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A deferred compensation plan withholds a portion of an employee’s pay until a specified date, usually retirement. The lump sum owed to an employee in this type of plan is paid out on that date.
Pensions, 401(k) plans, and employee stock options all are types of deferred compensation.
Key Takeaways
- Deferred compensation plans withhold a certain percentage of an employee’s salary or wages to fund a specific future benefit.
- Qualified plans like 401(k) and 403(b) retirement savings accounts have tax advantages and meet the requirements of the Employee Retirement Income Security Act (ERISA).
- Non-qualified plans are usually regulated by the employer.
Qualified vs. Non-Qualified Deferred Compensation Plans
Deferred compensation plans generally come in two forms: qualified and non-qualified. Although there are similarities, there are also distinct differences:
- A qualified deferred compensation plan complies with the Employee Retirement Income Security Act (ERISA) and has tax benefits. Examples are 401(k) and 403(b) retirement savings plans. They are required to have contribution limits and be nondiscriminatory, open to any employee of the company, and beneficial to all. They are also more secure, as they are held in a trust account.
- A non-qualified compensation plan is a written agreement between an employer and an employee in which part of the employee’s compensation is withheld by the company, invested, and then turned over to the employee at a future date, often at retirement.
Non-qualified plans don’t have contribution limits and are often offered only to certain employees, such as top executives. The employer may keep the deferred money as part of the company’s funds, meaning that the money is at risk if the company goes bankrupt.
Money from a qualified plan can be rolled over into an individual retirement account (IRA) or other tax-advantaged retirement savings vehicle. Money from a non-qualified plan cannot be rolled over into another plan.
Benefits of a deferred compensation plan, qualified or not, include tax savings and the potential for investment gains.
Contribution Limits
Because there are tax benefits, there are limits to the amount of money employees can set aside in deferred contribution plans such as 401(k)s and 403(b)s. These limits are established by the Internal Revenue Service (IRS) and adjusted annually for inflation.
The annual contribution limit for 401(k) plans in 2024 is $23,000. Employees age 50 or older can add a catch-up contribution of $7,500.
Plans that aren’t recognized by the IRS may not have a contribution limit. For instance, a profit-sharing plan may have no cap. And certain plans meant for executives may not have a limit either.
Benefits
There are a number of key benefits that employees should be aware of before they begin contributing to a deferred contribution plan. We’ve listed some of the key advantages below.
Tax Benefits
A traditional deferred compensation plan reduces an employee’s taxable income in the year in which it is deposited into the account and allows that money to grow without any taxes assessed on the invested earnings.
A traditional 401(k) is the most common deferred compensation plan. Contributions are deducted from an employee’s paycheck before income taxes are applied, meaning they’re pre-tax contributions.
As such, you’re only required to pay taxes on a deferred plan when you take a distribution (make a withdrawal). While taxes need to be paid on the withdrawn funds, these plans give the benefit of tax deferral, meaning withdrawals are made during a period when participants are likely to be retired and in a lower income tax bracket.
Note
Participants of 401(k) plans can withdraw funds penalty-free after the age of 59½. However, there is an exception known as the Rule of 55. If you’re at least 55 years old, you can withdraw funds penalty-free from the 401(k) of your most recent employer if you parted ways with your employer (you quit, were fired, were laid off, etc.).
Capital Gains
Deferred compensation has the potential to increase capital gains over time when offered as an investment account or a stock option. Rather than simply receiving the amount that was initially deferred, a 401(k) and other deferred compensation plans can increase in value before retirement.
While investments are not actively managed by the participants, the participants do have control over how their deferred compensation accounts are invested. They can choose from options pre-selected by their employer.
A typical plan includes a range of options from conservative stable value funds and certificates of deposit (CDs) to more aggressive growth stock funds.
It’s possible to create a diversified portfolio from various funds, select a target-date or target-risk fund, or rely on specific investment advice.
Pre-Retirement Distributions
Some deferred compensation plans allow participants to schedule distributions based on a specific date for a specific reason. This is called an in-service withdrawal. This added flexibility is one of the most significant benefits of a deferred compensation plan. It offers a tax-advantaged way to save for a child’s education, a new home, or other long-term goals.
It’s possible to withdraw funds early from most deferred compensation plans for specific life events, such as buying a new home. Certain withdrawals from a qualified plan may not be subject to early withdrawal penalties. However, income taxes will be due on withdrawals from deferred compensation plans.
Disadvantages of Deferred Compensation Plans
Just like any other type of investment, deferred compensation plans come with both benefits and drawbacks. The drawbacks differ between qualified and non-qualified compensation plans.
- Contribution Limits: You are only allowed to contribute a certain amount of money annually to a qualified plan. This rule applies to plans that are regulated by the IRS, such as a 401(k) or 403(b) plan.
- Loss of Investment: If it is a non-qualified plan, you are at the mercy of your employer. If the company files for bankruptcy, you risk losing some or all of your money. It can be claimed by the company’s primary creditors before you see a dime. This isn’t the case for qualified plans. Money in a qualified deferred compensation plan such as a 401(k) is protected by ERISA regulations.
- No Rollovers: If it is a qualified plan, you can roll over money to an IRA or another 401(k) plan if you change jobs. You can’t do that with non-qualified deferred compensation plans.
- Loss of Earnings: Setting your money aside in any investment is a risk. While there is a good chance your money will grow, there’s also the chance that your investment will diminish when the market takes a dip.
- No Immediate Access to Funds: Most deferred compensation plans do not allow you access to the money you’ve invested right away. IRS-regulated plans like the 401(k) are meant for retirement. So if you make a withdrawal before the age of 59 ½ (unless it’s a qualified early withdrawal), you will incur a penalty and taxes. Some non-qualified plans come with a waiting period or a vesting period.
How Do Deferred Compensation Plans Work?
Deferred compensation plans are perks provided by employers to their employees. They allow employees to elect a certain percentage or dollar amount of their compensation to be withheld for a certain purpose, such as retirement.
Plans can be qualified or non-qualified. Qualified plan types, such as the 401(k), come with contribution limits and tax benefits. Non-qualified plans include profit-sharing programs. The rules and regulations for non-qualified plans are largely up to the employer.
How Are Deferred Compensation Plans Taxed?
The taxation of deferred compensation plans depends on the type.
Qualified compensation plans like the traditional 401(k) are not immediately taxed. This means that you don’t pay any taxes on the contributions you make and you pay no taxes as your money grows over the years. You are, however, taxed when you make withdrawals during retirement. (The exception is the Roth 401(k), where you pay taxes upfront, in the year you contribute to the account, so that qualified withdrawals after age 59½ are tax-free. Note: The account must be at least five years old for the withdrawal to be qualified.)
Withdrawals from non-qualified plans typically count as taxable earnings when the employer distributes them to the employee. Employees may also be responsible for paying capital gains taxes on any of the earnings in their accounts. Be sure to verify the tax implications of your plan with your employer before you invest.
What’s the Difference Between a Qualified and a Non-Qualified Deferred Compensation Plan?
Qualified deferred compensation plans comply with federal regulations under ERISA. Examples include the 401(k) and the 403(b). The IRS sets contribution limits and updates them annually for inflation. It also outlines the rules about when you can withdraw funds, as well as the penalties and taxes you must pay if you want to access the funds before age 59½.
Non-qualified plans such as profit-sharing plans are controlled by employers. The rules for these plans may not be as strict (especially when it comes to withdrawals) as qualified plans.
The Bottom Line
Many employers offer more than a salary as compensation. These extra perks can come in the form of healthcare, vacation pay, and deferred compensation plans.
Qualified deferred compensation plans may be used for retirement while non-qualified plans can be used for other purposes, such as profit-sharing programs.
Regardless of the type, these plans allow employees to set aside a portion of their take-home pay to use in the future.
Be mindful that the rules and regulations vary, so read the fine print before you sign up for a plan.