Fortunately, HR leaders can support their team’s long term financial well-being with a deferred compensation plan. This powerful savings opportunity lets employees set aside a portion of their pay for retirement with special tax advantages.
Businesses can also gain from offering deferred compensation. It’s an attractive benefit that strengthens any total rewards strategy, helping employers attract and retain a loyal workforce. HR teams who provide deferred compensation plans show a commitment to employees’ futures.
What is deferred compensation, and how does it work?
In the broadest sense, deferred compensation is any income employees earn but don’t receive or pay taxes on until a future date, typically after retirement. Most deferred compensation works as a savings plan, diverting a portion of an employee’s pre-tax income into a fund that invests the money into stock options, a pension, or a retirement plan, allowing it to grow over time.
Employers can offer two types of deferred compensation plans to employees — qualified and nonqualified. Both investment options provide individuals with two tax advantages:
Contributions reduce annual income, decreasing the tax burden during employment.
When an employee retires and begins withdrawing funds, they typically end up in a lower tax bracket, meaning their now-taxable income is taxed at a lower rate.
Employers offer tax-deferred compensation plans to strengthen their salary and
benefits packages, attract employees, support long-term retention, and empower employees to build financial security.
Types of deferred compensation plans
Whether an employee receives a qualified or nonqualified deferred compensation plan often depends on their career status and income. Here’s more information about each category.
Qualified deferred compensation plans
Qualified deferred compensation is the most commonly available option for employees. The IRS applies yearly contribution limits to these funds, which cap how much an employee can contribute each year. Deferred income is not taxed until the employee retires and draws on the earnings.
Deferred compensation plans,
including the 401(k) and many 403(b) plans, are governed by the Employee Retirement Income Security Act (ERISA). Under this law, employee contributions must be held in a trust and kept separate from company operating funds. If the organization faces bankruptcy, deferred compensation is protected from creditors and remains available for employee retirement.
Common deferred compensation examples include:
401(k) plans. A 401(k) is an employer-sponsored retirement savings plan that allows employees to contribute pre-tax income from every paycheck into a secure fund.
403(b) plans. The 403(b) plan is similar to a 401(k) but intended for employees of specific nonprofit organizations, public schools, or educational facilities.
Keogh plan. A Keogh plan allows small business owners and self-employed individuals to save for retirement.
SEP IRA. The Simplified Employee Pension Individual Retirement Account (SEP IRA) allows self-employed people and business owners with minimal staff to make discretionary, tax-deductible contributions to an IRA for each employee. Employees cannot contribute.
Nonqualified deferred compensation plans
Unlike a qualified plan, a nonqualified deferred compensation (NQDC) plan doesn’t have an annual limit, allowing employees to continue saving after they’ve maxed their contribution to a qualified deferred compensation plan. NQDC retirement plans cater to high-income earners and senior employees.
Here are some examples:
Supplemental executive retirement plans (SERPs). Once an executive maxes out their annual 401(k) contributions, they can continue saving for retirement using a SERP account.
Bonus plans. Instead of receiving an annual cash bonus, executives can direct those funds into an NQDC savings account, deferring taxation until they receive their retirement income.
457(b) plans. This retirement savings plan provides a tax advantage for executives working for nonprofit organizations or state and local governments. Like a 401(k), the 457(b) allows employees to save part of their salary tax-free until they withdraw funds as part of their retirement income.
Typically reserved for high-earning employees, executives, and contractors, NQDCs are not subject to IRS caps, meaning they allow unlimited yearly contributions. The company usually disburses the funds upon retirement, but the contract can also stipulate scenarios where the employee receives a lump sum payment, including:
Disability
Death
Home purchase
College tuition
Personal emergency
The contract can also include forfeiture clauses where the employee loses their deferred savings under certain conditions, such as:
Unlike qualified deferred compensation plans, NQDCs are unsecured. If the employer declares bankruptcy, creditors can seize those funds, leaving the employee at risk of receiving nothing.
Pros and cons of deferred compensation
The benefits from deferred compensation vary based on the plan type, offering different advantages for both employers and employees.
Pros of qualified deferred compensation
For employees:
For employers:
Cons of qualified deferred compensation
For employees:
For employers:
Administrative complexity to setup and monitor
Potential financial penalties for noncompliance with IRS rules
Contribution limits and vesting schedules may not meet everyone’s needs
Pros of nonqualified deferred compensation
For employees (typically executives and high earners):
No contribution limits
More opportunities for high investment growth
Flexibility regarding when and how the company pays out deferrals, depending on contract terms
For employers:
Increased ability to attract and retain executives
Compensation packages tailored to employee needs
Cash flow flexibility due to deferred tax payments and disbursement
Improved employee performance by tying NQDC contributions to company goals
Cons of nonqualified deferred compensation
For employees:
Lack of security in the event of employer bankruptcy
Deferred amounts remain part of the company’s general assets
Limited investment options
Growth may be lower than what the employee can earn through personal investments
For employers:
Added administrative complexity
Poorly structured plans can result in financial penalties and the loss of tax advantages
Long-term liability on the company’s balance sheet
When well-managed, a deferred compensation plan isn’t just a secure and potentially lucrative option for employees — it’s also a powerful benefit for employers to offer.
Help employees gain financial flexibility and security with EarnIn
Deferred compensation plans present a tax-advantaged savings opportunity that helps employees achieve long-term security. Employers can offer these lasting financial benefits to attract and retain talent while taking care of their workforce.
Saving for retirement is always a smart move, but many employees need support earlier in their journey. That’s why EarnIn provides a suite of
financial wellness tools for your team, helping them achieve the financial flexibility to cover today’s expenses without losing sight of tomorrow.
With
earned wage access, employees can get paid in minutes — up to $150 per day and a maximum of $750 per pay period
— starting at just $2.99 per transfer.
In addition,
Tip Yourself lets employees effortlessly save with every paycheck
and
Balance Shield helps protect against overdrafts.
EarnIn is simple to set up, with no payroll integration required and no cost for employers.
Learn more about how EarnIn can help support employee financial flexibility.
Please note, the material collected in this post is for informational purposes only and is not intended to be relied upon as or construed as advice regarding any specific circumstances. Nor is it an endorsement of any organization or services.
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