Deferred compensation plan: Overview, definition, and example
What is a deferred compensation plan?
A deferred compensation plan is a type of employee benefit plan in which a portion of an employee's income is set aside to be paid at a later date, usually after retirement or when certain conditions are met. The idea behind a deferred compensation plan is that employees agree to delay receiving part of their income now in exchange for receiving it at a later time, often with tax advantages. These plans can take various forms, including non-qualified deferred compensation plans (NQDC) and qualified plans, such as 401(k) accounts, but typically differ in terms of tax treatment and eligibility requirements.
For example, a company might offer its executives a deferred compensation plan where they can choose to defer a portion of their salary or bonus for several years, receiving it with interest or other investment gains at retirement.
Why is a deferred compensation plan important?
A deferred compensation plan is important because it provides financial flexibility for both the employee and the employer. Employees benefit by reducing their current tax burden, as they defer income tax on the portion of earnings that are set aside for future payouts. It also offers a way for employees to save for retirement or other future financial goals.
For employers, offering a deferred compensation plan can be a valuable tool for attracting and retaining talent, especially for high-level employees or executives, by providing long-term financial incentives. Additionally, it allows companies to manage cash flow by delaying payouts. For employees, a deferred compensation plan can offer a disciplined way to save for retirement or other long-term needs, often with the added benefit of company contributions or investment growth.
Understanding deferred compensation plan through an example
A technology company offers its senior executives a deferred compensation plan where they can defer a percentage of their annual salary, as well as any performance bonuses, for up to 10 years. The deferred income is invested and grows over time, with the executives receiving the funds upon reaching retirement or when certain performance milestones are achieved. This allows the company to provide a long-term incentive for executives while also helping them plan for retirement in a tax-advantageous way.
In another example, a small business offers a non-qualified deferred compensation plan to its key employees. Employees can defer up to 25% of their annual salary, and the employer may choose to match a portion of the deferrals. This provides employees with an additional retirement savings vehicle, and the employer can deduct contributions as a business expense, helping to reduce taxable income.
An example of a deferred compensation plan clause
Here’s how this type of clause might appear in an employment contract:
“The Executive shall have the option to defer up to 30% of their annual salary and performance bonuses under the Company’s Deferred Compensation Plan. The deferred amounts shall be invested in a selection of funds offered by the Plan and will be payable to the Executive upon retirement, or at such time as specified in the Plan’s terms, with interest or growth based on the chosen investments.”
Conclusion
A deferred compensation plan provides both employees and employers with a valuable tool for managing income, taxes, and retirement planning. By allowing employees to delay receiving a portion of their income, these plans offer long-term savings opportunities while reducing current tax liabilities. For employers, deferred compensation plans are a way to incentivize and retain key talent, offering additional benefits and future payouts that can align employees’ financial interests with the company’s long-term success.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.