Deferred Compensation

What Is Deferred Compensation?

Deferred compensation is a plan that allows employees to delay receiving a portion of the compensation earned in one tax year to a future tax year. Portions of payments and bonus payments are some of the compensation employees may choose to defer. Deferred compensation is not considered taxable income for employees until they receive the deferred payment in a future tax year.

Deferred compensation plans are not required for all employees. Employers that choose to implement a deferred compensation plan usually do so for key employees or high-earning employees in their organization.

Employers should detail the conditions under which employees can access their deferred funds, and follow specific rules for deferred compensation to avoid penalties with the IRS.

Types of Deferred Compensation

Deferred compensation may look different for different organizations. There are two types of deferred compensation plans: non-qualified and qualified. Non-qualified deferred compensation plans are also referred to as Section 409A or NQDC plans.

On top of this, there are several types of deferred compensation Section 409A plans that the IRS recognizes, including:

• Excess Benefit Plans: Employees currently enrolled in qualified benefit plans can contribute additional funds to retirement plans as an excess benefit.
• Salary Reduction Arrangements: Employees on a deferred compensation plan may choose to defer a portion of their salary until a future year. For example, an employee who earns $80,000 per year may choose to defer $30,000 of their salary and only receive $50,000 for the current year.
• Supplemental Executive Retirement Plans (SERPs): Some companies choose to contribute non-qualified funds to a supplemental retirement fund the employee can access once they’ve retired and met the conditions set forth in the retirement plan. SERPs are usually reserved for key employees or highly compensated employees within a company.
• Bonus Deferral Plans: Employees can choose to defer any bonuses they receive—and their bonus tax—until a future date.

What Is a Qualified Deferred Compensation Plan?

A qualified deferred compensation plan is one that’s governed by and meets the standards set forth in the Employee Retirement Income Security Act of 1974 (ERISA). Some deferred compensation plan examples include a 401(k), 403(b), Keogh plan, or SEP IRA.

Some characteristics of qualified compensation plans:

• These plans have contribution limits.
• Only the employees of a company can participate in a qualified compensation plan.
• Employers are required to separate funds from a qualified plan from the rest of their business funds.

What Is a Non-Qualified Deferred Compensation Plan?

A non-qualified deferred compensation plan includes any plan for deferred compensation between an employee and an employer. This means that employees can choose to defer taxable income until a future year. The deferred income is not eligible to be taxed until it’s received.

NQDC plans differ from qualified deferred compensation plans in a few key ways:

• Employers don’t need to separate NQDC funds from the rest of their business funds.
• Non-qualified plans have no limit on employee contributions.
• Employers and employees determine the terms of these plans together.
• Employers can choose to make a non-qualified plan elective, allowing employees to choose to contribute, or non-elective so they can make the decision themselves.
• Employers can make deferred compensation agreements with independent contractors.

What Happens to Deferred Compensation If I Quit?

What happens to a deferred compensation plan when an employee quits depends on a few factors:

• The type of compensation plan the employee has
• How long the employee has had that plan
• The specific terms of an employee’s non-qualified plan

If an employee has a qualified deferred compensation retirement plan, such as a 401(k), they’ll be able to keep the deferred compensation if they’re considered to be vested by the time they quit the job.

In this case, “vesting” simply means ownership. Vesting happens over a specified period of time. After that period has passed, the employee owns the account outright, and the money is 100% theirs, even if they quit.

For example, an employer may have a one-year vesting period for a deferred compensation plan. This means that once the employee has made deferred compensation contributions for one year, the money belongs to them, even if their employment at the company ends.

Termination with NQDC Plans

NQDC plans work a little differently. These plans don’t meet ERISA standards. Instead, they’re subject to specific regulations for deferred compensation, meaning there are alternate rules employers have to follow.

Typically, all of the money in an employee’s non-qualified deferred compensation account belongs to the employer. Depending on the terms of the specific agreement, an employee may forfeit all or part of that money if they leave the company for any reason. As a result, these plans are sometimes referred to as “golden handcuffs.”

So what’s a deferred compensation plan’s main benefit for employees? While NQDC plans can complicate an employee’s financial future if their employment is terminated, these plans allow employees to reduce their taxable income and save for retirement.

Other Considerations for Deferred Compensation Plans

Quitting a job isn’t the only thing that can put a non-qualified deferred compensation account in jeopardy. A deferred compensation plan works on the premise that an employer will keep the money an employee is owed and return it at a later date, typically upon retirement.

Because the funds in a non-qualified account belong to the employer, they can be seized by the employer’s creditors. If the company becomes financially unstable, this can result in a total loss of employees’ deferred compensation.

Employees should consider this potential risk in light of other forms of financial compensation that are tied to company performance, such as stock options or stock purchase plans.

Is Deferred Compensation Taxable?

Deferred compensation is taxable, but those taxes are applied at a later date. This can make filling out tax forms for deferred compensation tricky, but employers need to ensure their taxes are filed correctly, or they may face an IRS audit and penalties. Employers are subject to different withholding requirements and regulations depending on how the deferred compensation plan is structured.

For example, employers can’t withhold income tax until the employee receives their compensation, but FICA (Federal Insurance Contributions Act) and FUTA (The Federal Unemployment Tax Act) taxes must be withheld and paid when employees defer income. However, if an employee deferred compensation agreement is dependent on future services, FUTA and FICA taxes are only withheld once the employee performs those services.

Deferred Compensation Accounting

Deferred compensation accounting may be based on employee performance. For example, when employees with high compensation get performance-based pay, the company may accrue deferred compensation for a specific length of time.

Deferred compensation accounting may also be based on both future and current employee performance. In such a case, the company only accrues the portion of compensation based on the employee’s current service.

Example

A company has a deferred compensation plan with the CEO that makes him eligible to receive his deferred benefits after he works with the company for five years. During those five years, the company accrues the cost of the CEO’s contract until he fulfills the terms of his employment agreement and is eligible to receive his funds.