Deferred compensation is defined as an arrangement at your place of employment where a part of the compensation due to the employee is set aside and paid at a later date.
It is a strategy that allows an employee to place that amount into a retirement account, where it gets accumulated and sits untaxed until the account holder withdraws the funds. It is after this withdrawal that the amount is subjected to tax and is considerably lower if deferred until retirement.
Meaning of deferred compensation
An earner must consider every option that can save taxes and set aside a larger egg nest that can be a blessing for retirement. The deferred compensation plan is like a critical tool that can see a person through his golden years.
As the name suggests, deferred compensation allows an employee to defer the compensation which he has earned in a specific tax year to a future tax year. These plans are not for every employee. It is the employer who sets up the terms and conditions under which an employee can gain access to such a scheme.
Both the employer and the employee in an organization can make contributions to deferred compensation schemes.
Examples of deferred compensation
Some notable examples of deferred compensation are
- Employee stock options – Given to an employee as part of a compensation plan
- Retirement plans – The amount paid to an employee once he retires from the organization is known as a retirement plan.
- Pensions – The amount paid when an employee retires
Types of deferred compensation
There are two types of deferred compensation
1. Qualified deferred compensation
The qualified deferred compensation plans have contribution limits that put a boundary on amount participation. There are also non-discrimination rules in place that states if a qualified plan is open, it is accessible for all employees and should benefit everyone equally.
These are strictly governed and offer more protection to the employee, meaning that the money in this scheme is safer compared with the amount invested in the non-qualified deferred compensation plan. Some of the best known qualified deferred compensation plans in place are 401(k) plans and 403(b) plans
2. Non-qualified deferred compensation
A non-qualified deferred compensation is a written agreement formal in nature between the employee and the employer where a portion of the compensation is held back, invested and given back to the employee by the employer later. The best thing about a non-qualified deferred compensation plan is that it is flexible if one compares it with the qualified compensation plan.
This is so because it does not have a participation or amount contribution limit. The amount of this scheme can be kept with regular business funds as no provision states that it has to be held in a trust. The disadvantage of a non-qualified deferred compensation plan is that the funds are not as secured as those that belong to qualified deferred compensation plans.
If a business is bankrupt or is in any financial crisis, the creditors have the authority to claim this amount. An example of a non-qualified deferred compensation plan is SERP or supplemental executive retirement plan.
Advantages of deferred compensation
The advantages of deferred compensation plans are as follows
- Deferred compensation plans aids in attracting new employees to the organization and also helps in retaining the existing ones
- Non-qualified deferred compensation plan helps to increase the cash flow, and the business has access to this fund
- The IRS does not have a limit on contributions, and an individual can easily defer a good amount in this scheme to increase your retirement money.
- It is up to the individual how he wants to pan out his deferred compensation. When he is in a low tax bracket, he can increase the amount whereas during the high tax brackets he can postpone or lower the amount.
- Employees covered under the deferred compensation plan only are subjected to taxation when they take out the money and not when it is getting accumulated
- Several retirement plans have discrimination rules and often limit contributions. But the deferred compensation plan follows no non-discrimination rules for the contributions of the participants and thus proves advantageous for executives, owners, and highly-compensated workforce
- In some cases, it is the employer who offers options for investments, and it is feasible to invest this money for higher earnings via a deferred compensation scheme
- Organizations that invest in a deferred compensation plan are not taxed on the income because the accumulated cash value is not subjected to taxation until it is distributed
- The deferred compensation plan is flexible by nature. The organizations have the liberty to name the people who will be covered under this scheme, select the terms of coverage and name any restrictions that they want to impose
- A business receives tax benefits if it offers a qualified deferred compensation plan to its employees. It can claim immediate tax reductions for the compensation and later when the employee receives compensation amount for the non-qualified deferred compensation plan.
- An advantage of deferred compensation is that it is possible to access your cash amount in case of a buy-out or a merger. The employee can take a payout which includes the total amount of what you have, and this enables us to secure the income.
Disadvantages of deferred compensation
The disadvantages of deferred compensation plans are as follows-
- One of the significant drawbacks of deferred compensation is that the amount along with investment earnings can be forfeited in case the company is going through the financial crisis
- The deferred compensation is used by several companies as a golden handcuff to keep vital employees within the company. There are rules in place in most companies where an employee forfeits all or part of his deferred compensation if he leaves early
- Another serious limitation of deferred compensation is that how and when it will be paid out must be made clear before the year the compensation is earned
- In some cases, the deferred compensation plan does not have good investment options, and the unavailability can prove harmful for an employee
- As per the rules, an employee leaving an organization before he is due to retire is not liable for his deferred compensation. The funds in Section 409A are not portable hence cannot be transferred into a new employer plan
- Several employer retirement plans give the option of the loan, but this is not the case with Section 409A deferred compensation plan
- The plan assets are available to any creditor in case of bankruptcy, and the employees can lose a large part of their hard-earned money
- A limitation of deferred compensation is that non-profit firms and government organizations are subjected to limiting rules of using these programs
- The disadvantage of taking out a complete lump-sum in case of a buy-out or merger is that the amount might be subjected to a higher tax rate of that time. But better be safe than sorry should be the mantra of the employee
- It is possible in the deferred compensation plan to lose a good part of the salary in case the terms of the plan violates
- An employee does not have any control over his assets with a deferred compensation plan because he does not have a say in how it will be invested