Summary Definition: An arrangement in which an employee’s earnings are withheld and paid out at a future date.
Deferred compensation is an agreement between an employer and an employee to delay the payment of a portion of the employee's earnings until a future date. In other words, employees earn money now, but receive it later.
Typically, funds are invested or saved in an account to earn interest or returns until they’re paid out, usually after the employee retires. This allows employees to reduce their taxable income each pay period and build savings for their future financial plans.
When enrolled in a deferred compensation plan, employees contribute funds from each pay period and wait to access the accumulated sum along with any earnings the plan has made.
Some employers will also match an employee’s contribution at a reduced rate. For example, if Employee A’s organization offers 5% matching and Employee A contributes $10,000 in a single year, the organization would then contribute $500 for that year as well.
Plans can be structured in a variety of ways but are generally classified as either qualified or non-qualified.
Qualified plans, also known as 457 plans, are subject to Internal Revenue Service (IRS) regulations, such as Internal Revenue Code (IRC) Section 457(b) and the Employee Retirement Income Security Act (ERISA). Contributions to these plans can grow tax-free and are even exempt from some taxes, such as Social Security and Medicare.
Non-qualified plans, also known as 409A plans, don’t offer the same advantages but can be more flexible in their design and implementation. For example, they don’t have to follow an annual contribution limit the way qualified plans do. This makes them more appealing to high-salary employees who wish to maximize their retirement savings on top of a qualified plan, such as a 401(k).
|Contributions are pre-tax dollars (i.e., gross pay)
|Contributions are post-tax dollars (i.e., net pay)
Held in a trust to protect from creditors in case of bankruptcy
|Not held in trusts
Benefits can go with employees from employer to employer
|Benefits might not be transferable between employers.
Some requirements for employees to participate
No eligibility requirements
Has annual contribution limits
|No annual contribution limits
While the idea of delaying parts of a paycheck may not sound immediately appealing, deferred compensation has several advantages.