What Is Deferred Compensation?

Deferred compensation lets an employee earn pay now and receive some or all of it later, according to the terms of an employer-sponsored plan or agreement. It can help coordinate income with retirement or another future date, but it is not a single kind of benefit: qualified retirement plans and nonqualified deferred compensation plans have different rules and protections. In a qualified plan such as a 401(k), plan assets are generally held separately from the employer’s money; in a nonqualified plan, deferred amounts are typically an unsecured promise by the employer to pay. The plan determines what compensation can be deferred, when the employee must elect to defer it, and how and when payment will occur. Because access to the money may be limited and employer risk can matter, the plan’s terms are essential to understanding what an election means.

How Deferred Compensation Works

Deferred compensation is an agreement between an employer and an employee to postpone payment of some compensation until a future date or event. The employee earns the compensation through work but does not receive all of it in the current pay period. Depending on the plan, eligible compensation may include salary, bonuses, commissions, or incentive payments.

Payment may be scheduled for retirement, separation from employment, a fixed calendar date, disability, death, or another event specified in the plan. The precise terms vary. Wikipedia’s overview of deferred compensation describes the general arrangement as an agreement to receive compensation later, while Investopedia explains that it commonly involves postponing salary until a specified future date, often retirement.

Why Employees Consider Deferring Pay

Employees generally consider deferred compensation as part of long-term financial planning rather than as a source of money for near-term expenses. It may suit someone whose current income covers immediate needs and who wants to arrange for income after regular employment ends. Depending on the plan, deferring pay may also help coordinate payments with retirement or another career transition.

These potential benefits depend on the plan and the employee’s circumstances. Deferring compensation can mean having less cash available now, and a future payment schedule may not fit later needs. The decision therefore involves more than choosing a payout date: it also requires considering plan protections, access to funds, and the employer’s ability to pay.

Qualified and Nonqualified Plans

The distinction between qualified retirement plans and nonqualified deferred compensation plans is especially important because the plans differ in who they serve and how deferred amounts are protected.

Qualified Retirement Plans

Qualified plans are workplace retirement arrangements governed by formal rules and established tax treatment. A 401(k), for example, lets eligible employees direct part of their pay into a retirement account under the plan’s terms. These plans are designed for a broad employee population and may include employer contributions, investment choices, vesting schedules, and contribution limits.

Qualified plan assets are generally held in a trust separate from the employer’s own money. This separation provides an important distinction if the employer encounters financial trouble. The plan’s specific rules still determine how contributions, vesting, and distributions work.

Nonqualified Deferred Compensation Plans

Nonqualified deferred compensation (NQDC) plans are typically offered to a narrower group, such as senior leaders or highly compensated employees. They may allow participants to defer salary, incentives, or bonuses beyond the limits available through a standard retirement plan.

The tradeoff is that deferred amounts are usually not held in a separate trust for the employee’s benefit. They typically remain a general, unsecured promise by the employer to pay later. If the employer becomes insolvent, participants may be treated like other unsecured creditors and may not recover all deferred amounts. This employer-credit risk is a central difference to consider when deciding whether, and how much, compensation to defer into an NQDC plan.

Other Arrangements That Deliver Value Later

Pensions, equity-based awards, and long-term incentive programs can also provide value in the future. They are not necessarily the same as deferred cash compensation. A stock option, for example, may depend on vesting and other award terms rather than a promise to pay deferred salary. The form of compensation, payment date, conditions, and risks can differ, so the plan documents matter.

What to Check Before Making an Election

Plans set their own rules for elections and payouts. Before choosing to defer compensation, find out what the plan covers and how it handles key events. In particular, check:

• Eligible compensation: Identify whether the plan covers salary, bonuses, commissions, or particular incentive payments.
• Election deadline: Confirm when an election must be made. Some plans set deadlines in relation to the beginning of a plan year.
• Payment trigger: Determine whether payment begins on a fixed date, at retirement, after separation from service, or upon another event.
• Payout form: Check whether the plan permits a lump sum, installments, or a choice between them.
• Changes and early departure: Find out whether an election can be changed and what happens if employment ends before the scheduled payout.
• Funding and employer risk: Establish whether assets are held separately or whether payment depends on the employer’s future ability to pay.
• Costs and investment options: Review any applicable fees and how the plan determines account performance or future value.

The plan document is the most reliable source for these details. A general description of the benefit or a coworker’s experience may not reflect the rules that apply to a particular participant or election.

Tax Timing and Other Tradeoffs

One reason employees consider deferred compensation is that income may be received, and potentially taxed, when it is paid rather than when it is first deferred. The tax treatment depends on the arrangement and the employee’s circumstances. Deferring pay does not eliminate taxes, and the payment schedule alone does not determine the full tax result.

Access is another important consideration. Deferred money may not be available for an emergency or an unexpected expense. A future payout may also overlap with other income, while a plan that tracks investments may have a future value that changes with performance. These factors can make an election difficult to adjust if personal circumstances change.

Public-Sector Deferred Compensation

Deferred compensation is not limited to private companies or executive programs. Public employers may also offer voluntary ways for employees to postpone income for retirement. For example, the Texas Payroll/Personnel Resource on deferred compensation plans explains that the Employees Retirement System of Texas established 401(k) and 457 deferred compensation plans under the Texa$aver program. It states that new state employees are automatically enrolled unless they opt out.

This example illustrates why the name of a benefit is not enough to understand how it works. A plan may use automatic enrollment, offer different account types, or have employer-specific rules. Employees need to review the terms that apply to their own plan.

*This article is for general informational purposes only and is not legal advice.