What Is a Deferred Compensation Plan? Benefits, Limits, and Tips

In today's competitive job market, it can be a struggle to attract and retain talented employees, but offering the right kind of compensation can help. One way to reward employees and incentivize them to stay with your company is with a deferred compensation plan. These plans offer tax benefits and long-term savings opportunities, which makes them an attractive option for both employers and employees.

In this article, we will explore the concept of deferred compensation plans, their benefits and limitations, and tips on how to implement them effectively.

What Is Deferred Compensation?

Deferred compensation simply means that an employee gets paid at a later date. A deferred compensation plan is an agreement between an employer and an employee to formally defer a portion of the employee's compensation to be paid out at some date in the future. These plans allow employees to set aside a portion of their income for retirement or other predetermined life events, providing them with more financial security and flexibility.

Deferred compensation plans can come in two forms: non-qualified and qualified plans.

Non-Qualified Deferred Compensation Plans

A non-qualified deferred compensation plan is funded informally through a written agreement that promises deferred funds, along with any investment gains, to be paid as a lump sum or as annual payments upon termination, retirement, or when the employee in question experiences severe financial hardship.

Examples of non-qualified deferred compensation plans include supplemental executive retirement plans, salary deferral agreements, bonus deferral plans, and excess benefit plans. These plans are not governed by the Employee Retirement Income Security Act (ERISA) and provide companies with a cost-effective way to compensate specific employees or classes of employees without straining their finances. These plans can potentially reduce the employee's tax bracket for the year.

Non-qualified plans have flexible rules and fewer requirements compared to qualified plans, but income and growth are subject to tax at the time of distribution.

Qualified Deferred Compensation Plans

Qualified plans, such as 401(k), 403(b), and 457 plans, must comply with the rules outlined by ERISA and, when made available by a company, are offered to all eligible employees. These plans provide greater tax advantages for both employers and employees. Contributions to qualified plans are made with pre-tax dollars, which reduces the employee's taxable income. Additionally, investment earnings within the plan grow, tax-deferred, until they are distributed.

What Are the Benefits of a Deferred Compensation Plan?

A deferred compensation plan offers a lot of benefits for both employees and employers. These advantages include:

• Tax benefits: Deferred compensation programs offer tax advantages to both employees and employers. Employees can lower their taxable income by deferring a portion of their compensation, potentially resulting in a lower tax bracket for the year. Employers can also deduct contributions made to qualified plans as business expenses, reducing their overall tax liability.
• Capital gains: Investments made within a deferred compensation plan can generate capital gains. These gains are not taxed until distributions are taken during retirement, allowing funds to grow more rapidly over time.
• Pre-retirement distributions: In cases of severe financial hardship, employees may be able to access their deferred funds before retirement. Although early withdrawals are subject to taxes and penalties, this flexibility can provide a safety net during unforeseen circumstances.
• Potential increase in employee retention: Offering a deferred compensation plan as part of an employee benefits package can significantly enhance employee retention. The long-term savings potential and financial security provided by these plans demonstrate that an employer is committed to the future and overall wellbeing of their employees.
• Greater ability to attract qualified candidates: A deferred compensation plan can be a valuable recruiting tool. Qualified candidates may be more inclined to join a company that offers such benefits because they will recognize the long-term value and security provided by these plans.

These benefits could make a deferred compensation plan a worthwhile investment for any company interested in employee-driven success.

What Are the Limitations of a Deferred Compensation Plan?

While a deferred compensation program can provide many benefits, these plans are also subject to some limitations. These include:

• Contribution limits: Deferred compensation plans have contribution limits established by the IRS, which are adjusted annually for inflation. For 2022, the annual contribution limit for employees was $20,500, and it has been increased to $22,500 in 2023 for plans such as 401(k)s and 403(b)s.
• Financial risks: In non-qualified plans, there is a risk of losing deferred funds if the company goes bankrupt or faces financial difficulties. Employees should take care to evaluate the financial stability and reputation of a company before they participate in that company’s deferred compensation program. Qualified plans, however, are typically insured against such financial risks. 
• Additional limitations: Both employees and employers should carefully monitor deferred compensation plans as they can fluctuate in value based on investment performance. Moreover, if an employee switches jobs or leaves the company, they may lose access to their entire account. Roll-over options can vary depending on the plan, but should always be considered to avoid potential loss of funds.

While deferred compensation plans carry some risks and may not be the end-all-be-all for an employee’s retirement plan, they should still be considered for all their benefits as a valuable financial tool.

How Do Deferred Compensation Plans Work?

If you want your company to start a deferred compensation program, HR managers will play a crucial role. Here is an overview of the steps involved in the process:

1. Company objectives: HR managers should start by understanding the company's goals and objectives for implementing a deferred compensation plan. This includes considering factors such as employee retention, attracting top talent, and alignment with the company's overall compensation strategy.
2. Plan design: HR managers will work closely with benefits consultants, financial advisors, or plan administrators to design a deferred compensation program that meets the company's objectives while complying with legal and regulatory requirements. The plan design should consider factors such as eligibility criteria, contribution options, vesting schedules, investment options, and distribution rules.
3. Legal and compliance considerations: HR managers will need to ensure that the deferred compensation plan complies with relevant laws and regulations. This may involve consulting with legal counsel or benefits experts to ensure adherence to tax laws, ERISA regulations (if applicable), and other relevant guidelines.
4. Communication and education: HR managers play a crucial role in communicating the details of the deferred compensation plan to employees. They should develop a communication strategy that effectively explains the plan's features, benefits, and enrollment process. Clear and concise communication is essential to help employees understand the available options and make informed decisions regarding their participation.
5. Employee enrollment and education: HR managers facilitate the enrollment process by providing employees with the necessary documentation and guidance. They should ensure that employees receive comprehensive education about the plan, including workshops, informational materials, and access to resources that help them make informed decisions.
6. Plan administration: HR managers oversee the ongoing administration of the deferred compensation plan. This involves working closely with plan administrators, recordkeepers, or financial institutions responsible for managing the plan. HR managers are responsible for monitoring employee contributions, coordinating with payroll to ensure accurate deductions, managing investment options (if applicable), and addressing employee inquiries or concerns related to the plan.
7. Compliance monitoring and reporting: HR managers need to regularly monitor the plan's compliance with legal and regulatory requirements. They should review plan documents, conduct periodic audits, and ensure timely reporting and disclosure of information as required by law. Compliance monitoring helps mitigate potential risks and ensures the plan's integrity and effectiveness.
8. Evaluation and review: HR managers should periodically evaluate the deferred compensation plan's performance and its alignment with the company's goals. They can gather feedback from employees, analyze participation rates, assess the plan's impact on employee retention, and make adjustments or enhancements as necessary to optimize the plan's effectiveness.

By following these steps, HR managers can successfully set up and administer deferred compensation plans that provide employees with valuable long-term savings opportunities while supporting the company's overall compensation and retention strategies.

How Are Deferred Compensation Plans Taxed?

The tax treatment of deferred compensation plans depends on whether they are qualified or non-qualified.

Contributions to qualified plans are made with pre-tax dollars, reducing the employee's taxable income for the year. However, distributions during retirement are subject to ordinary income tax rates. Early withdrawals before age 59½ may incur taxes and penalties. Employees should always consult their tax professionals regarding the specific tax implications of their plans.

Non-qualified plans are funded with after-tax dollars, and the employee pays taxes on the contributions in the year they are deferred. Upon distribution, both the deferred funds and any investment gains are subject to ordinary income tax rates. As with deferred plans, a tax professional should be consulted to understand the impact of special situations or changes in tax law.

Why Offer a Deferred Compensation Plan?

Employers should consider offering deferred compensation plans to provide additional benefits to their employees. These plans can contribute to increased employee retention by demonstrating a commitment to long-term financial security and wellbeing. By offering a deferred compensation program, companies can attract and retain qualified candidates who value the opportunity to build retirement savings and enjoy potential tax advantages.

Beyond your compensation plan, make sure the benefits you offer employees support their needs. Reach out to a Wellbeing Specialist and ensure the health and overall wellbeing of your team.

References

• Boyte-White, Claire. (2023, January 22). Understanding 401(k) Withdrawal Rules — Qualified Distributions Are Allowed at Age 59 ½. Investopedia. Retrieved May 25, 2023 from https://www.investopedia.com/articles/personal-finance/111615/how-401k-works-after-retirement.asp. 
• Paycor. (2022, August 5). Are your benefits compliant under ERISA? Retrieved May 25, 2023 from https://www.paycor.com/resource-center/articles/erisa-benefits-compliance/.
• IRS. (2022, October 21). 401(k) Limit Increases to $22,500 for 2023; IRA Limit Rises to $6,500. Retrieved May 25, 2023 from https://www.irs.gov/newsroom/401k-limit-increases-to-22500-for-2023-ira-limit-rises-to-6500