Deferred Compensation (Definition, Types)

Deferred Compensation Definition

Deferred compensation is basically an arrangement whereby a portion of the income of an individual is set aside and paid at a later date; it is generally done in order to defer the payment of taxes as the amount contributed towards such deferred compensation is in most cases not taxed until the income is actually paid off. Examples include employee stock options, pension, and retirement plans.

Types of Deferred Compensation

Deferred compensation is broadly classified as Qualified and Non – qualified. The two plans majorly differ in terms of legal treatment. It is most often used to refer non-qualified plans but technically it covers both. Qualified v/s Non-Qualified

#1 – Qualified

Qualified plans are pre-tax plans which means the tax is deducted or paid on the amount invested in such plans upfront, i.e. the day when an investment is made. Qualified plans are beneficial because in case of bankruptcy the creditors cannot access the fund in the process of liquidation. Qualified contribution plans are capped by law.

#2 – Non – Qualified

Non – qualified contribution plans are post-tax plans which means the tax on such plans is paid on the actual receipt of the amount i.e. retirement date or a predetermined future date. Non – qualified plans are used by the employer to hire and retain valuable employees of the company without having any upfront cash outflow. Such plans are not offered to all the employees and also not capped for maximum contribution.

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Understanding Deferred Compensation

Suppose an individual has an income of $250,000 per annum and opts to defer its compensation using non-qualified deferred compensation designed by his employer he will have to consider a number of factors before making a decision. Few considerations can be listed as follows,

The contribution made under non-qualified plans is not protected against the creditor’s claims in case of bankruptcy, so one needs to understand and evaluate the financial position of the company.
The Expectation is correct with regards to decrease in the future tax rate which will provide him with the tax benefits due to deferral.
The agreement of the distribution dates should be such that aligns with his own goals like retirement, college education, etc. as under non-qualified plans, early distribution is not possible.

How Does Deferred Compensation Work?

An employee can opt for a plan based on his personal tax situation. If the expectation is that the future income tax rate would be lower then the current rate the employee can opt for non-qualified deferred compensation plans because it offers potential tax benefits by deferring the tax payment to a later date, i.e. when the amount is actually paid out usually retirement date. Whereas if the expectations are that future tax rate will be higher employees can opt for the qualified plan or non-qualified plan under which the tax deduction is at the time of investment and not at the time of distribution.

However, employees who expect the increase in future tax rates will opt for qualified plans so that the tax is paid as per the current tax rate which would be lower as compared to the prediction of higher rates in the future.

There is a various factor that affects the decision which can include countries economic situation, benefits extended by the government, prospective tax laws, etc.

Advantages

Under non-qualified option there is no legal binding for the maximum contribution, so an individual can invest whatever amount he desires to in non-qualified plans.
The individual can have savings due to tax deferrals, i.e. if the expectation is that future income tax rates will be lower in comparison to the current tax rates one can invest in the non-qualified plans whereby the income is subject to tax on its actual receipt i.e. on retirement or another predetermined date.
Employers are also benefited by the deferred compensation as it frees the current cash flow and deferred to a future date.
Another advantage for employers is that they can retain the employees for a longer period by incentivizing them using deferral plans.
Under a non-qualified plan, an individual is able to set the date of distribution which helps in planning future goals like retirement, college education, etc.

Disadvantages

If an employee opts for a qualified deferral plan there will be capped in the maximum contribution.
If a plan is selected whether qualified or non-qualified without proper planning there can be a possibility that there are not benefits turn out due to the wrong prediction of taxation aspects.
The contribution made under the non-qualified option is much riskier as they are subject to fulfillment of the creditor’s claim in case of bankruptcy of the company.
The employees who don’t complete their tenure with the business generally forfeit their benefits.
In case an employee decides to switch the job, he may have to lose the entire benefit or may have to take a lump-sum payment which may trigger a high tax payment.

Conclusion

Deferred compensation is now a day considered as an important tool in tax planning and various permutations and combinations are done for maximum benefits of individual and company. Since such planning requires expert knowledge of various laws like revenue laws of the country/ state and understanding of risk of investment as per the individuals risk appetite it is always vital that an informed decision is made for such investment and usually help of financial advisor is suggested as this can help in increasing the returns and also in reducing the risk of investments.