Definition
Deferred Compensation is a portion of an employee’s income that is paid out at a later date after it is earned. This method of payment, usually a part of executive compensation plans, allows the employee to potentially reduce their tax burden. It can be in the form of retirement plans, pensions, or stock-option plans.
Key Takeaways
- Deferred Compensation is a financial agreement where a portion of an employee’s income is paid out at a date after which the income was earned. Typically, this is used for retirement plans and pensions, allowing employees to defer receiving some of their income until their tax rates are lower.
- There are two types of deferred compensation plans: qualified and non-qualified. Qualified plans fall under ERISA guidelines, are non-discriminatory, and have a contribution limit. Non-qualified plans are more flexible, aren’t subject to ERISA guidelines, and can be offered to a select group of employees.
- While deferred compensation can lead to tax benefits and act as a key tool for employee retention, they are not devoid of risks. They depend upon the company’s financial health as the employee’s deferred money isn’t transferred to an external account, meaning if the company goes bankrupt, they might lose their deferred compensation.
Importance
Deferred compensation is a significant financial term, primarily because it allows employees to delay receiving part of their income until a later date, often in retirement. This practice has various importance, including providing potential tax benefits.
Since this income is not taxed until it is received, it can help lower a person’s current taxable income, which may result in tax savings. Furthermore, it enables individuals to plan for their future by ensuring a source of income during their retirement years.
This is particularly attractive to high earners who wish to manage their income effectively to maximize their long-term financial planning strategies. Overall, it gives employees a robust financial tool for their income management and tax planning.
Explanation
Deferred compensation is an arrangement in which a portion of an employee’s income is paid out at a later date after which the income is actually earned. The key purpose of deferred compensation is to defer the payment of income and thus the amount of tax due on this income.
This is used as a strategic income and tax planning tool, especially for high earning individuals, as it allows them to minimize their current income tax liability and postpone it to future years when they might fall into a lower income tax bracket. In terms of function, deferred compensation is commonly used as a retirement savings mechanism, especially for top-level executives in a company.
In these arrangements, the deferred money is usually invested so that it will grow over time, thereby providing a lump sum payment or series of payments to the employee at the time of retirement. This not only helps individuals to enhance their retirement income but also aids in retaining key talent within the organization as these plans often come with stipulations requiring the individual to remain employed by the company for a certain number of years.
Examples of Deferred Compensation
Retirement Plans: One of the most commonly known forms of deferred compensation is retirement plans like 401(k) or 403(b). Employees contribute a portion of their salary to these accounts before taxes each pay period. The amount contributed, plus any employer match, can grow tax-deferred until retirement, which is when the employee pays taxes on the withdrawal.
Stock Options: Companies often offer stock options as part of a deferred compensation package, especially to executives. Stock options give employees the right to purchase company stock at a predetermined price. Employees might have to fulfill certain conditions (such as remaining with the company for a set number of years) before these options vest and become available for the employee to exercise and sell.
Deferred Bonuses: In certain industries like finance or law, deferred bonuses are common. The employer promises a bonus to the employee at a certain future date based on the employee’s current performance. This serves as an incentive for the employee to continue to perform at a high level and to stay with the company until the deferred bonus is paid out.
FAQs About Deferred Compensation
What is Deferred Compensation?
Deferred Compensation is a portion of an employee’s income that is paid out at a date after which that income is earned. Common examples of deferred compensation include pensions, retirement plans, and employee stock options.
What are the benefits of Deferred Compensation?
The main benefit of Deferred Compensation is the deferred tax. The income tax is not charged until the funds are paid out, usually when the employee retires. It can potentially reduce the tax bracket of the employee.
What are the risks involved in Deferred Compensation?
The major risk associated with Deferred Compensation is that the employer may fail to pay the deferred amount due to bankruptcy or financial distress. Furthermore, the tax regulations may change over time affecting the deferred income worth.
How does Deferred Compensation affect retirement funds?
Deferred Compensation allows employees to plan for their retirements by allocating a portion of their income to a later date, generally after retirement, thus increasing their retirement funds. The deferred income grows tax-free which can increase the overall retirement savings.
Can I withdraw my Deferred Compensation early?
Early withdrawal of Deferred Compensation is usually subject to penalties and taxes. It’s generally advisable to wait until the specific date agreed upon to avoid these charges.
Related Entrepreneurship Terms
- Non-Qualified Deferred Compensation (NQDC)
- Vesting Schedule
- Pre-tax Contributions
- Employee Retirement Income Security Act (ERISA)
- Retirement Planning
Sources for More Information
- Internal Revenue Service (IRS): Official website of the U.S. government agency responsible for tax collection and tax law enforcement. It offers detailed explanations of various financial terms including deferred compensation.
- Investopedia: A comprehensive site that provides educational articles and videos on topics in personal finance and investing, specifically about deferred compensation.
- The Balance: A personal finance site that explains deferment options for compensation, its benefits, and potential drawbacks.
- The Motley Fool: A multimedia financial-services company that provides financial solutions for investors of every kind. You can find insights about various financial topics including deferred compensation.
