Deferred Compensation: Meaning And Benefits

what is deferred compensation

Deferred compensation can make life easier. Apart from tax benefits, it can act as a safety net or an occasional bonus to your regular earnings. But what is deferred compensation? What are it´s main benefits? In this article we´ll tell you all about it.

What Is Deferred Compensation?

Deferred compensation is defined as an addition to an employee’s regular compensation. It is usually set aside to be paid at a later date.

They’re usually in the form of retirement benefits, pension funds, and restricted stock units. Since deferred compensation is not taxed along with regular salary, it also has tax benefits.

Employers use deferred compensation to retain their teams. On the other hand, for the team, it is a safety net and an additional source of income. While most companies have all plans for all their employees, some programs, like stock-option plans, are reserved for top executives.

Types Of Deferred Compensation

1.    Golden Handcuffs

These are also 409A plans or Non-Qualifying Deferred Compensation (NQDC) Plans. As the name might suggest, this type of plan is given only to the top-level executives of the company.

Many firms use this plan to hire top-quality talent without paying them immediately. NQDCs are contractual and are often flexible.

2.    Qualified Deferred Compensation Plan

In most countries, federal laws mandate that all employees are eligible to receive deferred payments in the form of pension benefits. In the US, the Employee Retirement Income Security Act regulates these plans.

QDCs are still paid even when the company goes bankrupt.

Benefits Of a Deferred Compensation Plan (DCP)

1.    Reduces Taxes

If you’re in the high-income tax bracket, DCPs are primarily beneficial to reduce your tax obligations.

A deferred compensation plan will allow you to receive a part of your salary later. This way, you can reduce your yearly taxable income. When you receive DCPs after you retire, you’d have saved up on your tax obligations if you fall in the lower tax bracket.

Furthermore, QCDs don’t have a cap. The absence of it can add significant value to your capital.

2.    Safety Net

For people in the lower tax bracket, this is less of a tax-saving instrument and more of a safety net for retirement. Most welfare states today mandate the firms within their jurisdiction to pay deferred compensation in the form of pension plans. Pension plans act as a safety net during retirement.

Some plans include insurance premium payouts. Facilities like health insurance or term insurance will cover employees during tough times.

In the case of Qualified Deferred Compensation Plans, employees are secured from creditors in case of bankruptcy. Legal protection in most countries makes sure that employees do not have a loss of pay during their tough days.

3.    Capital Gains

Did you know that deferred compensation can help you beat inflation? You can sometimes channel the money you get as deferred compensation into mutual funds or other financial instruments that can hedge inflation rates. This way, you’d have more money to help you during retirement.

4.    Team member Retention

If you own a start-up or a large firm, deferred compensation plans can significantly increase team member retention. The program will make sure that your team is happy and secure.

To acquire talent for leadership roles, deferred compensation plans can act as a tool to save costs.

While deferred compensation plans are highly beneficial to both the employer and the firm, it has a few downsides.

Downside Of Deferred Compensation Plans

1.    If The Company Files For Bankruptcy

If you’re in the higher income bracket, DCPs can sometimes be a gamble. If the company files for bankruptcy, the creditors can cancel your deferred payouts entirely.

2.    Money Is Illiquid Until Retirement

In some cases, you cannot access these funds until you retire. While this can be good for your retirement, you cannot use DCPs as a safety net during bad times when you’re still working.

3.    Might Limit Your Investment Options

While some of you can access restricted stock units, others do not receive DCPs in company stocks. In such cases, there are a few ways you can hedge against inflation. The money parked in your deferred funds may not be able to beat inflation.

4.    Might Limit Your Disposable Income

The money that you’d have for consumption can be less. It may affect your current lifestyle at the cost of your future.

FAQs About Deferred Compensation

What are 409A plans?

409A plans is another name for Non-Qualifying deferred compensation plans. These plans are contractual and are given to top executives in a company. They’re usually in the form of restricted stock units.

What is a highly compensated employee (HCE)?

The Internal Revenue Service (IRS) in the United States defines an HCE as a person who either owned 5% of the company at any time of the year or received more than $135,000 in the 2022 tax year (This limit will increase in the 2023 tax year) and was in the company’s top 20% pay.

What are 457 plans?

The 457 plan is specifically for public sector employees. It allows you to put your pre-tax earnings in an account. In other words, it is the 401(k) plan for local and state government employees in the USA.

What is a pension plan? How does it work?

A pension plan is an employee benefit you get after retirement. Here’s how it works: You make regular contributions to a fund pool when you’re working. Once you retire, you get a steady payout from the fund.

What is a 403(b) plan?

403(b) is a retirement fund for employees of tax-exempt organizations like public schools. It is just like the private sector’s 401(k) plan.

What is a Qualified Annuity?

A qualified annuity is a savings plan funded by pre-tax dollars. That is, it is deducted from employees’ gross earnings along with investments.

Should You Get Deferred Compensation?

Despite its ills, deferred compensation is a good idea not just for employees but also for companies. If you’re in the high or low tax bracket, the benefits of DCPs are greater than their drawbacks.

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