Definition — in one line
Deferred compensation is an arrangement in which an employee elects to receive part of their pay at a later date (often at retirement) instead of when it is earned, postponing ordinary income tax on that amount until distribution.
How deferred compensation works — simple mechanics
– You tell your employer to defer some portion of salary, bonus, or other pay.
– For most plans, Social Security and Medicare (FICA) taxes are paid at the time you defer, while federal/state income tax is delayed until you actually receive the money.
– The deferred amount may be invested and can grow tax-deferred until distribution.
– Payouts usually begin at a date you select (e.g., retirement) or trigger on specified events (change in company ownership, defined emergencies). Some plans may permit earlier payments under narrow conditions.
Two broad categories
1. Qualified deferred compensation plans
– Governed by ERISA (the Employee Retirement Income Security Act).
– Typical examples: 401(k) and many 403(b) plans.
– Subject to legal rules that limit contributions and protect plan assets for participants (creditors generally cannot seize plan assets if the employer goes bankrupt).
– Employer must follow formal plan rules and reporting requirements.
2. Non‑qualified deferred compensation (NQDC) plans
– Contractual agreements between employer and participant (often referred to under Internal Revenue Code section 409A or labelled “golden handcuffs”, SERPs / “top‑hat plans”).
– No statutory cap on how much can be deferred.
– Commonly offered to executives, key employees, or contractors; often used to retain or incentivize talent.
– Funds are typically unsecured company liabilities. If the employer becomes insolvent, deferred amounts can be claimed by creditors.
– Payouts and forfeiture rules depend on the contract terms; some NQDCs can be cancelled if you leave, compete with the employer, or are terminated for cause.
Taxes — key points
– Income tax: deferred until distribution (except for Roth-style plans, where tax is paid when contributions are made and qualified withdrawals are tax-free).
– Payroll tax: Social Security and Medicare are generally due when compensation is deferred.
– Taxation at distribution depends on your tax bracket at that time; deferral can reduce lifetime taxes if you expect a lower rate in retirement.
Benefits
– Reduce current-year taxable income (income tax on deferred portion is postponed).
– Potentially lower lifetime tax burden if you are in a lower bracket at distribution.
– No statutory contribution limits in many NQDC plans—useful for high earners who exceed qualified-plan limits.
– Deferred amounts can grow tax-deferred until distributed.
Drawbacks and risks
– In NQ
DC plans, deferred amounts are typically unsecured: if the employer becomes insolvent, deferred pay is treated like a general creditor claim and may be lost or only partially recovered.
Other common drawbacks and risks
– Employer-credit risk: deferred compensation is usually an unfunded promise. Even if the company “sets aside” assets, they are often held in a trust that remains reachable by creditors unless it’s a true (and rare) funded arrangement. Verify whether the plan uses a rabbi trust (assets are protected from the employer but still reachable by creditors) or another funding vehicle.
– Lack of statutory protections: many nonqualified deferred compensation (NQDC) plans do not fall under ERISA (Employee Retirement Income Security Act) protections that apply to qualified plans such as 401(k)s.
– 409A compliance risk: Internal Revenue Code Section 409A sets strict rules on deferral elections, permissible payment events, and distribution timing. Failure to meet 409A rules can trigger immediate taxation, a 20% penalty tax, and interest on underpayment.
– Reduced liquidity and flexibility: deferred amounts are illiquid until a specified distribution event (separation from service, retirement, disability, death, fixed date). You typically cannot access the money for emergencies without triggering tax consequences.
– Tax-rate risk: the tax benefit assumes you will be in a lower tax bracket when amounts are distributed. If future tax rates (or your marginal rate) are higher, deferral can increase lifetime tax paid.
– Plan-change / employer-action risk: employers can amend or terminate NQDC plans, change crediting rates, or alter distribution terms subject to the plan document. Some changes may be constrained by contracts or board approvals, but risk remains.
– Timing and vesting constraints: distributions often depend on vesting and defined events. For highly compensated employees, some plans impose additional delays (for example, a six-month delay after separation to avoid certain tax issues).
– Estate and beneficiary complexity: because amounts are not in qualified accounts, beneficiary rules can be more limited; estate tax and creditor issues can be complex.
Checklist: what to ask before agreeing to defer compensation
1. Is the plan qualified under ERISA or nonqualified? (Most deferred comp for executives is nonqualified.)
2. How is the deferred amount held? Is there a rabbi trust or other funding vehicle? Are assets segregated or simply bookkeeping entries?
3. What are the precise distribution events (retirement, separation, disability, death, change in control, fixed date)? Are there acceleration provisions on a change in control?
4. When must I make the deferral election (e.g., by December 31 prior year)? Are elections irrevocable?
5. How are deferred balances credited (fixed interest, market-based, or tied to a notional investment)? Is there a minimum crediting rate?
6. What are the tax consequences at deferral and at distribution? Will payroll taxes apply and when?
7. Are there 409A compliance certificates or opinions? Has the plan been reviewed by counsel for 409A risks?
8. What is the sponsor’s creditworthiness? Would I accept unsecured payment from this employer in bankruptcy?
9. How does the plan treat beneficiaries and death benefits?
10. Can the deferred amount be rolled into other plans or taken as a lump sum?
Practical numeric examples
Example 1 — pure tax-deferral comparison
– You defer $50,000 of salary today.
– Current marginal federal + state tax = 35% => immediate tax saved = $50,000 × 35% = $17,500.
– The deferred $50,000 grows (pre-tax) for 10 years and is valued then at distribution at $90,000. If your tax rate at distribution is 25%, tax due = $90,000 × 25% = $22,500.
– Net after-tax proceeds at distribution = $90,000 − $22,500 = $67,500.
– If instead you had taken the $50,000 today, paid 35% tax (net $32,500) and invested after-tax dollars to the same pre-tax gross growth would not be comparable because growth would have been on the after-tax base; you’d need to model expected investment returns and compare after-tax wealth in both scenarios. Key point: deferral can increase investable base by delaying
– deferral can increase investable base by delaying taxation, so more money compounds pre-tax. To compare apples-to-apples you must model (a) the pre-tax growth rate, (b) current marginal tax on the cash if taken today, (c) expected tax at distribution, and (d) how after-tax investments would be taxed while invested (for example, ordinary income vs. capital gains). Below is a concise framework and a worked numeric example.
Worked example (numbers consistent with earlier context)
– Assumptions
– Employer deferred amount today (pre-tax): $50,000.
– Current marginal income tax rate (if taken today): 35%.
– Deferred plan grows at an annual pre-tax return r ≈ 6.06% for 10 years, so (1 + r)^10 = 1.8 (50,000 → 90,000 pre-tax after 10 years).
– Marginal income tax rate at distribution: 25%.
– If you instead take after-tax cash today and invest in a taxable account, assume long-term capital gains tax rate g = 15% (tax only on the gain when sold).
– Time horizon n = 10 years.
– Deferred-compensation outcome (taxed at distribution)
– Pre-tax future value = 50,000 × 1.8 = 90,000.
– Tax at distribution = 90,000 × 25% = 22,500.
– Net after-tax proceeds at distribution = 90,000 − 22,500 = 67,500.
– Immediate-cash-and-invest outcome (take pay today, invest after-tax)
– After-tax principal today = 50,000 × (1 − 35%) = 32,500.
– Pre-tax future value in taxable account = 32,500 × 1.8 = 58,500.
– Tax
– Tax on the gain =
Tax on the gain = (58,500 − 32,500) × 15% = 26,000 × 0.15 = 3,900.
Net after‑tax proceeds from immediate cash + taxable investment = 58,500 − 3,900 = 54,600.
Comparison (same example):
– Deferred compensation (taxed at distribution): 67,500.
– Immediate after‑tax cash invested (taxed on gain): 54,600.
Result: Deferred compensation yields 67,500 − 54,600 = 12,900 more after 10 years in this scenario.
General formulas (useful for other inputs)
– Let A = pre‑tax amount deferred (50,000 in the example).
– Let F = (1 + r)^n = growth factor over n years (1.8 in the example).
– Let T_d = tax rate at distribution on deferred money (25% here).
– Let T_p = marginal income tax rate today on pay you could take instead (35% here).
– Let g = long‑term capital gains rate when you sell the taxable investment (15% here).
Then
– Net_deferred = A × F × (1 − T_d).
– Net_immediate = A × (1 − T_p) × [F × (1 − g) + g].
(You can derive Net_immediate by calculating tax only on the gain: tax = g × A × (1 − T_p) × (F − 1), then subtract from pre‑tax future value in the taxable account.)
Break‑even distribution tax rate
Break-even distribution tax rate
Set Net_deferred = Net_immediate and solve for T_d (the tax rate that would make deferred compensation and taking pay now equivalent after taxes and investment growth).
Start from
F × (1 − T_d) = (1 − T_p) × [F × (1 − g) + g]
Step-by-step algebra
1. Divide both sides by F:
1 − T_d = (1 − T_p) × [F × (1 − g) + g] / F
2. Solve for T_d:
T_d = 1 − (1 − T_p) × [F × (1 − g) + g] / F
A slightly simpler rearranged form:
T_d = 1 − (1 − T_p) × (1 − g + g/F)
Worked numeric example (use the variables from the earlier context)
– F = 1.8 (growth factor over n years)
– T_p = 35% (0.35) — marginal tax rate today
– g = 15% (0.15) — long‑term capital gains rate on taxable account
Compute:
– (1 − T_p) = 0.65
– F × (1 − g) + g = 1.