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What Is a Deferred Compensation Plan? Benefits & Tips
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Workforce Management

Deferred Compensation Plans

One Minute Takeaway

  • A deferred compensation plan allows a portion of an employee’s compensation to be paid at a later date.
  • Because deferred compensation plans help to reduce taxable income, these plans are often used for high-income earners.
  • A deferred compensation plan involves some risk and employees should consult an advisor before enrolling.

As a leader, it pays to investigate all of the benefits available to make your employees’ lives easier. Adding deferred compensation plans for employee stock options, pension, and retirement plans, to your company’s benefits package could make good business sense. These programs help employees save for retirement or significant events (e.g., new home, college tuition, health or other personal crises, death) by reducing taxable income and realizing capital gains.

What is a Deferred Compensation Plan?

A deferred compensation plan allows a portion of an employee’s compensation to be paid at a later date, usually to reduce income taxes. Because taxes on this income are deferred until it is paid out, these plans can be attractive to high earners. There are two types of deferred compensation plans, non-qualified and qualified plans. It’s important to know the details, pros and cons of each type of plan.

  • Non-Qualified (e.g., supplemental executive retirement plans, salary deferral agreements, bonus deferral plans, and excess benefit plans):
    • Governed by the IRS
    • Cost-effective tool for compensating and rewarding specific employees or classes of employees without taxing a company’s finances
    • Funded informally with a written agreement that includes a promise from the employer to pay deferred funds, plus any investment funds, as a lump sum or annual payments upon termination, retirement, or severe financial hardship to the beneficiary
    • Potentially reduces the employee’s tax bracket for that year
    • No annual contribution and deferral limits, unless defined by the plan
    • Fewer requirements than a qualified plan
    • Has flexible rules and fewer protections
    • Income and growth are subject to tax at distribution
  • Qualified [e.g., 401(k), 403(b), and 457 plans)
    • Must conform to Employee Retirement and Income Security Act (ERISA) rules and be offered to all employees
    • Require compensation limits
    • Have a 10% penalty on withdrawals made before age 59½
    • Taxes are paid when income is earned, not when the income is paid
    • More secure, held in a trust account

How Do Companies Fund Deferred Compensation Plans?

Companies can pay for agreed-upon benefits of a non-qualified deferred compensation plan from cash flow. However, a more secure funding method would be to purchase company-owned cash value life (COLI) or short-term disability (COSDI) insurance for each participant. The company remains the owner, premium payer, and beneficiary for each policy. Salary deferrals (contributions) and/or company contributions pay the insurance premiums. Policy cash values grow income tax-deferred and can be accessed via loans or withdrawals to pay plan benefits at the employee’s retirement.

The benefits of funding a deferred compensation program with COLI/COSDI also allow the employer to recover the plan’s cost, in whole or in part, through receipt of death proceeds. Contractually guaranteed cash values also help ensure funds will be available when needed. Long-term financing and group rates also help ease the financial burden on small businesses.

What are the Potential Downsides?

A deferred compensation plan involves some risk. The most significant downsides are:

  • Losing funds if the company goes insolvent or files bankruptcy
    • Unless deferred compensation funds are in a trust, creditors can take employee accounts to settle company debts
    • Creditors can even take money from employees in the event they leave a company before the company files bankruptcy (if the employee knew the company was close to bankruptcy)
  • Penalties and taxes for accessing funds early
    • Taking a lump sum distribution could trigger a large tax bill and penalties on the total distribution
    • If an employee switches jobs or quits, they could lose their entire account
    • No rollover options
  • Deferred compensation plans can both increase and decrease in value, so they require careful management

With plans varying from company to company, HR leaders should encourage employees to speak with financial or legal advisors before entering a deferred compensation plan.

Which Employees Should Choose a Deferred Compensation Plan?

Because deferred compensation plans help to reduce taxable income, these plans are often used for high-income earners who have maxxed out their 401 (k) or other retirement plans. However, because these plans offer employees the opportunity for tax-deferred savings, employees who receive bonuses may also be interested in this investment option. It’s important to note and consider plan restrictions on contribution amounts.

Employees are allowed to enroll at any time during the year. Once offered a deferred compensation plan, employees have 30 days to enroll. After registration, the company withholds and invests a fraction of the employee’s salary until the agreed-upon distribution date. Employees can modify their plans annually.

Managing Deferred Compensation Plans for the Long Haul

Deferred compensation plans can be an integral piece of your company’s human resource management puzzle. They add an important benefit, encourage employees to stay for the long haul, and support personal goals for the future.

Paycor Compensation Planning empowers HR leaders and their managers by removing the heavy burden of administering, tracking, and executing compensation plans and events. With a single source of truth to manage compensation, you’ll never have to rely on spreadsheets or enter data in multiple places again. With automated workflows and guided support tools, you will be able to make better, more informed decisions about retirement planning and pay practices while ensuring that salaries, bonuses, and employee rewards are equitable and competitive.

Get out of the weeds of admin and recordkeeping—once and for all. By building effective compensation programs that help drive recruiting and retention, you can eliminate workforce challenges like high turnover and missing out on top talent.