What Is Deferred Compensation and How Does It Work?

Deferred compensation plans don’t have to be confusing. They’re simply a way for companies to promise to pay workers in the future, rather than present day, in order to gain tax benefits for both the business and its staff. They can be offered to all employees or just a few, depending on the terms of the plan you create. Besides tax advantages, a key reason companies like to use deferred comp plans is that they can help to attract and retain employees.

What Is Deferred Comp?

Deferred compensation, in any form, is employee pay that is earned in one time period but not received by the employee until a future time—when it’s then subject to tax. It’s like a promise to pay, where both the employer and the employee must meet certain requirements. Plans can take many forms, such as a 401(k) plan, a profit-share plan, or a deferred bonus paid only if certain goals are met.

Deferred comp plans can be offered by companies of any size. However, some require a lot of administration and record-keeping, which might be easier to outsource. Choosing the right outsourced administrator for the size of your company is an important cost consideration. A benefit consultant or tax advisor should be consulted to ensure any new plan is set up correctly.

If designed correctly, deferral plans have tax benefits for the company and its employees.

When Is Deferred Compensation Paid Out?

The time until payment depends on the type of plan. A 401(k) plan will be deferred until a government-mandated age, though certain circumstances allow employees to access the money sooner. A short-term bonus plan is one where the payment must be made within two-and-a-half months of the end of the taxable year. This type of plan has less complexity than long-term plans but also fewer tax benefits.

For nonvoluntary plans, the participant typically gets rights to the deferred amount over time, called the vesting period. Once the award, or part of the award, has vested, the money can be paid to the employee. Vesting periods are set by the company and can vary. Some examples are:

• Three-year cliff vesting: The deferred amount, or award, is held by the company for three years and then paid in one lump sum.
• Five-year pro-rata vesting: One-fifth (20%) of the award is paid at the end of every year.
• Ten-year cliff vesting: This is usually seen in plans focused on enhanced retirement benefits.

Since an employee does not have rights to an award until it is vested, if they leave the company before the award is vested, they will lose all unvested amounts. So the length of the vesting period versus the size of the award can have an impact on employee retention.

In a 401(k) plan, the employer can contribute or match an employee contribution. The employer contribution amount might have vesting attached such that if the employee resigns within two years, the award is canceled. But even once vested, no payments will happen until the participant meets the age qualification. Voluntary employee contributions can never be canceled.

Like 401(k), other deferred amounts are often invested on behalf of the employee during the vesting period. Any resulting gains or losses are tax-deferred until the award is distributed.

What Are the Benefits of a Deferred Compensation Plan?

Deferred comp plans have potential tax benefits for employees and employers. Basically, income tax is deferred until payments are made. If the plan has a long-time horizon, the participant might be in a lower tax bracket when they receive their funds.

The employer can see cash-flow advantages since the money does not need to be paid out immediately. The exception is qualified retirement plans, which require contributions to be transferred to a third party.

Plans can also support employee retention by tying eligibility to future company results or by giving an employee a feeling of ownership in the company.

What Are Qualified and Non-qualified Deferred Compensation Plans?

Pension and 401(k) plans are retirement plans that “qualify” for special tax treatment under the Internal Revenue Code. They must satisfy certain requirements for expenses to be deductible from income.

• They must be offered to all employees fairly and cannot favor key executives.
• Annual contribution limits are set by the government.
• Funds must be held in a trust separate from the company’s assets and cannot be used by the company.
• The deferred amounts are protected from company creditors should the worst happen.

Qualified plans are also referred to as ERISA plans, after the Employee Retirement Income Security Act (ERISA), which was introduced in 1974 to ensure protection for retirement assets.

Because qualified plans have annual limits, many companies offer additional nonqualified plans for their highly paid employees. A nonqualified deferred comp plan (NDCP) is not an ERISA plan.

• It can be offered to only a select group of employees, such as just the founder or the executive team.
• Rules are mostly defined by the company so are more flexible than qualified plans. For instance, NDCPs can have higher annual deferral limits than a 401(k) plan, and the distribution schedule does not need to be tied to age.
• Funds are not put in a trust and are available for company use.
• The award can be canceled and the amount kept by the company if an employee leaves the company before the end of the vesting period.
• Participants are not able to withdraw funds early.

A voluntary nonqualified plan allows the employee to choose, subject to the plan rules, how much base or bonus they would like to defer to the future. Amounts that are part of a voluntary deferral plan do not have a vesting period.

What Are the Rules for Deferred Compensation Under 409A?

Voluntary NDCPs are subject to section 409A of the Internal Revenue Code, which governs the timing of voluntary elections and future payments. It is important to adhere to the 409A rules, or else employees could be subject to additional taxes of 20%, plus penalties. Among the key rules are: 

• The plan must be in writing.
• The plan document must specify the amount to be paid, the payment schedule, and the trigger that will result in payment.
• The payment trigger can only be a specified date, separation from service, a change in ownership, disability, death, or an unforeseeable emergency, as defined in IRS guidance. 
• The employee must make an irrevocable election to defer before the year in which the compensation is earned.

For example, an employee is asked in November to confirm the amount of their following year’s bonus that they would like to defer. They must know when the money will be paid to them and what the payment schedule will be. The next year, when the employee is told how much the bonus will be, the previous deferral percentage must be applied, regardless of whether the bonus is above or below expectations.

An example of an unacceptable plan term would be “payment will be made when the company achieves x amount of revenue.” This is not a fixed date, so it cannot be a payment trigger for a voluntary NDCP.

The Takeaway

Deferred compensation plans can take many different forms. If designed correctly, deferral plans have tax benefits for the company and its employees. A benefits consultant or tax advisor can help with plan design. A company needs to consider which type of plans support its compensation philosophy and financial goals before choosing one or more that is right for the business.