Deferred compensation is a financial arrangement where a portion of an employee’s income is paid at a later date, often as part of a retirement package or long-term incentive plan. The goal is to provide tax benefits for both the employee and the employer, and it allows employees to receive additional compensation once they retire or meet certain milestones.
Key Takeaways
- Deferred Compensation allows employees to delay a portion of their income, typically until retirement.
- It provides tax advantages, as the employee typically pays taxes on the compensation in the future when their income may be lower.
- Example: If an executive earns $100,000 per year, they might choose to defer $20,000 of their salary to be paid out when they retire, allowing them to reduce their taxable income for the current year.
What Is Deferred Compensation?
Deferred compensation refers to an arrangement where an employee agrees to receive part of their salary or bonuses at a later date, often after retirement. Instead of receiving all their pay upfront, the deferred portion is set aside and paid in the future, often with additional benefits like interest or investment returns.
There are two main types of deferred compensation:
- Qualified Plans: These are employer-sponsored retirement plans, like 401(k)s, where contributions are made on a pre-tax basis, and the funds grow tax-deferred until retirement.
- Non-Qualified Plans: These plans allow high-level employees to defer additional income, often used by executives, and are not subject to the same regulations as qualified plans.
How Deferred Compensation Works
In a deferred compensation plan, employees agree to set aside a portion of their income, and the money is typically invested. The company may also contribute to the plan, but the employee does not receive the deferred amount until a future date, such as upon retirement or after meeting specific performance goals.
Deferred compensation can be beneficial for both the employer and employee. For the employee, it offers the advantage of reducing taxable income in the present and deferring taxes until a time when their income may be lower. For employers, it provides a way to retain key employees by tying the deferred compensation to long-term performance or milestones.
Example of Deferred Compensation
Consider an executive who earns $500,000 per year. They might elect to defer 20% of their salary ($100,000) to be paid out over the next five years after they retire. The company can invest this deferred amount, and when the executive retires, they will receive the amount with interest or investment returns.
By deferring their salary, the executive reduces their taxable income for the current year, which could result in a lower tax bracket, while also having the benefit of receiving the deferred amount as a lump sum when they retire.
Advantages and Disadvantages of Deferred Compensation
Advantages:
- Tax Deferral: Employees can lower their current taxable income, which can help reduce their overall tax burden.
- Retirement Savings: It provides an additional retirement savings option, especially for higher earners.
- Attractive to High-Level Employees: It can be used as a retention tool for top executives and key employees.
Disadvantages:
- Risk of Non-Payment: In the case of non-qualified plans, there’s a risk that the employer might not be able to pay out the deferred compensation in the future.
- Taxation Upon Withdrawal: While the compensation is deferred, it will be taxed when paid out, which might be at a higher rate if the employee’s income increases.
Is Deferred Compensation Right for You?
Deferred compensation is often used by executives and high earners who have the ability to plan for their future and reduce their taxable income. However, it’s essential to understand the terms of the arrangement and the risks involved, particularly with non-qualified plans.
If you’re considering deferred compensation, it’s a good idea to consult with a financial advisor or tax professional to ensure it aligns with your long-term financial goals.
Deferred compensation is a useful tool for managing taxes and saving for retirement, particularly for those with higher incomes. By agreeing to defer a portion of their salary, employees can reduce their tax burden and increase their retirement savings. However, it’s important to weigh the potential risks and ensure that the arrangement works with one’s overall financial strategy.
