What is deferred compensation and how does it work?

Competitive compensation packages help you build your team and steer your company toward its goals. Options like deferred compensation plans reward employees' current contributions, secure their futures, and make your company an attractive place to work—it's a win-win-win. 

Deferred compensation plans are flexible and tax-advantaged, helping you retain top-tier talent. Understanding the available plans and how they differ from other options is vital to nurturing your employees' long-term financial success while growing your company.  

In this guide, we'll explore deferred compensation, including qualified versus nonqualified plans, and how these plans compare to other employee retirement accounts in the United States.

What is deferred compensation? 

Deferred compensation plans allow employees to postpone receiving part of their compensation package, such as their regular salary or incentive-based compensation, like bonuses. Instead of receiving this pay immediately, employees receive it later, typically at retirement. These plans help employees save for the future and reduce their tax bills.  

For example, an employee earning $200,000 annually at age 58 might defer $25,000 annually until retiring at age 65. The employee's deferred compensation plan would then hold $175,000.  

How does deferred compensation work?  

With a deferred compensation plan, the employer sets aside a portion of the employee's total earnings. The employer and employee decide the amount together. Funds accumulate over time and can't be taxed immediately, so employees only pay federal income taxes on deferred compensation once the money is paid out. Medicare and Social Security taxes may still be required. 

When employees receive their deferred compensation, the amount of taxes they pay depends on their current tax bracket. In retirement, this is often a lower tax bracket than during employment. For example, if an employee earns deferred compensation in a state with high income taxes but retires in a state with low or no income taxes, their tax liability could be significantly reduced. 

Choosing a deferred compensation plan can help lower employees' total taxable income. In some cases, employees can save on taxes if they withdraw the compensation during retirement at a lower tax rate.  

Types of deferred compensation plans 

There are two main types of deferred compensation: qualified and nonqualified plans. While both are beneficial for retirement savings, they differ in significant ways. 

Qualified deferred compensation plans 

Qualified deferred compensation plans include 401(k) plans and specific 403(b) plans. These plans, regulated under federal law, allow employees to contribute a portion of their pretax salary to a retirement account. The money in that account grows tax-deferred until the money is withdrawn in retirement. The taxes are paid when the money is taken out of the account.  

The Internal Revenue Service (IRS) sets an annual contribution limit for qualified deferred compensation plans. These funds are highly secure and can't be accessed by creditors in bankruptcy.  

Nonqualified deferred compensation plans (NQDC) 

NQDC plans are more flexible than qualified deferred compensation plans. These savings plans, contractual agreements between employers and employees, can be part of a company's compensation policy.

NQDC plans are often preferred by executives and high-earning employees because they don't have contribution caps. Funds are accessible when an employee retires but can be paid out for emergencies, disabilities, termination, or a change in company ownership. 

The money in NQDC plans is not protected in the same way as the money in qualified deferred compensation plans. Creditors can claim these funds if bankruptcy occurs. Always discuss any changes in compensation plans or company ownership with employees immediately.  

Deferred compensation plans versus 401(k)s

Deferred compensation and 401(k) plans are two investment options for retirement income. Here's how they compare:  

Eligibility and usage 

Deferred compensation plans are often used by high-paid employees during peak earning years. These plans help employees defer large amounts of money until around the typical retirement age of 65, and they are typically preferred by high earners because many low-earning employees cannot afford them.  

401(k) plans, on the other hand, are available to everyone. In most cases, high-earning employees contribute to both deferred compensation and 401(k) plans.  

Contribution limits 

401(k) plans have annual contribution limits for employees, like $23,000 in 2024. The benefits of deferred compensation plans include much higher contribution limits, allowing employees to defer as much as 50% of their annual income.  

For example, an employee earning $500,000 annually in 2023 could contribute 4.5% of their income, or $22,500, to their 401(k). The same employee could contribute up to $250,000 of their $500,000 income to a deferred compensation plan in 2023.  

Tax treatment 

When an employee contributes to a 401(k), the funds grow tax-free until withdrawal. With deferred compensation plans, employees pay payroll taxes like Social Security and Medicare but do not pay income taxes until the deferred compensation is received. Deferred compensation plans reduce the employee's taxable income while the funds are being deferred.  

Access to funds 

401(k) plans offer more flexibility in accessing funds. Early withdrawals are sometimes approved for hardships like unemployment and medical expenses. 401(k) plans can also be borrowed against.  

The money in deferred compensation plans is typically locked in until a specified date, and employees cannot access these funds until then. While this helps employees save for the future, that money cannot be accessed for unexpected expenses, and it can also not be borrowed against for loans. 

Risk 

401(k) plan funds are protected under federal retirement laws. This means the money is secure no matter what. While qualified deferred compensation plan funds are protected from creditors, the money in nonqualified deferred compensation plans is not, making these plans riskier.  

Hire and retain global talent with Oyster 

Offering competitive benefits is critical to building a global team, and deferred compensation plans are just one tool you can leverage to attract top talent. With Oyster Total Rewards, you can offer tailored benefits to meet the unique needs of your workforce. No matter where your Team Members are located, the comprehensive platform streamlines everything from health benefits to retirement plans, salaries, and equity. 

Oyster's strategic approach helps you feel informed and confident so you can choose a compensation model and develop a global compensation plan that allows you to expand faster. Excellent compensation, including employee benefits, helps your team feel valued and supported, enhancing your company's ability to succeed worldwide.

Frequently asked questions  

Is deferred compensation considered taxable income? 

Deferred compensation is not considered taxable income for employees until they receive the deferred funds in a future tax year.  

Do employees report deferred compensation as wages?

Because deferred compensation isn't subject to income tax withholding at the time of deferral, employees don't report it as wages on Form 1040 when filing their taxes. 

What happens to deferred compensation if an employee quits? 

If an employee has a qualified deferred compensation plan, the funds in the plan are theirs. This applies even if the employee fails to give adequate notice or leaves the role on bad terms, but they must be past the vesting period if the company has one. A vesting period is the timeframe for when an employee gains control of their assets and benefits.