Deferred Compensation: What It Is and How It Works

Deferred Compensation Meaning

Do you have an inkling of what deferred compensation is? You may have come across the term, yet find it challenging to fully understand. Rest assured; you are not alone, and this article aims to educate you on deferred compensation. Whether you’re an employer mulling over offering deferred compensation as a benefit to your employees or an employee considering enrolling in such a plan, read on to learn everything you need to know about deferred compensation.

What is deferred compensation?

Firstly, what is deferred compensation? Deferred compensation refers to income that isn’t earned at present but rather is distributed in future years. Typically, the wages, salaries, and bonuses you earn as an employee are taxed the same year you receive them, but deferred compensation isn’t taxed until the money is paid out in the future. It is a type of retirement or savings plan that rewards you for your past work and encourages you to continue engaging in the company’s growth or performance.

Types of deferred compensation plans

There are various forms of deferred compensation plans, including nonqualified deferred compensation, elective deferral plans, and bonus plans. Nonqualified deferred compensation mostly benefits high-earning executives and employees. It involves deferring compensation beyond the year in which it was earned and is exempt from taxation, unlike qualified plans such as 401(k)s and 403(b)s. Elective deferral plans, on the other hand, enable you to withhold a portion of your salary for retirement savings, while bonus plans allow you to defer bonuses and commissions to a later date.

Advantages of Deferred Comp

One of the primary advantages of deferred compensation plans is the tax benefit they offer. Since the income isn’t taxed until distribution, you can reduce your taxable income during the year in which you’re earning it and potentially save more money in taxes. Additionally, deferred compensation plans help incentivize longevity by compensating you for your time and encouraging you to remain with your employer until the deferral period is up.

Employers also benefit from offering deferred compensation plans. They allow the company to recruit and retain valuable employees, as the plan acts as an incentive for high-performing employees to remain with the organization for an extended period. These plans also act as a means to defer taxes for the company since the payment isn’t expensed for tax purposes until the distribution.

Disadvantages of Deferred Comp

However, it’s worth noting the risks associated with deferred compensation plans. They may be affected by changes to tax laws, and there’s a possibility of losing the deferred amount if the company goes bankrupt. Additionally, if you enroll in a deferred compensation plan and then leave the company before the deferral period is over, you may be forfeiting your deferred amount.

Conclusion

In conclusion, deferred compensation is an excellent retirement and savings plan that significantly rewards employees for their hard work and encourages long-term engagement with the company. It provides numerous benefits to both employers and employees, including tax benefits, talent retention, and increased employee motivation. As with any investment plan, it’s vital to research extensively and weigh the pros and cons before enrolling in this plan. Always seek the advice of an expert financial advisor before making any critical financial decisions.