In tight labor markets, deferred compensation plans can be essential to entice job candidates. But how exactly does delayed compensation work?

Often described as golden handcuffs, deferred compensation offers employees financial security. This benefits the company and employees, contributing to a healthy culture and stable workforce.

Definition

A deferred compensation plan allows employees to receive a portion of their salary or wages at a future date rather than immediately. It is a way to reward employees for their services and encourage them to stay with the company. The money is usually invested in a retirement account that earns interest over time. In addition, it can help employees save on taxes and provide financial security in the event of a layoff or bankruptcy.

Deferred compensation can take many forms, including pensions, 401(k) plans, and employee stock options. Some companies also offer nonqualified deferred compensation or NQDC. These contractual agreements include salary reduction arrangements, excess benefit plans, and bonus deferral plans. They are often provided to key employees and highly compensated executives and may be taxable when the employee realizes the amount.

In most cases, the funds deposited in a deferred compensation plan are taxed at your marginal Federal income tax rate when you eventually receive them. However, there are some exceptions. For example, if you are moving from a high-tax state to a low-tax one, you can have the funds in your deferred compensation account withdrawn and transferred to the new location to avoid paying taxes. This option is called “rollover.” However, you should always consult a financial advisor before making this decision.

Understanding the deferred compensation definition and its various forms empowers both employers and employees to make informed decisions regarding financial planning and long-term goals. Employees can secure their financial future by choosing the right plan and understanding the benefits and drawbacks, while employers can attract and retain top talent.

Taxes

A portion of an employee’s salary that is not taxed when earned but is subject to income taxes when paid is known as deferred compensation. This deferral of taxable income reduces an employee’s current income taxes. It may help them avoid paying taxes in future years if they expect to be in a lower tax bracket upon receiving the money.

Some plans allow employees to choose how they want their deferred compensation distributed. However, this is often based on the plan details and an employee’s current and expected future tax situations. Most of the time, the employer will provide you the option of receiving payments in installments over a predetermined time or in one lump sum.

A lump sum distribution is typically taxed at the highest marginal tax rate. However, reducing the tax impact on such payments is possible by “bunching” other deductible expenses, such as charitable contributions or real estate taxes.

Nonqualified deferred compensation is a form of compensation that includes salary or bonus elective deferrals and other amounts such as stock options. These arrangements are often used as retention tools, with employers offering high-level executives a substantial reduction in their taxable income in exchange for agreeing to stay with the company over the long term. Some of these arrangements are also known as golden handcuffs due to the significant incentive they provide to keep highly compensated employees from accepting offers from other companies.

Investments

Deferred compensation is usually invested in mutual funds and other safe investment options that pay steady interest payments. This increases the value of your future distribution, reducing the taxes you must pay. This is highly advantageous for those considering retiring in a lower tax bracket.

Unlike 401(k) plans, which have a lot of flexibility regarding how they can be invested, many deferred compensation programs offer only a limited set of investment choices. This can make it challenging to achieve good investment diversification. Also, since the account that holds your deferred compensation is considered an unsecured liability, you may lose some or all of your assets if your company goes bankrupt.

If you are already maxing out your 401(k) and still want to save additional money, looking into nonqualified deferred compensation plans (NQDCs) might be wise. These can provide greater flexibility in how you invest your deferred compensation. But it’s essential to consider the dangers of making these kinds of investments. It is best to consult with a financial advisor before deciding about NQDCs.

Benefits

Deferred compensation is an excellent incentive tool for high-level executives and key employees, especially in a competitive environment. It allows them to delay income taxes, build wealth, and invest in the company’s stock or other assets. This helps to improve employee motivation, retention, and morale. However, it is essential to understand the tax consequences of these arrangements and their potential impact on your future financial picture before deciding to participate in your employer’s plan.

Typically, participants in nonqualified deferred compensation plans can receive their distributions either in a lump sum or in installments over a set number of years. Companies may also offer investment options, such as stable value funds and certificates of deposit, as well as more aggressive bond and equity investments. Reviewing the plan documents and consulting with an advisor before selecting a distribution option is essential.

Another consideration is that if you decide to change your distribution choice, it can only occur after the year you are scheduled to receive your first payment. This restriction is usually meant to prevent employees from accelerating their distributions in anticipation of a retirement event that could push them into a higher income tax bracket, defeating the purpose of deferring the income.

Generally, a participant’s money in a deferred compensation account is considered part of their wages. Hence, the distributions are subject to state income tax, even if the employee lives in a different state when the distribution is received. To help mitigate this issue, many plan administrators allow participants to roll over the distributions into IRAs or other retirement savings accounts.