What is Deferred Compensation?
Deferred compensation forms a contractual arrangement between an employer and an employee, wherein the latter consents to the postponement of a portion of their salary until a later date, generally post-retirement. This strategic approach authorizes the employee to delay the tax obligations associated with said income until its actual receipt, thereby potentially lowering their tax liability, especially if they find themselves in a lower tax bracket during that period. Various manifestations of deferred compensation include retirement plans, pension schemes, and stock-option plans.
How Deferred Compensation Works
Deferred compensation enables employees to defer the receipt of a part of their salary to a subsequent point in time, usually post-retirement. This strategic maneuver empowers the employee to postpone the taxation of the deferred income until its actual disbursement, potentially resulting in a reduced tax liability should the individual find themselves in a lower tax bracket during that juncture. In addition to the tax benefits, deferred compensation serves as a mechanism for employees to bolster their retirement savings and foster increased allegiance to their employer.
Nevertheless, the efficacy of deferred compensation is accompanied by certain drawbacks. These include the inherent risk of forfeiture of deferred income in the event of employer bankruptcy, the concomitant lack of liquidity and flexibility, and the prospect of encountering higher tax implications in the future. Consequently, a judicious evaluation of the advantages and drawbacks is imperative for individuals contemplating participation in deferred compensation programs.
Types of Deferred Compensation
There are two different sorts of deferred compensation plans: qualified and nonqualified.
Qualified Deferred Compensation Plans: A qualified deferred compensation plan is a sort of retirement savings plan that follows the Employee Retirement Income Security Act of 1974 (ERISA) rules. This law protects employees' retirement funds by keeping them in a separate trust account. The plan must be available to all employees and can only be used for their benefit. This means that if the company goes bankrupt, the creditors cannot take the money from the plan. Some common examples of qualified deferred compensation plans are 401 (k) and 403 (b) plans.
Non-Qualifying Deferred Compensation Plans: Nonqualified deferred compensation plans are not subject to ERISA rules and regulations. They are more flexible and customizable than qualified plans but also carry more risks. The plans are usually offered to executives or key employees who have a higher income potential. The funds are not held in a trust account but rather in the company’s general assets. This means that the employee is an unsecured creditor of the company and may lose the deferred income if the company goes bankrupt or is sued. Some examples of nonqualified deferred compensation include stock options, phantom stock, and deferred bonus plans