Deferred Compensation: What It Is, Plan Pros and Cons
A nonqualified deferred compensation plan can reduce your taxable income, but there are risks to consider.
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What is deferred compensation?
Deferred compensation is a type of employee benefit plan that allows employees to postpone a portion of their income until retirement or another future date, reducing their current taxable income.
Types of deferred compensation plans
Deferred compensation plans may be qualified or nonqualfied.
Qualified deferred compensation plans
Qualified deferred compensation plans — as well as 401(k)s, profit-sharing plans, incentive stock options, pensions — are protected by the Employee Retirement Income Security Act of 1974, which sets strict fiduciary standards for employee benefit plans. For instance, all employees must have plan access, there are restrictions on plan contribution amounts, and plan assets must be held in a separate trust account out of reach of creditors.
» Saving for retirement? Read about other retirement plans
Non-qualified deferred compensation plans
Nonqualified deferred compensation plans, also called supplemental executive retirement plans or elective deferral plans, are not required to follow ERISA guidelines. NQDC plans can offer further flexibility and options for the employee; however, this also means they carry additional risk.
These plans have been dubbed “golden handcuffs'' because they're often used as a retention tool for key talent or highly compensated employees. The significant reduction in taxable income is extremely attractive, or “golden.” Because deferred compensation plans may require that you stay with your employer to receive the deferred income, you’re “handcuffed” or heavily incentivized to remain with your company for the longer term.
457 Plans
One common type of deferred compensation is the 457 plan, which refers to employer-sponsored NQDC plans typically available to governmental employees (local and state) along with certain nongovernmental organizations, such as nonprofits.
How deferred compensation works
To participate in a deferred compensation plan, two things generally have to exist:
A defined enrollment period.
A written agreement with your employer designating details such as:
Amount of income deferred: Employees can defer a portion of their salary, bonus or other eligible cash payments. Your plan may allow you to roll your elections over from year to year, or it may require you to make new elections each year.
Deferral period: You need to schedule when you’d like to receive your deferred income. You may be able to select a lump-sum distribution or installments spread across several years. You may want to have income strategically distributed to meet financial goals, such as future tuition payments or retirement.
» Other ways to save for college: Learn about 529 plans
Investments: Deferred compensation plans typically distribute deferred income in addition to any investment growth you would have earned during the time it was deferred.
Deferred compensation typically is not placed directly into an actual investment; you designate investment choices for bookkeeping purposes. Your employer uses your choices as a benchmark to calculate appropriate investment returns during the deferral period.
Benefits of deferred compensation
There are compelling advantages of deferred compensation plans.
Tax advantages
When you defer income, you also defer federal and state taxes on that income until you receive it. This can be appealing if you’re in a high tax bracket and expect to be in a lower tax bracket in the future. You can reduce your present taxable income and schedule your distributions to arrive when you're in a lower tax bracket.
The money you’ve socked away in your deferred compensation plan may grow tax-deferred as well. This usually means you pay taxes on your investment growth when the funds are distributed.
» Other tax strategies: Learn how to reduce capital gains taxes
Unlimited contributions
If the plan is non-qualified, it’s not subject to ERISA standards and there’s no cap on your contribution amount. This can be helpful for employees who are already maxing out the contribution limits on 401(k)s, IRAs or other traditional retirement plans.
Goal targeting
With deferred compensation plans, employees can choose when to receive distributions. A plan may allow “in-service” withdrawals or distributions so you can access your deferred income prior to retirement to meet other financial goals or obligations. For example, you may want to buy a new home or pay your child’s college expenses at some point. You can schedule income distributions to meet those needs.
Flexibility
Compared with other retirement accounts such as 401(k)s or traditional IRAs, NQDC plans can offer more flexibility; there are no required minimum distributions or age restrictions on withdrawals.
Downsides of deferred compensation
Deferred compensation also has some important disadvantages.
Loss potential
Assets in non-qualified deferred compensation plans are not held in a separate trust; they are commingled with company funds (qualified plans, on the other hand, have ERISA protections). Accordingly, people participating in non-qualified deferred compensation plans could lose money if the company encounters financial hardship or if they leave the company. This makes it important to consider the financial health of the employer when deciding whether to participate in your NQDC plan.
Deferred compensation plans can be very complex, which is why it's often a good idea to find a qualified financial advisor who can help you determine whether it’s better for you to max out other options before contributing to a NQDC plan.
Withdrawal restrictions
After selecting your distribution date, it may be difficult to make any changes, so tread carefully when timing your deferral period. Many employees with access to NQDC plans may also have other forms of equity compensation with a timing element, such as restricted stock units or stock options. Taking a holistic approach can help you plan out your income stream and minimize your potential tax burden.
In addition, there are some limitations to NQDC plans compared with qualified retirement plans such as 401(k)s. Employees cannot take loans from their deferred compensation plan. And upon receiving plan distributions, funds cannot be rolled into an IRA or other tax-deferred retirement vehicle.
Investment restrictions
Some plans may offer as many investment choices as in a 401(k). Other plans may be more restrictive, offering only limited or expensive investment choices, or potentially only company shares. It could add risk to your overall investment portfolio if you’re overly exposed to your company’s stock or unable to sufficiently diversify your portfolio.
Tax changes
Some employees intend to move to a lower-tax state when they retire and might consider deferring compensation until they’ve done so. However, certain states base deferred compensation taxes on your elected payout period; for payout periods less than 10 years, you may be required to pay taxes to the state in which the compensation was earned. State and federal tax rules change from time to time, so consider consulting with a qualified financial advisor if you’re making long-term plans.
