Deferred Compensation - Explained
What is Deferred Compensation?
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Table of ContentsWhat is Deferred Compensation?How Deferred Compensation is Used?Types of Deferred CompensationNon-Qualifying Deferred Compensation Plans From the Employee PerspectiveAcademic Research on Deferred Compensation
What is Deferred Compensation?
A deferred compensation refers to a compensation scheme in which a portion of an employees income is separated to be paid on a later date. The payment of a deferred compensation is delayed until a future date. Employee stock option plans, pension plans and retirement plans are common examples of deferred compensation. This type of compensation requires withholding a portion of the employees income which is disbursed at a later date, often after the working life of the employee is over.
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How Deferred Compensation is Used?
Many companies give their employees the benefit of deferred compensation which is a form of compensation the employees enjoy at a later date. Aside from offering employees tax benefits, deferred compensation guarantees an employee of a steady income after retirement. Income tax on deferred compensation is not deducted until the compensation is disbursed. This helps employees reduce their tax burden as income tax on deferred compensation is removed when the compensation is paid. Roth 401(k) as an employee-benefit plan is quite different in terms of tax payment, this is because taxes are paid on this plan when the income is earned and not when the income is paid in other forms of deferred compensation. Here are some important things to know about deferred compensation;
- A deferred compensation refers to a portion of an employees pay that is set aside to be disbursed at a future date.
- Employees enjoy certain tax benefits on deferred compensation because taxes on this type of income are not removed until the compensation is paid.
- Examples of deferred compensation are employee stock option plans, pension plans and retirement plans.
- Deferred compensation can either be qualified or non-qualified.
Types of Deferred Compensation
Deferred compensation is categorized based on the following criteria; legal perspective, how employers view them, the functions they serve and how employees access them. There are two categories of deferred compensation, they are;
- Qualified Deferred Compensation Plans: Plans under the qualified deferred compensation plan are 403(b) plans, 401(k) plan and 457 plans. These forms of compensation are regulated by the Employee Retirement Income Security Act (ERISA) and must be offered directly to all employees of a company.
- Non-Qualified Deferred Compensation Plans (NQDC): NQDC plans are otherwise called 409(a) plans, these forms of compensation are not offered to all employees, rather, they can be offered to independent contractors. Companies that use NQDC plans seek to attract employees with talents that will contribute significantly to the growth of a company.
Non-Qualifying Deferred Compensation Plans From the Employee Perspective
From the perspectives of the employees of a company, NQDC plans are monetary agreements between them and their employers which grant employees flexibility to a high extent. The disbursement time for NQDC plans vary and is based on the decision of the management of a company. For instance, some companies might choose to pay out the compensation at a fixed future date while some pay employees at the point of retirement. Since a NQDC is a contractual agreement between an employee and his employer, a breach of contract by the employee that caused the retention of the deferred compensation by the company. For instance, if an employee does not spend up to the expected time or gets fired due to misconduct, the NQDC is forfeited. NQDC plans also helps employees reduce their tax burdens because taxes on these compensations are deducted when the compensation is paid. `NQDC plans offers employees a good way to save up for retirement. However, NQDC plans are not as secure as the qualified deferred plans due to the different levels of protection they enjoy. For instance, if a company becomes insolvent or goes bankrupt, the funds set aside for NQDC plans are likely to be seized. Hence, employees of companies who are financially weak or have the tendency of insolvency find NQDC plans as risky.
Academic Research on Deferred Compensation