What is deferred compensation?
Deferred compensation, also known as deferred pay, is a financial agreement between an employer and a worker where the employer sets aside part of the employee’s earnings to be paid at a later date. Deferring compensation usually offers tax benefits and can help with long-term financial planning.
Executives, employees, or independent contractors may request to defer their compensation to a time when they will be in a lower tax bracket, often during retirement. Other milestones that can trigger the payment of deferred funds include disability, death, or the selling of the company. Some people may choose to defer income to put money aside for their future while reducing the immediate and total tax owed.
Employers can benefit from offering deferred compensation by attracting top talent, boosting employee performance, and increasing cash flow. Employees benefit from tax advantages along with help ensuring future financial security.
Types of deferred compensation
The options for deferring compensation will depend on local labour laws. In the US, for example, there are two main types of deferred pay: qualified deferred compensation plans, and non-qualified deferred compensation (NQDC) plans. These plans are treated differently from a legal standpoint and serve different purposes to employers.
Examples of deferred payments
Most businesses and employees have participated in some kind of deferred payment plan, even if they didn't know it. These are just a few examples of commonly offered deferred payment plans.
Retirement plans
Deferred compensation retirement plans withhold a portion of employee earnings until retirement. They allow employees to invest these funds (usually pre-tax) in various assets to grow over time. Deferred compensation retirement plans often offer better investment options, allowing workers to make a higher return on investment before receiving the money.
Retirement plans include pensions and employee stock options. In the US, for instance, one of the most common NQDC retirement options is the unfunded pension plan. It is an employer-managed retirement plan that defers a portion of annual earnings that the worker will receive once triggered by retirement, a specified date, death, disability, an emergency, or a change in company ownership.
Bonus deferral plans
Some employers offer bonus deferral plans as part of their overall compensation package, particularly to key executives and highly compensated employees. Bonus plans allow workers to defer some of their annual bonuses or performance-related commissions to a future date, typically when they reach specific milestones. Bonus deferral can help companies incentivize and retain key employees.
Severance packages
Deferred compensation severance packages can offer long-term financial benefits in addition to a standard severance package. After an agreed vesting period where the employee can choose to invest the funds in stocks, bonds, or funds, the employee will receive a lump sum payment or payment installations. Deferred severance often includes cash payments based on a multiple of the employee’s base pay.
What you need to know:
- Deferred compensation is a long-term incentive, allowing employees to defer a portion of their income until a later date.
- It serves as a valuable tool for retirement planning, helping employees build financial security for their post-career years.
- Deferred compensation often provides tax advantages, allowing employees to defer income tax on the deferred amount until distribution in the future.
- Employers can offer various customisation options, allowing employees to tailor their deferred compensation plans based on individual financial goals.
- It can be a powerful tool for attracting and retaining top talent, as it demonstrates a commitment to the financial well-being of employees beyond their immediate compensation.