What is Deferred Compensation?

Deferred compensation is a compensation plan that allows employees to delay receiving compensation earned in one tax year until a future tax year. It can include portions of payments and bonus payments.

Types of Deferred Compensation Plans

There are two types of deferred compensation plans: non-qualified and qualified. Non-qualified deferred compensation plans are also called Section 409A or NQDC plans. 

Qualified deferred compensation plans, such as 401K, have contribution limits and are only for employees. Employers must separate those funds from the rest of their business funds. Non-qualified deferred compensation plans include any plan for deferred compensation between an employee and an employer. Employers do not need to separate NQDC funds from the rest of their business funds. Non-qualified plans have no limit on employee contributions and terms are determined between an employer and employee. The decision can be elective or non-elective.

Why Choose to Implement a Deferred Compensation Plan?

Employers who choose to implement a deferred compensation plan usually do so for key employees or high-earning employees in their organization. Employees may defer taxable income until a future year, and the deferred income is not taxed until received.

To avoid penalties with the IRS, employers should detail conditions under which employees can access their deferred funds and follow specific rules for deferred compensation. Employers are subject to different withholding requirements and regulations depending on how the deferred compensation plan is structured. Employers cannot withhold income tax until the employee receives their compensation, but FICA and FUTA taxes must be withheld and paid when employees defer income.

Deferred compensation accounting may be based on the performance of the employee. Highly compensated employees may have performance-based compensation in the cost of the deferred compensation is accrued during a predetermined period. Deferred compensation accounting may also be based on both future and current employee performance. In that case, only the portion of compensation based on the employee’s current service is accrued.

To sum it up, deferred compensation, whether qualified or non-qualified, enables employees to receive compensation in a future tax year. Employers should be aware of withholding requirements and regulations to avoid penalties. Accounting for deferred compensation may be based on performance or both future and current performance.