Deferred Compensation

Deferred compensation is an arrangement where you agree to receive a portion of your income, such as salary or bonuses, at a future date rather than immediately. This can be especially useful for managing current tax obligations and boosting retirement savings by deferring income to a time when you might be in a lower tax bracket.

Types of Deferred Compensation

Deferred compensation plans generally fall into two main categories:

1. Qualified Plans: These are IRS-regulated retirement plans, such as 401(k)s, 403(b)s, and 457(b) plans, which offer tax-deferral benefits, contribution limits, and protections under the Employee Retirement Income Security Act (ERISA). Employees typically contribute pre-tax dollars, reducing taxable income now, with taxes due upon withdrawal. Learn more about different types of qualified plans.

2. Non-Qualified Deferred Compensation (NQDC) Plans: These plans are employer-established arrangements that don’t follow all IRS rules governing qualified plans. They offer more flexibility in contributions and payout options but come with greater risk since the funds are considered a company liability and are not protected if the employer faces financial difficulties. Executives and highly compensated employees often use NQDC plans.

How Deferred Compensation Works

An employee and employer agree that a portion of the employee’s salary or bonuses will be deferred until a later date, such as retirement, termination, or a predetermined payout schedule. This deferred amount may be credited to an account which might earn some investment returns, although this depends on the plan’s structure.

Because income taxes are triggered only upon distribution, deferring compensation defers tax liability, potentially lowering total taxes paid if the recipient is in a lower bracket at payout.

Eligibility and Use Cases

• Qualified Plans like 401(k)s are available to most employees and have contribution limits defined by the IRS (e.g., $23,000 for those 50 and older in 2025). You can read about Solo 401(k) plans for self-employed workers.
• NQDC Plans are typically offered to executives and key employees as a retention or succession-planning tool.
• Business owners may use deferred compensation as part of retirement strategies.

Benefits of Deferred Compensation

• Tax deferral: Delaying income taxes until payment, which can reduce your current tax bill.
• Retirement savings: Improves financial security by accumulating savings dedicated to retirement.
• Flexibility: Non-qualified plans allow more personalized payout terms.
• Attraction and retention: Employers use these plans to reward and keep talented employees.

Risks and Considerations

• Employer solvency risk: Funds in NQDC plans are unsecured and may be lost if the employer becomes financially insolvent.
• Complexity: Plan terms can be complicated, with restrictions on withdrawal and penalties for early access.
• No access to deferred funds before payout: Deferred income typically cannot be used before distribution without tax and penalty consequences.

Practical Tips

• Review whether your plan is qualified or non-qualified.
• Diversify your retirement savings across different account types.
• Estimate your tax bracket both now and at expected payout to optimize tax benefits.
• Monitor your employer’s financial health if enrolled in a NQDC plan.

Glossary

• Deferred Compensation: Income earned now but received at a later date.
• Qualified Plans: IRS-regulated plans like 401(k)s with tax advantages and legal protections.
• Non-Qualified Deferred Compensation (NQDC): Flexible, higher-risk deferred pay agreements not fully governed by IRS rules.
• Tax Deferral: Postponement of tax payments until income is received.
• Vesting: The process by which right to deferred compensation becomes non-forfeitable over time (see vesting schedule).

Frequently Asked Questions (FAQs)

Is deferred compensation taxable? Yes. You pay income tax on the deferred amounts when you receive them, not when you earn the income.

Can I access my deferred compensation early? Typically not without penalties, though this depends on your specific plan’s rules.

What happens if my employer goes bankrupt? For non-qualified plans, deferred funds may be lost as they are considered unsecured company liabilities.

Deferred compensation plans are valuable tools for financial planning and retirement saving when understood fully and used wisely. Always consult with a tax advisor or financial planner to tailor your deferred compensation strategy to your personal goals and risk tolerance.

References and Further Reading

• IRS – Retirement Plans FAQs
• Consumer Financial Protection Bureau – Retirement Planning
• Investopedia – Deferred Compensation Overview