Deferred compensation is a portion of an employee's salary that is reserved for future payment. In most cases, taxes on the earnings are deferred until the compensation is paid out. Examples of deferred compensation include insurance schemes, contingency plans, and stock option plans.
An employee’s salary may seem straightforward at first glance. However, employers may make several types of payments to their employees. One such payment is deferred compensation. As the name indicates, it is a portion of an employee’s salary that is deferred or delayed.
In this article, we delve into the meaning of deferred compensation, understand its types and how it works, and check out its advantages and disadvantages.
What is deferred compensation?
As the name indicates, deferred compensation is a part of an employee’s salary that is deferred or set apart for payment at a later date. The duration of deferment is determined by the terms of the individual’s employment and the employer’s policies. However, as the definition of deferred compensation suggests, this is not an additional payment made to an employee. It is a part of their regular salary that is delayed or set aside for a specified period.
The deferred compensation may be offered in the form of cash payments, bonuses, stock options or any other monetary benefits. They can also be structured as pension plans or retirement plans.
Types of deferred compensation
Deferred compensation plans can be classified based on the type of payment made to the employee or the structure of the plans. Typically, employers may offer compensation in the form of cash payments, insurance coverage, stock options or even contingency plans.
Based on how the plans are structured, they may be classified as qualified or non-qualified options. Let us explore what each of these types entails.
1. Qualified deferred compensation
This type of deferred compensation, which is common in the U.S., is governed by the Employee Retirement Income Security Act (ERISA). It comes with clear and defined contribution limits, participation guidelines and security. It is also mandatory and universally applicable to all employees who meet certain age-related and employment-related conditions. Furthermore, qualified plans should also be impartial — and avoid favouring some employees over others.
2. Non-qualified deferred compensation
Non-qualified plans are more flexible. They are not governed by the ERISA, so employers can decide which employees are eligible for non-qualified deferred compensation plans. Typically, this type of compensation is offered to key management personnel and high-level employees. There is also no specified compensation limit, so the amount that is contributed to an employee’s account is flexible.
How deferred compensation work?
Deferred compensation plans have simple working structures. They involve setting aside a portion of the regular payments payable to an employee. The amount set aside depends on the type of plan and the employer’s policies. This amount is paid to the employee later — generally at the time of retirement. Some types of deferred payments may also be delayed for a specified duration.
The nature of compensation also varies from one plan to another. It may be paid out as monetary compensation or offered in the form of stock options or even mutual funds. The latter category can result in potential capital gains for the employee.
Qualified vs. non-qualified deferred compensation plans
Deferred compensation plans, especially those that are offered in countries like the United States of America, are classified into two types: qualified and non-qualified deferred compensation plans. Here is a table outlining the key differences between the two.
| Particulars | Qualified deferred compensation plans | Non-qualified deferred compensation plans |
| Governed by | Qualified plans are governed by the Employee Retirement Income Security Act (ERISA), which is a law protecting employees in the U.S. | Non-qualified plans are not governed by the Employee Retirement Income Security Act (ERISA). |
| Contribution limits | Qualified plans impose a limit on the total amount of contribution an employee can make in a year. | Non-qualified plans have no restrictions on employee contributions. |
| Eligibility | Qualified plans must mandatorily be offered to all employees in an organisation. | Enrollment in non-qualified plans is not mandatory and may even be offered selectively to certain employees in an organisation. |
| Protection | The payouts from qualified plans are protected from creditors in the event of bankruptcy or default. | The payouts from non-qualified plans are not protected and can be attached to pay creditors’ dues. |
| Tax treatment | Qualified plans offer tax benefits to both employers and employees. | Non-qualified plans do not offer any kind of tax benefit. |
Advantages of deferred compensation
Deferred compensation offers a host of benefits to both employers and employees. Let us explore some of the key advantages in more detail.
1. Tax benefits
Deferred compensation is not taxed in the hands of employees until they receive it. By opting to receive a portion of their salary or income at a later point in time, employees can reduce their current tax burden.
2. Increased retirement savings
Some deferred compensation plans are only paid out once the employees retire. Until then, they are invested, where they accumulate interest and grow over time. This could lead to a significant increase in the retirement corpus.
3. Payout flexibility
Deferred compensation plans provide flexibility in terms of payout options. For instance, it can be paid out as a salary, cash bonus, or stock option. Such a high level of flexibility helps both employees and employers plan their cash flows more efficiently.
4. Talent acquisition
With deferred compensation plans, employers can easily attract and retain talented employees, especially high-level executives and key managerial personnel.
4. Better cash flow management
Since employers can defer the payments to employees at a later point in time, delayed compensation can help them reduce their payroll expenses, leading to better short-term cash management.
Disadvantages of deferred compensation
Although deferred compensation offers numerous benefits, it also comes with a few risks and drawbacks. Here are some of the key disadvantages of these plans.
1. Lack of security
Many deferred compensation plans are unsecured and lack protection. The employees may end up never receiving their dues if the employer is unable to pay due to financial difficulties.
2. Restrictions on flexibility
Once the deferred compensation plan is in place, there is very little room for flexibility. Employees may not be permitted to alter the terms of the plan once they have accepted it, even if their personal circumstances change.
3. Future liability
Deferred compensation plans create a future liability for employers, which must be managed carefully. If not, they could have a significant negative impact on the company’s financial position.
4. Strictly regulated
Some deferred compensation plans are strictly regulated by statutory acts. Employers must carefully administer the plans since even minor violations can lead to severe penalties.
Is deferred compensation a good idea?
Opting for a deferred compensation plan is typically beneficial for the employee for various reasons. Firstly, it helps set aside a definite amount for the future, thus preventing impulsive spending in the present. This can be helpful for anyone who is having trouble investing for their future goals.
Additionally, deferring compensation also postpones the tax liability on the said amount. This is another reason why such plans are good ideas for employees who are currently in high tax brackets but expect to retire in lower tax brackets.
That said, deferred compensation plans may not be very attractive for an employee whose salary — without the deferred payment — is otherwise quite low. This is because it cuts down on the amount immediately at the employee’s disposal.
How is deferred compensation paid out?
Deferred compensation is most often paid out when the employee retires. Alternatively, some plans also have a specified vesting period after which the compensation is offered, even if the employee is not retiring.
It can also be paid as a lump sum or in instalments. Lump sum amounts may lead to high taxes in the year of payment, while instalment-based payouts can help optimise the tax liability by spreading it across different years.
How does deferred compensation affect your taxes?
The impact of deferred compensation plans on your taxes depends on the amount deferred, the period of deferment and the prevailing tax laws. Typically, delayed compensation is only taxed when it is actually received. Some deferred compensation plans may even offer tax benefits in certain countries. To better understand how any compensation that is deferred may be taxed, you can seek professional advice from a financial or tax expert.
Deferred compensation vs. EPF
The Employee Provident Fund (EPF) scheme in India is a type of deferred compensation. The EPF contribution is deducted from an employee’s regular pay and set aside in their EPF account, ready to be used at the time of retirement. This amount is also matched by the employer.
That said, there may also be other types of deferred compensation beyond the EPF scheme. It varies from one employer to another and may also be available only to employees who meet certain designation or role-related criteria.
Key takeaways
- Deferred compensation is a type of payment made to certain employees.
- It involves delaying or deferring a part of the salary or regular compensation payable to an employee.
- The taxes due on such deferred payments are also postponed accordingly.
- Deferred compensation plans are commonly classified as qualified or non-qualified plans.
Conclusion
The bottom line is that deferred compensation plans can benefit employees in many ways, including tax optimisation and retirement planning. However, if you are not eligible for any deferred compensation, you can still save for your future by investing in mutual funds. Some mutual fund schemes like ELSS offer tax benefits for investors, while others may have a longer investment horizon that can be aligned with your retirement plan.
