Executive deferred compensation plans provide attractive ways to defer income and save money. Our experienced team can help you design and implement a plan that works best for you. Learn more below.

What is an executive deferred compensation plan?

These are an attractive way for employers to delay payment of a portion of the income from an employee’s earnings until a later date. Disbursements usually happen when an employee retires, but they can take place at other times as well.

Employees realize more favorable tax treatment and enjoy capital gains over the long haul.  Employers can use this as an attractive benefit to retain key employees for extended periods.  This can induce employees to remain with a company until retirement, rather than leaving to go to a competitor, and forfeiting future payments.

The two main types of executive deferred compensation plans are qualified and non-qualified plans. 

Qualified deferred compensation plans

Qualified deferred compensation plans are required to follow the Employee Retirement Income Security Act (ERISA) rules and procedures.  These include investments such as 401(k) plans.  Funds are set aside in a dedicated account to fund participants’ contributions.

Non-qualified plans

Non-qualified plans are not required to follow the ERISA and provide more flexibility but with fewer protections.  Known as NQDCs, they allow employees to contribute a much higher amount of their income than allowed under ERISA plans.  Most NQDCs include the provision of paying benefits early, such as when the executive becomes disabled or dies prematurely.  However, ERISA statutes do not protect NQDCs.  An employee is putting their faith in a company that it will honor its obligation to fund the deferred compensation obligation.

Under these general categories, there are several kinds of deferred compensation plans.  They include salary reduction arrangements, bonus deferral plans, supplemental executive retirement plans (SERPs), phantom stock plans, and excess benefit plans.

How do deferred compensation plans work?

Deferred compensation plans are optional benefits offered by employers.  Both types offer several benefits and they remain a popular way to protect an employee’s financial interests into retirement.

An employee can be offered enrollment in a deferred compensation plan when hired, or they may enroll at certain future intervals.

An employee will need to decide what portion of their current income can be deferred to a later date, still leaving them with plenty of current income on which to live.  The decision will need to be made as to what kind of plan is best, as well as what specific investment vehicle best meets an employee’s investing and retirement needs.  And the employee will need to decide how long to defer the compensation.  This could be 10, 15, or 20 years, or when they turn 65.

Riders can be added to a plan, such as disability premium payments, hardship loans, and others.

It is always recommended to consult with a financial advisor or investment pro to help sort your options and arrive at the best mix that includes a deferred compensation account.  A big part of this is examining the tax implications before, during, and after enrollment.

Changes can be made in your investment options to a certain degree.  They are not always easy to execute, so it’s best to do your due diligence upfront to make the wisest decision the first time around.

Common Types of Executive Deferred Compensation Plans

Executive deferred compensation plans fall into two broad categories.  Legally, they are very different, and from an employer’s perspective, they serve different purposes as well.

Qualified Deferred Compensation Plans

Qualified deferred compensation plans are governed by the Employee Retirement Income Security Act (ERISA).  This includes 401(k) plans, 403(b) plans, and 457 plans.  All employees must be offered participation.  Contributions to these plans are capped by law.  Also, qualifying deferred compensation is set aside for the sole benefit of all recipients.  This means creditors cannot lay claim to the funds if the company does not pay its debts.

Non-Qualifying Deferred Compensation (NQDC)

Non-qualifying Deferred Compensation plans are also referred to as 409(a) plans due to the section of the tax code where they reside.  NQDCs emerged as a response to the cap on employee contributions to government-sponsored retirement savings plans. Before NQDCs, high-income earners were not able to contribute the same proportional amounts to their tax-deferred plans as lower earners.  NQDCs allow high-income earners to defer the ownership of income to avoid income taxes on their earnings while still enjoying tax-deferred investment growth. 

Unlike qualified deferred compensation plans, independent contractors are eligible for NQDC plans.  NQDCs also have fewer restrictions than qualified plans.  Contributors can use their deferred income for other savings goals such as travel or education expenses.  They also don’t have to be offered to all employees, and there are no caps on contributions.

The drawback of NQDCs is that they are not protected under ERISA.  If a company declares bankruptcy or they are sued, the employee’s assets in the NQDC are not protected from creditors.  Also, funds from NQDCs cannot be rolled over into an IRA or other retirement accounts after they’re paid out.

NQDC plans are future obligations of the employer, so they must decide how to finance that burden. Some make annual contributions to the fund while others pay the obligation out of operational funds when they become due.  Other employers may use life insurance products as a way to meet their commitment.

There are several sub-types under both qualified and non-qualifying plans: salary reduction arrangements, bonus deferral plans, supplemental executive retirement plans (SERPs), and excess benefit plans.

Salary reduction arrangements and bonus deferral plans allow employees to defer a portion of their earnings.  Under these terms, plans are a lot like defined contribution plans. Employers fund SERPs and excess benefit plans and provide a defined benefit in retirement, so they are equivalent to defined benefit plans.

Differences between Deferred Compensation Plans and 401(k)s

Deferred compensation plans are often used to supplement participation in 401(k) plans.  Deferred compensation plans mean that an employee agrees to defer part of their compensation until a specified future date.

For example, an executive earning $500,000 at age 55 might agree to defer $100,000 of their annual compensation each year for the next 10n years until they reach 65.  Those funds are set aside and earn a return on investment until they are designated for distribution back to the employee.

With deferred funds, the employee still pays Social Security and Medicare taxes.  They do not pay income taxes on the deferred compensation until they receive those funds.

An employee can borrow against the value of most 401(k) plans.  Deferred compensation plans are a lot less liquid and generally can’t be accessed until distribution.

Deferred compensation plans are usually best suited for high paid executives who do not need all of their current income to live on and who want a way to reduce their current tax burden.  Deferred compensation plans reduce the amount of taxable income and may reduce exposure to the alternative minimum tax.  By deferring income until retirement, the goal is that their total compensation will put them in a lower tax bracket resulting in tax savings.

Another critical difference between deferred compensation and a 401(k) is the amount of money that can be deferred.  The maximum allowable annual contribution to a 401(k) account in 2019 is $19,000, or $25,000 for people over 50, due to catch up contributions.  Deferred compensation supplements these amounts by allowing as much as 50% of compensation to be deferred.

Another difference is that deferred compensation plans offer better investment options than many 401(k) plans.   This is counterbalanced by the fact that, unlike with a 401(k) plan, funds received from a deferred compensation plan cannot be rolled over into an IRA account.

Deferred compensation plans are much less secure than 401(k) plans.

Possible forfeiture is one of the main risks of a deferred compensation plan because they are funded informally. In lay terms, there is simply a promise from the employer to pay the deferred funds, and any investment earnings, to the employee at the time specified. A 401(k) formally establishes an account that is separately insured.

This means if an employer goes bankrupt, there is no assurance that the employee will ever receive their deferred compensation funds. The employee becomes another creditor of the company and is paid after bondholders, and preferred stockholders get their cut first.

How Deferred Compensation is Taxed

In simple terms, employees pay taxes on the money when they receive it, not when they earn it.

So, the smartest way to handle tax issues related to deferred compensation is to avoid having all of the deferred income distributed to them at the same time.  When this occurs, it can put the employee into a higher tax bracket for that particular year.

Ideally, if it is available through an employer’s plan, it is best to designate each year’s deferred income to be distributed in a different year.  For example, if you defer 10 years’ worth of income, you’re better off receiving year-by-year distributions over the following 10-year period or when you retire.

Another way to look at it is that if you receive $200,000 a year in salary and $25,000 in deferred compensation, at the end of 10 years you’ll have $250,000 accumulated in deferred compensation, plus additional investment amounts.

If you receive your deferred compensation in a lump sum, you could  pay taxes on that entire amount in a single year.  This defeats the purpose of trying to minimize your tax burden.  However, if you spread that amount over 10 years, then you’ll pay taxes on $25,000 each year plus appreciated amounts.

The administrator always predefines deferred compensation plans.  You must understand in advance how distribution occurs when it is time for you to cash out.

Another thing to consider is that your federal tax obligation will be the same no matter where you live when you receive the money.  However, where you live could have a significant impact on the amount of state income tax you will have to pay.

Generally, deferred compensation is taxable in the state where the employee worked and earned the compensation.  It does not matter if the employee moves after retirement.  However, if an employee elects to take the deferred compensation payments over 10 years or more, the deferred compensation payments are taxed in the state of residence when the payments are made.  This can make a significant difference on a tax obligation if you move to Florida, Washington or Nevada, where there is no state income tax.  Moving to any state with a lower income tax than where you earned the money still offers you an added tax benefit to a lesser degree.

If a plan only allows for lump-sum distribution, then one strategy to lessen the burden is to bunch other tax deductions in the year you receive the deferred compensation money.  You have some flexibility when certain deductible expenses are paid, such as real estate taxes or charitable contributions.  When you double up on these expenses, they can have a direct impact on a more significant tax deduction the year you take your lump sum deferred compensation distribution.

Advantages of executive deferred compensation plans

The key advantages of qualified executive deferred compensation plans include:

• Tax savings. Deferred plans require the tax payment when the participant receives the cash.

• Realization of capital gains.  Money grows without annual tax assessed on the invested earnings.  Rather than simply receiving the  initially deferred amount, a 401(k) and other deferred compensation plans can increase in value before retirement.

• Preretirement distributions are allowed for certain life events such as hardship or buying a home, depending on how the plan is structured.  Some deferred compensation plans allow participants to schedule distributions based on a specific date. This in-service date provides flexibility and is one of the most substantial benefits of a deferred compensation plan. It is a tax-advantaged way to save for a child’s education, a new house, or other long-term goals.

• In-service distributions can also help mitigate the risk of companies defaulting on obligations.  Sometimes, people are not comfortable leaving deferred compensation management with their employer. Preretirement distributions let them protect their money by withdrawing it from the plan, paying tax on it, and investing it elsewhere.

• With a 401(k), participants can withdraw funds penalty-free after the age of 59½.   There is a loophole known as the IRS Rule of 55 which allows anyone between the ages of 55 and 59½ to withdraw funds penalty-free if they have quit their job or been fired or laid off from it.

• Funds from a qualified plan can be rolled over into an IRA or other tax-advantaged retirement savings vehicle.

• They are protected by the Employee Retirement Income Security Act (ERISA).  They are secure and held in a trust account. 

• They are required to be nondiscriminatory, open to any company employee, and benefiting all equally.

• A 401(k) is the most common deferred compensation plan, and contributions are deducted from an employee’s paycheck before taxation.  However, they are limited to a maximum pre-tax annual contribution of $19,000 from employees, as of 2019.  There is an additional allowable $6,000 in catch-up contributions for people 50 and older.

• Although participants do not actively manage investments, people have control over how their deferred compensation accounts are invested by choosing options that are preselected by the employer.

• It is possible to create a diversified portfolio from various funds, select a simple target-date or target-risk fund, or rely on specific investment advice.

Advantages of non-qualified deferred compensation plans include:

• Tax savings. Deferred plans require the tax payment when the participant receives the cash.

• Realization of capital gains.  Money grows without annual tax assessment on the invested earnings.

• Preretirement distributions, depending on how the plan is structured.  Some deferred compensation plans allow participants to schedule distributions based on a specific date. This in-service date provides flexibility and is one of the most substantial benefits of a deferred compensation plan. It offers a tax-advantaged way to save for a child’s education, a new house, or other long-term goals.

• They have flexible or no contribution limits depending on the terms of the plan.

• They can be targeted just to specific employees, such as top executives.

• It is possible to create a diversified portfolio from various funds, select a simple target-date or target-risk fund, or rely on specific investment advice.

• Employers can attract key employees through significant benefits that defer to a future date, ensuring a long-term commitment by the new hire. Offering a nonqualified deferred compensation program can level the playing field by tailoring a benefits package that is equal to or better than that of larger companies.

• Employers can ensure the stability of employment to retain key employees through “golden handcuffs” by offering deferred benefits subject to forfeit unless certain conditions are met.

• Many employers use insurance strategies to fund their deferred compensation benefits informally.

• The costs of setting up and administering a plan are minimal. Once initial legal and accounting fees have been paid, there are no individual annual costs, and there are no required filings with the IRS.

Disadvantages of executive deferred compensation plans

• Qualified deferred compensation plans have a 10% penalty on withdrawals made before age 59½.

• Deferred compensation plans can both increase and decrease in value, so observe them closely.

• The employer may keep the deferred money as part of the business’ funds, meaning that the money is at risk in the event of a bankruptcy.

• Funds from a non-qualified plan cannot be rolled over into an IRA or other tax-advantaged retirement savings vehicle.

• Elections to defer compensation must happen before the compensation is earned.  Election timing rules differ depending upon whether the compensation is treated base pay, performance-based, or some other form of compensation.

• Unless dictated by the plan language, the key employee must determine when and in what form the deferred compensation is to be paid when they elect to defer.

• Unlike qualified plans, contributions to a nonqualified deferred compensation plan are not a currently deductible expense for employers.  There is no current tax deduction to an employer for any amounts that may be set aside to pay future benefits from the plan. Also, if funds are set aside, any investment earnings on those funds can be taxable income to the employer.

• There are provisions related to forfeiting benefits in unfunded deferred compensation plans.  These may include:
  • Termination of employment before a specified vesting date, if the plan contains vesting provisions.
  • If an employee terminates before reaching normal retirement age, death, or disability.
  • If an employee terminates and enters into competition with the employer.
  • If an employee is terminated for “cause.”

• You can’t withdraw funds at will; you must choose a distribution date at some point in the future. Distributions must be taken on the designated date, regardless of whether you need the funds or how the market is doing.

• It’s not easy, but you can change an NQDC plan election date (e.g., to receive deferred compensation at age 70 rather than at age 65) only under certain conditions. The subsequent election must be made at least 12 months before the date the payment was initially scheduled to begin.  The election change delays the payment date for at least five years, and that the election is not effective until at least 12 months after it is made.

How to Set Up an Executive Deferred Compensation Plan

Executive deferred compensation plans are relatively easy to set up.  However, it is best to have a professional administrator manage the plan once an employer has created this benefit.

An employer needs to decide what their overall business strategy is, and how stable their long-term prospects are.  These must be blended with how deferred compensation obligations will fit the company’s overall compensation policies and philosophy.

In most cases, NQDC plans fall into five categories:

1. Salary reduction arrangements (sometimes with employer matching contributions)
2. Deferred bonus plans
3. Supplemental executive retirement plans
4. Supplements to normal compensation
5. Excess benefit plans that solely provide benefits to employees, due to benefit limitations under the employer’s qualified plan

Some companies use more than one type of plan, electing to treat base compensation and bonuses differently, or limiting who can participate in a certain kind of plan. 

When setting up a plan, employers must consider who can participate if they are crafting an NQDC plan.  All employees must be allowed to participate in a qualified plan, such as a 401(k).

The vesting timeframe must also be considered.  Employers can establish vesting schedules that serve their individual purposes. The employer may design the plan to set vesting of five or even 10 years, ultimately based on what employees value as an incentive. Most vesting schedules run for a period of two to six years.

Qualified plans are limited by law to contributions of no more than $19,000 per year, or $25,000 per year for employees age 50 and older.  With NQDCs, amounts are much more flexible, and 50 percent or more of an employee’s current income may be able to be set aside.

The structure of the arrangement can be influenced by the current and future income needs of the employee and tax treatment of deferred amounts, among other variables.   

Employers must also decide payment timing.  This can include when an employee retires or plans that pay deferred amounts only at the earliest date of death, disability, or separation from service with the company. 

Is Deferred Compensation a Good Idea?

Here are some things to consider when deciding if a deferred compensation is right for you:

Do you annually max out on your contributions to traditional retirement plans?  Many investment advisors believe you should make the maximum contribution to a 401(k) or 403(b) plan before enrolling in an NQDC plan.  This is because 401(k) and 403(b) plans are funded directly and protected under the ERISA, while NQDC plans are not.

What kind of distribution schedule does the plan offer?  A lump-sum distribution will provide fewer benefits than a plan that allows for distribution over many years, ideally when you retire.

What investment choices does the plan offer? Some plans promise a fixed or variable rate of return on deferred compensation.  However, most companies base the growth of deferred compensation on the returns on other investments, such as the same investment choices as those in the company 401(k) plan. Others follow major stock and bond indexes.  More options equal more flexibility that you can design to suit your needs.

Is the company financially secure? It’s one thing to work out deferred compensation from a stable 100-year-old Fortune 500 company, and quite another from a smaller company with significant ups and down in recent years.  You must feel confident an employer will honor a deferred compensation commitment in the future. 

What is my tax situation now and by participating in deferred compensation, how will that affect my tax burden in the future?  Look at your cash flow needs in addition to your tax issues to decide if you really can afford to participate in a deferred compensation plan.

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