Deferred Compensation

Deferred compensation is an arrangement in which a portion of an employee’s income is paid out at a later date after which the income was earned. Examples of deferred compensation include retirement plans, pensions, and stock options. These plans can offer significant tax advantages for both employers and employees.

Types of Deferred Compensation Plans

Qualified Deferred Compensation

Qualified deferred compensation plans are those that meet the requirements of the Employee Retirement Income Security Act (ERISA). They generally include benefits such as tax deferral, non-discrimination rules, and are subject to contribution limits. Common examples are 401(k) plans, 403(b) plans, and pension plans.

• 401(k) Plans: These are employer-sponsored retirement savings plans that allow employees to contribute a portion of their salary on a pre-tax basis. Employers often match these contributions up to a certain percentage.

• 403(b) Plans: Similar to 401(k) plans, 403(b) plans are designed for employees of public schools, tax-exempt organizations, and certain ministers. Participants can make pre-tax contributions, and these plans often have additional catch-up provisions for older employees.

• Pension Plans: These are employer-funded retirement plans where the employer commits to making regular contributions to a pool of funds set aside specifically for future benefit payments to employees.

Non-Qualified Deferred Compensation

Non-qualified deferred compensation (NQDC) plans, also known as 409A plans (named after the section of the IRS code that governs them), do not have to comply with many of the ERISA provisions and offer greater flexibility. They are often used to provide additional benefits to key executives and highly compensated employees.

• Deferred Savings Plans: These plans allow employees to defer a portion of their salary or bonus until a future date, usually retirement. While contributions and earnings grow tax-deferred, distributions are taxed as ordinary income.

• Stock Options: Employers may compensate employees with company stock or options to buy company stock at a future date at a set price. These plans provide potential capital gains tax advantages if the stock’s value appreciates over time.

• Supplemental Executive Retirement Plans (SERPs): These are employer-sponsored plans that provide additional retirement income to key executives. SERPs can be used to supplement the benefits provided by standard qualified retirement plans.

Advantages of Deferred Compensation

For Employees

• Tax Deferral: Contributions to most deferred compensation plans are not subject to current income tax. Instead, taxes are deferred until the funds are withdrawn, which is often during retirement when the individual may be in a lower tax bracket.

• Retirement Savings: Deferred compensation plans encourage saving for retirement by providing structured savings programs and possible employer contributions or matches.

• Investment Growth: Funds in many deferred compensation plans have the opportunity to appreciate over time through investments, potentially generating considerable returns by the time of withdrawal.

For Employers

• Recruitment and Retention: Offering deferred compensation plans can make an employer more attractive to potential employees and help retain current staff, especially in competitive fields.

• Tax Advantages: Employer contributions to some deferred compensation plans are tax-deductible, providing a tax benefit to the company.

• Financial Flexibility: By deferring compensation, employers may benefit from improved cash flow management as actual payouts are delayed to a future date.

Risks and Considerations

For Employees

• Plan Solvency: For non-qualified plans, the deferred amounts are often subject to the claims of the employer’s creditors, meaning that if the employer faces financial difficulties, the deferred compensation could be at risk.

• Tax Rates: Future tax rates are uncertain. An employee deferring income in anticipation of a lower tax rate upon retirement may find that tax legislation changes, resulting in higher-than-expected tax liabilities.

• Liquidity Risks: Deferred compensation is not easily accessible during financial emergencies, as there are often restrictions and penalties associated with early withdrawals.

For Employers

• Funding Obligations: Employers need to ensure they’re capable of meeting future compensation payment obligations, which requires sound financial planning and potentially setting aside resources.

• Regulatory Compliance: Especially with non-qualified plans, employers need to navigate complex IRS rules (such as those in section 409A) to avoid significant penalties and excise taxes.

Legal and Financial Framework

ERISA Compliance

Qualified deferred compensation plans must comply with ERISA, which sets minimum standards to protect individuals enrolled in pension and health plans. This includes fiduciary responsibilities, funding standards, and employee rights to sue for benefits and breaches of fiduciary duty.

Section 409A

Section 409A of the Internal Revenue Code was added to address the treatment of non-qualified deferred compensation plans. It imposes certain requirements on the timing of deferral elections and distributions. Non-compliance with Section 409A can result in significant penalties, including immediate income inclusion and additional excise taxes.

Tax Implications

The tax treatment of deferred compensation varies based on the type of plan. Qualified plans typically offer tax-deferred growth until distributions are made, while contributions to non-qualified plans are typically included in the employee’s taxable income when they become accessible. Both types of plans have specific reporting requirements to the IRS.

Key Companies and Resources

Several companies specialize in providing deferred compensation plans and related services. Notable names in this space include:

• Fidelity Investments: Offering a wide range of retirement and deferred compensation solutions for companies and individuals. Fidelity Deferred Compensation Plans
• Vanguard: Provides investment management services and retirement planning options, including deferred compensation plans. Vanguard Deferred Compensation
• Charles Schwab: Offers tailored non-qualified deferred compensation plan solutions along with comprehensive financial and retirement planning services. Schwab Executive Services

These companies offer tools and resources to help both employers and employees manage their deferred compensation plans effectively.

Conclusion

Deferred compensation plans play a crucial role in financial planning for both employees and employers. They offer tax advantages and help in accumulating significant retirement savings. However, it is essential to carefully consider the risks and legal complexities associated with these plans to ensure they meet the financial goals and compliance requirements of all parties involved.