict distribution rules. You can give yourself a financial cushion by saving an emergency fund and a slush fund.
- Potential Tax Implications: Taxes on distributions may be higher if taken in a lump sum. (Read about 9 Ways to Use Your Tax Refund).
- Early Withdrawal Penalties: Qualified plans may impose penalties for withdrawing funds before retirement. Withdrawing early could derail your savings goals or leave you with insufficient retirement funds. (Learn about the 4% Rule).
- Dependence on Employer Stability: For non-qualified plans, employees must trust that their employer will be able to fulfill deferred payment obligations in the future. (Read more about How to Advance Your Career).
Smart Summary
Deferred compensation allows employees to delay income and potentially reduce their tax liability while providing early opportunities to start investing. While deferred compensation offers significant benefits, it also comes with investment risks. Employees should carefully assess their personal finance needs, tax implications, and the stability of their employer before participating in a deferred compensation plan.
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(1) U.S. Department of Labor. ERISA. Last Accessed March 8, 2025.
(2) U.S. Bureau of Labor Statistics. Employee Benefits in the United States – March 2024. Last Accessed March 8, 2025.
