When is Deferred Compensation Appropriate to Offer?

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If your executives already have a 401(k) but you want to bring in another form of compensation to encourage them to fill your high-paying positions, deferred compensation may be the answer.

Deferred compensation is pay that’s earned at one time but paid out to an employee at a later date. A 401(k) is a type of qualified deferred compensation, whereas nonqualified deferred compensation typically supplements a 401(k).

Although deferred compensation can be given to any employee, it’s particularly appealing to highly paid employees. That’s because deferred compensation has no contribution limits, so high earners can defer as much of their earnings as they’d like to save for retirement when they’ll likely need the money more. 

Deferred compensation also grows tax-free, only getting taxed once money is withdrawn.

Still, this form of executive compensation also comes with some drawbacks for employers and employees, which I’ll dig into below, so weighing the pros and cons of this compensation type is important. 

What Exactly Is Deferred Compensation?

Deferred compensation is paid in addition to an employee’s regular salary. However, instead of being paid with a paycheck like a bonus might be, it’s paid at a later date. That date is specified by the employer or employee, depending on the reason for the deferment. 

Common types of deferred compensation include 401(k) retirement plans, restricted stock units, and 457(b) plans. 

Deferred compensation is categorized as qualified or nonqualified. 

Qualified deferred compensation plans follow federal guidelines and tax laws. As a result, they’re generally stricter regarding contribution limits, reporting, and tax withholding.

Nonqualified deferred compensation plans are not subject to the same guidelines and tax laws, so they’re usually easier for companies to administer. Companies can also create their own rules, to a point, regarding how their nonqualified compensation plans work, so long as there’s a written agreement between the employer and employees receiving the plan. 

The key differences between each type of plan include:

  • Employee requirements: Only employees can have qualified deferred compensation plans. However, both employees and independent contractors are eligible for nonqualified deferred compensation plans. Also, employers don’t need to offer nonqualified deferred compensation to every employee, but if they provide qualified deferred compensation, it must be offered to all company employees. 
  • Taxing: With both qualified and nonqualified deferred compensation, employers must withhold FICA taxes at the time the money is earned. However, in the case of nonqualified plans, FICA taxes may not need to be collected until the deferred compensation is paid out if the employee or non-employee is required to complete “substantial future services,” according to the IRS, to receive their pay.
  • Contributions: Qualified plans have limits as to how much money can be deferred annually. In 2023, the cap is set to $22,500. In contrast, nonqualified deferred compensation plans do not have contribution limits. 
  • Safeguarding: Qualified plans have more security than nonqualified plans. Qualified plans are protected from an employer’s creditors, whereas nonqualified plans don’t carry the same protection, leaving employee cash vulnerable.

Deferred compensation usually refers to nonqualified deferred compensation rather than qualified. Instead of referencing qualified compensation, it’s more common to speak about specific qualified deferred compensation plans, like 401(k) or restricted stock units. 

Deferred compensation can help attract talent by offering pay that an employee can cash out at a later time. But, as I’ve identified, nonqualified plans don’t have the same level of security as qualified plans. 

So, companies often provide both a 401(k) and deferred compensation in their compensation packages to give employees the benefits of both.

When Deferred Compensation Works Best for Employers

Because there are fewer restrictions and guidelines surrounding nonqualified deferred compensation, these plans are generally simpler for employers to set up and manage. This can be an advantage for newer companies still in their beginning growth stages to keep their accounting a bit less complicated.

Organizations that want to offer deferred compensation to select workers, like their executives only, might also choose nonqualified plans, as companies aren’t obligated to offer the plan to all workers. Similarly, companies wanting to extend the plan to the contractors they work with can benefit from setting up nonqualified deferred compensation.

Qualified deferred compensation is a better option for organizations offering the benefit to all employees, as the law requires it to cover every employee of an organization providing it.

Deferred compensation serves as an attractive benefit for employees of all levels, but it’s most commonly used as a recruitment tool for senior positions. 

Companies want executives to fill roles long-term, and longevity is the nature of deferred compensation. According to a study from Principal Financial Services, 63% of employees use deferred compensation to save for retirement. With a deferred compensation plan in place, executives might see more value in remaining with the company to help their savings grow, in turn reducing the company’s turnover.

The biggest challenges with deferred compensation lie in their agreements. These plans require clear, detailed written agreements that explain the plan’s structure, how the compensation will be provided, and when employees can receive their compensation. 

You want to be sure to close any potential gaps in your plan’s rules or loopholes in its verbiage to avoid confusion and potential legal challenges.

Newer companies should also consider that employees may be skeptical of a deferred compensation plan when the company doesn’t have enough longevity to prove its trustworthiness. From an employee’s standpoint, they might wonder whether their saved cash might get lost in an eventual bankruptcy.

Employers should be proactive in mitigating employee concerns through transparency in their deferred compensation policies, explaining the potential ripple effect of bankruptcy on their funds. It’s also beneficial to offer a qualified deferred compensation plan, like a 401(k), giving workers an option between the two.

When Deferred Compensation Works Best for Employees

Although it comes with some risks, deferred compensation is probably more beneficial for employees than it is for employers, hence why it’s an attractive benefit used for recruitment and retention.

The most significant perk? Tax savings.

Deferred compensation plans can reduce an employee’s income tax for the current year by allowing them to tuck some of their earned income away for future use. If they defer $10,000 of their salary this year, that’s $10,000 less in income they’ll need to pay income tax on. 

Once the employee actually receives their compensation, they’ll owe income tax on it. However, employees don’t usually cash in on their deferred compensation until retirement, when they’ll likely be in a lower tax bracket than they currently are.

Therefore, earners in top tax brackets typically need to think about participating in a deferred comp plan the most, like single filers earning about $180,000 or more. These earners bump into a 32% tax bracket, but reducing earned income with deferred compensation can bring them back down to the 24% bracket. 

Nonqualified deferred compensation plans also have zero contribution limits, as opposed to qualified plans, allowing employees to save as much of their income as they’d like for future use. 401(k) plans are eligible for up to $22,500 in elective contributions annually, which is still an appealing amount to save for retirement.

Despite their benefits, deferred comp plans are unsecured, meaning that an employee’s savings could be at risk if the company goes bankrupt. Employees should consider whether to participate in a plan with a new company or a company lacking a strong financial health history. 

Nonqualified deferred compensation distribution dates also usually can’t be adjusted once they’re set, so it’s crucial for employees to ensure that the timing outlined in the plan makes sense for them and their future goals.

Is Deferred Compensation Worth It?

In a word, sometimes.

For employers looking to provide their employees with additional benefits to help recruitment and retainment efforts, deferred compensation is something to consider. This is especially true for large organizations seeking benefits their executives really want. 

Employees should consider the financial health of their company, the timing of the plan, and whether their salary warrants storing money away in a deferred compensation plan. 

Nonqualified plans can be risky for employees, so it’s best to use them in conjunction with a qualified deferred compensation plan, like a 401(k), to minimize potential loss.

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