Deferred compensation is a smart financial strategy for high earners, allowing employees to set aside a portion of their income to be paid later—often during retirement. But what exactly is deferred compensation, and why should you consider offering it to your employees?
What is Deferred Compensation? Types, Benefits & Risks
For employees who earn a sizable salary, finding ways to manage income through smart financial planning is essential — and deferred compensation can be a critical part of that strategy. But what is deferred compensation, and why should you offer it? This plan allows employees to set aside a portion of their earnings to be paid at a later date, often during retirement, and reduce immediate tax liability.
For employers, offering deferred compensation plans can help attract and retain top talent. It not only provides tax advantages for employees but also encourages long-term loyalty. However, these plans come with legal and financial complexities. Understanding the risks and benefits of deferred compensation is crucial before making a decision to implement it.
Types of deferred compensation plans
Deferred compensation, also considered one of the different types of employee benefits, has two primary varieties: qualified plans and non-qualified deferred compensation (NQDC) plans.
Qualified vs non-qualified plans: A comparison
Qualified plans | Non-qualified plans | |
|---|---|---|
ERISA compliance | Required | Not required |
With contribution limits | ✓ | ✕ |
Creditor protection | High | Low |
Target audience | All employees | Executive/key employees |
Qualified plans
Qualified deferred compensation plans are governed by the Employee Retirement Income Security Act (ERISA) and include options like 401(k) and 403(b) plans. These plans:
- Limit contributions: Annual caps apply, such as $23,500 in 2025 for 401(k)
- Offer creditor protection: Assets are shielded from bankruptcy or lawsuits
- Provide tax benefits: Contributions are pre-tax, reducing taxable income
- Require compliance: Employers must follow strict rules to maintain tax advantages
Non-qualified plans
NQDCs, such as Supplemental Executive Retirement Plans (SERPs) or stock options, are not subject to ERISA and are typically reserved for executives or high-income earners. Key features include:
- No contribution limits: Employers can offer unlimited deferred compensation
- Tax flexibility: Payments may be taxed as ordinary income when distributed
- Higher risk: Assets are not protected from creditors and may be subject to employer insolvency
How does a deferred compensation plan work?
When workers enroll in a deferred compensation plan, they allow you to delay paying out a part of their employee compensation during payroll runs. This also means that you don’t need to process the applicable payroll tax deductions for that amount until the accumulated fund is released to the employee.
While the process can differ depending on the company, managing this plan typically follows these steps:
- Prepare the agreement: Both you and your employee need to agree on the amount to defer, when it will be paid out, and any conditions of the plan, such as potential investment options and interest earning rules.
- Income deferrals: Based on the agreement, the amount is set aside during the pay run(s) it was supposed to be processed. You have to keep the accumulated amount in a secure fund separate from your business funds.
- Payout period: When the time comes to release the funds, follow the agreed-upon payment method (in a lump sum or via installments) and process the applicable taxes.
Deferred compensation examples
If you’re wondering what deferred compensation is in practice, here are some scenarios to help you understand when this can be applied.
Deferred compensation benefits & risks
While qualified and non-qualified plans have numerous advantages, both you and your employees should also consider the potential downsides.
| Pros | Cons |
|---|---|
| Good tool for attracting and retaining top talent | Qualified plans restrict withdrawals until retirement or separation from the employer. |
| Reduces employees’ taxable incomes during high-earning years | Non-qualified plans require careful legal and tax planning; lack creditor protection |
| Total amount deferred only gets taxes when released, often at a lower rate post-retirement | Funds may vanish if the employer goes bankrupt |
| Funds may accumulate interest if invested by the company before payout | May incur IRS penalties for accessing funds before retirement age |
Deferred compensation frequently asked questions (FAQs)
Yes, provided this is part of their company’s deferred compensation plan. Employees should also know about the investment and interest-earning rules before signing up for the plan.
No, it isn’t — at least not until employees receive the deferred funds in the tax year of the agreed payout date.
If the employees signed up for a qualified plan and they quit, the funds are theirs to use, provided they are past the plan’s vesting period, if applicable. For non-qualified plans, they may be subject to restrictions or forfeiture upon termination, depending on the terms of the plan.
