# Understanding Deferred Compensation: Benefits, Plans, and Tax Implications

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## What Is Deferred Compensation?

Deferred compensation is a strategic financial option that allows employees to postpone receiving a portion of their salary until a specified future date, often [retirement](https://www.investopedia.com/terms/r/retirement.asp). This approach can offer immediate tax benefits and is commonly found in various forms such as [retirement plans](https://www.investopedia.com/terms/r/retirement-planning.asp), [pension plans](https://www.investopedia.com/terms/p/pensionplan.asp), and [stock-option](https://www.investopedia.com/terms/s/stockoption.asp) plans. Understanding both the qualified and non-qualified versions is crucial for maximizing retirement savings and managing tax implications.

### Key Takeaways

*   Deferred compensation is a portion of an employee's salary that is delayed for future payment, typically at retirement.  
    
*   This financial strategy usually offers tax benefits by postponing income tax until the funds are paid out.  
    
*   There are two types of deferred compensation plans: qualified plans, which adhere to federal regulations, and non-qualified plans, which typically cater to high-income earners.  
    
*   Non-qualified deferred compensation plans come with the risk of losing funds if the company goes bankrupt, unlike qualified plans.  
    
*   Employees must pay Social Security and Medicare taxes on deferred income at the time of deferral but defer income taxes until distribution.  
    

## Understanding the Mechanics of Deferred Compensation

An employee may negotiate for deferred compensation because it offers immediate tax benefits. In many cases, the taxes due on the income is deferred until the compensation is paid out, often when the employee reaches retirement age. If employees expect to be in a lower [tax bracket](https://www.investopedia.com/terms/t/taxbracket.asp) when retiring, they have a chance to reduce their tax burden.

[Roth 401(k)](https://www.investopedia.com/terms/r/roth401k.asp)s are an exception, as they require the employee to pay taxes on income as it is earned. The balance in a Roth account is, however, normally tax-free when it is withdrawn. It can be a better option for people who expect to be in a higher tax bracket when they retire.

## Exploring Different Types of Deferred Compensation Plans

Deferred compensation is either qualified or non-qualified, differing in legal treatment and purpose.

### What Are Qualified Deferred Compensation Plans?

Qualified deferred compensation plans are governed by the [Employee Retirement Income Security Act (ERISA)](https://www.investopedia.com/terms/e/erisa.asp), a key set of federal regulations for retirement plans. They include 401(k) plans and many [403(b) plans](https://www.investopedia.com/terms/1/403bplan.asp).

Funds in qualified deferred compensation plans are for the sole benefit of their recipients. Creditors cannot access the funds if the company goes [bankrupt](https://www.investopedia.com/terms/b/bankruptcy.asp). Contributions to the plans are capped by law.

### Delving Into Non-Qualified Deferred Compensation Plans

Non-qualified deferred compensation (NQDC) plans are contractual agreements between employers and participants. Also known as [409(a) plans](https://www.investopedia.com/terms/n/nqdc.asp) or, in some cases, [golden handcuffs](https://www.investopedia.com/terms/g/goldenhandcuffs.asp), NQDCs take different forms, including bonus plans, equity ([stock](https://www.investopedia.com/terms/s/stock.asp)) arrangements, and [supplemental executive retirement plans (SERPs)](https://www.investopedia.com/terms/s/serp.asp), otherwise known as "[top hat plans](https://www.investopedia.com/terms/t/top-hat-plan.asp)."

NQDC plans have no caps on contributions and are typically offered only to top-level employees and key talent that the company wants to retain. Independent contractors are eligible for NQDC plans. (This isn't the case with qualified deferred compensation plans.)

Compensation is usually paid out when the employee retires, although there can be provisions for earlier payouts in case of certain events like a change in ownership of the company or a strictly-defined emergency. Depending on the terms of the contract, deferred compensation might be canceled by the company if the employee is fired, defects to a competitor, or otherwise forfeits the benefit.  

From the participant's perspective, NQDC plans offer a reduced tax burden and a retirement savings bonus. This is especially valued by [highly compensated employees](https://www.investopedia.com/terms/h/highly-compensated-employee.asp) because qualified 401(k) plans have annual contribution limits. On the downside, the money in NQDC plans does not have the same protection as a 401(k) balance. If the company goes bankrupt, creditors can seize funds from NQDC plans.

Some companies use NQDC plans to hire expensive talent while postponing full compensation. That approach, however, can be a gamble for the employee.

> **Important**
>
> The employee pays Social Security and Medicare taxes on the deferred income at the time of the deferral but does not pay income tax on it until the funds are actually received.

## Comparing Deferred Compensation Plans and 401(k)s

A deferred compensation plan is generally an addition to a company 401(k) plan and may be offered only to a few executives and other key employees as an incentive. Generally, those employees participate in both plans. They max out their contributions to the company 401(k) while enjoying the bonus of a deferred compensation plan.

That said, a 401(k) plan that includes a matching contribution from an employer is technically a form of deferred compensation. It's part of a regular salary that is payable only after the employee leaves the company or retires, much like a type of non-qualified deferred compensation called a "[golden parachute](https://www.investopedia.com/terms/g/goldenparachute.asp)", which is reserved for highly-compensated employees.

However, the 401(k) is a qualified plan, meaning the employer must stick to federal regulations that ensure the integrity of such plans. Non-qualifying plans are less regulated.

## Benefits of Choosing Deferred Compensation

Unlike 401(k)s or [individual retirement accounts (IRAs)](https://www.investopedia.com/terms/i/ira.asp), there are no contribution limits to a deferred compensation plan. An eligible employee can, for example, earmark an annual bonus as retirement savings.

The money in both of these plans can grow tax-free until it is withdrawn. (The big exception is the Roth 401(k) or [Roth IRA](https://www.investopedia.com/terms/r/rothira.asp), where contributions are taxed when they are made and no further taxes are due on withdrawals.)

The absence of contribution limits can add a great deal of value to a deferred compensation plan for a highly-paid employee.

The plans also offer tax-deferred growth and a tax deduction for the period that the contributions are made.

Pros

*   No limits on contributions
    
*   Tax-deferred asset growth
    
*   Current-period tax deduction
    

Cons

*   Balances are not protected in case of company bankruptcy
    
*   The money is not available until retirement
    
*   No way to borrow against balance
    

There are, however, some drawbacks.

## Drawbacks and Risks of Deferred Compensation

With a deferred compensation plan, you are effectively a creditor of the company, lending the company the salary you have deferred. If the company declares bankruptcy in the future, you can lose some or all of this money.

Even if the company remains solid, your money is locked up, in many cases, until retirement, meaning that you cannot access it easily.  

Depending on the plan's structure, you also may find yourself with limited investment options. It may include only the company's stock, for example.

Unlike with a 401(k) plan, when funds are received from a deferred compensation plan they cannot be rolled over into an IRA account.

## Is Deferred Compensation a Good Idea?

Nobody turns down a bonus, and that's what deferred compensation typically is.

A rare exception might be if an employee feels that the salary offer for a job is inadequate and merely looks sweeter when the deferred compensation is added in. In particular, a younger employee might be unimpressed with a bonus that won't be paid until decades down the road.

In any case, the downside is that deferred compensation cannot be accessed for years, normally until the employee retires.

For most employees, saving for retirement via a company's 401(k) is most appropriate. However, high-income employees may want to defer a greater amount of their income for retirement than the limits imposed by a 401(k) or IRA.

## How Is Deferred Compensation Paid Out?

The distribution date may be at retirement or after a specified number of years. This must be designated at the time the plan is set up and typically cannot be changed.

It is generally better for the employee if the deferred income is distributed over several years. A large single payout can push the recipient into a higher tax bracket for the year.

Note that distributions cannot be rolled into a qualified retirement plan. That means the taxes are due for that year.

## How Does Deferred Compensation Affect Your Taxes?

In a non-Roth scenario, those making contributions to a plan enjoy a [tax deduction](https://www.investopedia.com/terms/t/tax-deduction.asp) in that year.

The funds grow tax-deferred until the payout date.

If you retire in a lower tax bracket or a [lower-tax jurisdiction](https://www.investopedia.com/financial-edge/0210/7-states-with-no-income-tax.aspx), you will benefit from the tax deferral upon retirement.

## The Bottom Line

Non-qualified deferred compensation (NQDC) plans offer high-earning employees a way to defer income beyond the limits of a 401(k), but they carry risks. These plans lack the regulation and protection associated with qualified plans like 401(k)s, leaving funds vulnerable if the company goes bankrupt.

Financial advisors recommend prioritizing maximum contributions to a 401(k) before considering NQDC plans and ensuring the company is financially stable before participating. These plans can be advantageous for tax deferral and retirement savings, but they should be approached with caution.  

> **Article Sources**
>
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>     
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>      
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>      
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