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What Is Deferred Compensation?

Chime Team • July 10, 2024

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Deferred Compensation

Deferred compensation is a financial arrangement where part of an employee’s income is paid out and taxed at a later date. Various savings, pensions, and insurance plans offer deferred compensation, delaying income tax until the money is paid out in the future.

The upside of deferred compensation lies in its tax advantage. By deferring a portion of their income, employees can potentially lower their immediate income tax liability, as taxes on this portion of income are postponed until the funds are withdrawn. For instance, an employee might choose to defer compensation until retirement, when they are presumably in a lower tax bracket.

Offering deferred compensation plans can enhance the attractiveness of an employer’s employment benefits packages, helping secure skilled personnel in competitive job markets.

There are two main types of deferred compensation: qualified and non-qualified plans.

Qualified plans, like 401(k)s, are subject to Employee Retirement Income Security Act (ERISA) guidelines, offering tax benefits to both employees and employers but with contribution limits and strict withdrawal rules.¹ For instance, there are limits on the amount of money that can be contributed to these plans.

Typically, qualified plans are funded by the employer, and funds can’t be withdrawn until there is a triggering event allowed by the plan, such as retirement or disability. The employer must provide a written document outlining the details of the plan including the amount of funds deferred, the timing of when they will be paid out, and the triggering events that must occur before the payments are released.

Non-qualified plans are not subject to ERISA guidelines and are not as heavily regulated as qualified plans. Nonqualified plans also provide more flexibility regarding contributions and distributions but have fewer tax advantages.

For instance, nonqualified plans don’t have a limit for employee salary deferral contributions or employer contributions. Instead, the maximum is determined by the terms of the plan. However, some plans assign specific rules around when the plan is payable (e.g. on retirement).

Non-qualified plans are typically offered to high-earning employees and executives. For example, a top executive may opt to defer a portion of their annual bonus into the company’s non-qualified plan. This deferral can not only reduce their taxable income for the year but also allow the deferred amount to potentially grow tax-deferred until withdrawal, usually during retirement when they may be in a lower tax bracket.

Understanding deferred compensation can help you make more informed decisions about your long-term financial planning and retirement savings. By incorporating deferred compensation into your broader financial strategy, you can manage your tax liabilities, plan for future expenses, and secure a stable income stream in retirement.

Deferred compensation is closely linked to broader economic and policy discussions about retirement security, tax policy, and workforce management. How these plans are structured and taxed can have significant implications for individual financial health, the sustainability of public and private retirement systems, and overall economic well-being.

For employees, deferred compensation provides a mechanism to save and invest for the future in a tax-efficient manner. For employers, it’s a valuable tool for attracting and retaining talent. As with any financial planning tool, it’s essential to understand the specific features, benefits, and limitations of deferred compensation plans to make the most of this opportunity.

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1 Information from the U.S Department of Labor's "Employee Retirement Income Security Act (ERISA)" as of June 18, 2024: https://www.dol.gov/general/topic/retirement/erisa

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