Deferred CompensationCompensation that is set aside to be paid later

The main purpose of starting and operating a business is to earn profits.

We can say that the same principle applies to employment.

Employees seek employment to earn a salary (usually in the form of money).

Generally, an employee receives compensation (salary or wage) once a month, though some employers may pay weekly or bi-weekly.

However, employees may also have the option to defer a portion of their compensation.

Aptly termed deferred compensation, this refers to a portion of an employee’s compensation that the employer sets aside to be paid at a future date.

But why would any employee want to defer his/her compensation?

Isn’t money received now better than money received later?

In this article, we will be exploring what deferred compensation is.

How does it work?

Is it always optional or are there cases where it is required?

What are the benefits of deferred compensation for the employer and employee?

Are there several categories of deferred compensation? Let’s find out.

What is Deferred Compensation?

Deferred compensation refers to a portion of an employee’s compensation that the employer sets aside.

That employer will then pay it on a specified future date, usually on the date of the employee’s retirement.

Since this portion of the employee’s compensation is deferred, the income taxes related to it are also deferred.

They only become due when the employee actually receives the payment.

There are some exceptions to this such as in the case of Roth 401k(s), which is an employer-sponsored retirement plan.

Examples of deferred compensation include pension plans, retirement plans (including 401k plans), stock-option plans, etc.

The main benefit of deferred compensation is that it provides the employee a source of stable income after his/her retirement.

But that can only be felt when the employee actually retires.

So what’s the benefit that the employee enjoys during his/her employment?

It mainly has to do with tax. When the employee defers a portion of his/her compensation, that portion’s income tax is also deferred.

This is most advantageous when the deferment results in the employee being put in a lower tax bracket.

Not only does the employee set aside money for the future, but s/he also saves money in the present time because of the lower income tax.

Do note that deferred compensation does not eliminate the obligation of paying income taxes.

The employee will still have to pay the related income taxes when s/he finally receives the deferred compensation.

If the employee retires with a lower tax bracket, that’s another reduction in income tax, which is another benefit.

The Types of Deferred Compensation

We can categorize deferred compensation into two main categories: qualified deferred compensation, and non-qualified deferred compensation.

It’s important to distinguish the two as they greatly differ in their respective legal treatment.

Additionally, from the employer’s perspective, a qualified deferred compensation serves a different purpose than an nonqualified deferred compensation.

They also have different limitations.

Take note of these when talks about deferred compensation spring up. When someone refers to deferred compensation, they usually mean the non-qualified deferred compensation type.

Qualified Deferred Compensation

Qualified deferred compensation refers to plans that qualify under the Employee Retirement Income Security Act (ERISA).

The ERISA was enacted to ensure the protection of the employees’ retirement assets.

This act states that employees have a right to full information about their retirement plans and that it should not come at a cost.

It also requires that the retirement assets of the employees be put in a trust account for added security.

Examples of qualified deferred compensation (that qualify under ERISA) are 401(k) and 403(b) plans.

If an employer has a qualified deferred compensation plan in place, it must offer the plan to all of its employees (note: independent contractors don’t qualify as employees).

The plan must also be for the sole benefit of the employees.

This means that creditors of the employer cannot claim the funds under such a plan as payment for any remaining debts.

There is a limitation on how much compensation an employee can defer under a qualified deferred compensation plan.

In 2022, the IRS limits the compensation deferral of an individual to $20,500.

This limit applies to the aggregate total of the following plans: 401(k), 403(b), SIMPLE plans, and SARSEP (note that there’s a separate limit for deferred compensation under a 457(b) plan).

Be careful to not exceed the individual limit as the excess may be subject to double taxation.

If there is an excess, it should be returned to the employee on or before April 15 of the next year to avoid double taxation.

Due to the added protection, qualified deferred compensation plans follow stricter rules than non-qualified deferred compensation plans.

In addition, the ERISA also includes rules on how employers should provide sufficient funding for their qualified deferred compensation plans.

Non-Qualified Deferred Compensation

Retirement and pension plans that don’t qualify under ERISA are what we refer to as non-qualified deferred compensation (NQDC) plans (a.k.a. 409(a) plans). NQDC plans typically have characteristics that make them unable to qualify under ERISA.

For example, there is no limit on the amount of compensation that an employee can defer under an NQDC plan.

This makes it more attractive to employees that earn a high amount of compensation.

Unlike qualified deferred compensation plans, an employer doesn’t have to offer its NQDC plans to all of its employees.

In other words, they’re optional. Additionally, an employer can offer its NQDC plans to independent contractors.

This gives employers a way to hire and maintain a relationship with expensive freelancers.

The independent contractor gets to enjoy the benefits of deferred compensation, while the employer can postpone the payment of its obligations to its independent contractors.  

Employers often only offer NQDC plans to their high-earning employees and independent contractors.

For employers, NQDC plans provide a way to attract and retain their high-value employees.

For employees, NQDC plans provide another way to save on taxes outside of the usual qualified deferred compensation plan.

Since NQDCs plans are formal agreements between employers and employees (or independent contractors), they still have to follow certain laws and regulations.

However, they are more flexible than qualified deferred compensation plans.

For example, an NQDC plan may include a stipulation where the employee must stay with the business for at least five years. Or it may include a non-compete clause.

However, NQDC plans don’t enjoy the same protection that qualified deferred compensation plans do.

They can be risky on the part of the employee as creditors of the employer can seize them as payment for any remaining debts in the event of liquidation.

Qualified Deferred Compensation vs Non-Qualified Deferred Compensation

Both qualified deferred compensation and NQDCs provide a way for employees to defer their compensation.

However, they have significant differences. Qualified deferred compensation plans follow the rules and regulations under ERISA.

On the other hand, NQDC plans don’t have to follow ERISA although they still have to follow certain laws and regulations (particularly those that govern contractual obligations).

This allows for more flexibility.

An advantage that NQDC plans have over qualified deferred compensation plans is that they don’t have a limit on the amount of compensation that employees can defer.

The limit for qualified deferred compensation plans is an aggregate total of $20,500 (in 2022).

This limit does not apply to NQDC plans, which may make them more attractive to high-earning employees.

However, NQDC plans don’t enjoy the same level of security that qualified deferred compensation plans do.

The ERISA provides that funds under a qualified deferred compensation plan must be solely for the benefit of the employee.

This means that creditors of the employer cannot seize such funds for the payment of any remaining debts.

NQDC plans don’t have this same level of protection which makes them inherently riskier.

Lastly, if an employer has a qualified deferred compensation plan in place, it must offer such a plan to all of its employees.

Take note: employees.

This means that independent contractors cannot avail of a qualified deferred compensation plan.

On the other hand, NQDCs don’t follow the same restrictions.

This means that an employer can offer them to only select employees. Also, independent contractors can avail themselves of an NQDC plan.

Why Avail of a Deferred Compensation Plan?

While money received now is generally better than money received later, there are compelling reasons why an employee would want to avail of a deferred compensation plan.

Besides, if it’s a qualified deferred compensation plan, it’s compulsory.

Firstly, deferred compensation plans provide a stable source of income for employees after their retirement.

In a way, deferred compensation plans are like planning for the future. They are there so the employee won’t have to worry about earning income for when they retire.

Another benefit of deferring compensation is that it may result in lower income taxes for the current period.

The deferred portion of the employee’s compensation only becomes taxable when s/he actually receives it.

This is most beneficial if the reduction in taxable compensation for the current period results in the employee being put in a lower tax bracket.

Take note that this only defers the tax obligation. The employee will still have to pay the taxes for deferred compensation when s/he eventually receives it.

Lastly, it may allow the employee to earn more from his or her deferred compensation.

Employers often invest the funds (under a deferred compensation plan) in mutual funds or other similar investment options that offer a steady stream of income.

This adds value to the plan, which results in the employee potentially receiving more at his/her retirement.