What is Deferred Compensation?
Deferred compensation is an arrangement where a portion of an employee’s income is delivered at a date after which that income is actually earned. Stock options, retirement plans and pensions are all common examples of deferred compensation. The largest benefit of deferred compensation is the fact that it is devoid of tax to the date at which the employee tangibly receives the funds. In the United States, deferred compensation is attached with stringent requirements regarding the timing of deferral elections and distributions.
Deferred compensation is a formal/written agreement constructed between an employer and an employee where the employee will voluntarily agree to have part of their pay withheld by the company, subsequently invested on their behalf, and delivered back to them at a pre-determined time in the future.
Deferred compensation is only offered to senior management or other highly compensated employees. Moreover, deferred compensation may be made available to certain public workers; deferred compensation is not restricted to public companies.
When is Deferred Compensation Used?
Deferred compensation agreements are constructed either at the request of a high-ranking executive within the company or as an incentive by the Board of Directors. A deferred compensation plan is always constructed by lawyers and the subsequently recorded to ensure that the provisions are aligned with the company’s rules.
Deferred compensation plans take a percentage of an employee’s pay to invest the funds in various stocks, bonds and other investment vehicles. A constructive receipt will be attached to the plan which impedes an executive from having control over the investment choices. If the executive is given free rein to invest the funds, he must fulfill immediate tax obligations and penalties.
Deferred Compensation is regulated—in regarded to usage—by the Employee Retirement Income Security Act of 1974. This piece of legislation implements the following regulations for employees looking to partake in a deferred compensation plan:
1. Assets in plans (such as a pension) that fall under the Employee Retirement Income Security Act of 1974 must be placed in a trust for the employee. If the company goes insolvent, attached creditors will not be allowed to secure assets inside the company’s ERISA plan. Deferred compensation, because it does not fall under the Employee Retirement Income Security Act, is deemed as a general asset of the corporation.
2. All plans formulated under the Employee Retirement Income Security Act are not allowed to discriminate in favor of employees based on compensation.
3. The federal income tax rate will change on a regular basis.
How is a Deferred Compensation Plan Taxed?
Under a qualified deferred compensation plan, the company’s contribution is deductible as soon as it is made; however, it is not taxable to the participants until the funds are withdrawn. So, for example, if a company puts $1,000,000 into a deferred compensation plan (like a 401k) for their employees, it will write-off $1,000,000 for that taxable year. If the company is placed in the 25% federal taxation bracket, the contribution is $750,000.
