Glossary of Human Resources Management and Employee Benefit Terms
Deferred compensation is a compensation plan that allows employees to defer compensation earned in one tax year to a future tax year. Portions of payments and bonus payments are some of the compensation employees may choose to defer. Deferred compensation is not considered taxable income for employees until they receive the deferred payment in a future tax year.
There are two types of deferred compensation plans: non-qualified and qualified. Non-qualified deferred compensation plans are also referred to as Section 409A or NQDC plans.
Deferred compensation plans are not required for all employees. Employers that choose to implement a deferred compensation plan usually do so for key employees or high-earning employees in their organization. Employers should detail the conditions under which employees can access their deferred funds, and follow specific rules for deferred compensation to avoid penalties with the IRS.
There are several types of deferred compensation Section 409A plans that the IRS recognizes, including:
Excess Benefit Plans: These plans allow employees currently enrolled in qualified benefit plans the option to contribute additional funds to retirement plans as an excess benefit.
Salary Reduction Arrangements: Employees on a deferred compensation plan may choose to defer a portion of their salary until a future year. For example, an employee that earns $80,000 per year may choose to defer $30,000 of their salary and only receive $50,000 for the current year. Deferred funds are not eligible as taxable income for employees until they receive the funds in the future.
Supplemental Executive Retirement Plans (SERPs): Some companies choose to contribute non-qualified funds to a supplemental retirement fund the employee can access once they’ve retired and met the conditions set forth in the retirement plan. Employees that receive SERPs are usually key employees or highly compensated employees within a company.
Bonus Deferral Plans: Employees can choose to defer any bonuses they receive until a future date and may defer their bonus tax until they receive it in the future.
A qualified deferred compensation plan includes compensation plans such as a 401K. Qualified compensation plans have contributions limits and are only for the employees of a company. Unlike a non-qualified compensation plan, employers are required to separate funds from a qualified plan from the rest of their business funds.
A non-qualified deferred compensation plan includes any plan for deferred compensation between an employee and employer. This means that employees can choose to defer taxable income until a future year. The employee’s deferred income is not eligible to be taxed until they received the funds in the future.
Unlike qualified deferred compensation plans, employers do not need to separate NQDC funds from the rest of your business funds. Non-qualified plans also have no limit on employee contributions, and terms are determined between an employer and employee. The employer may choose to make the non-qualified plan elective and allow employees to choose to contribute, or non-elective and make the decision themselves. Employers can also make deferred compensation agreements with independent contractors.
Filling out tax forms for deferred compensation can be tricky, but employers need to ensure their taxes are filed correctly or they may face an IRS audit and penalties. Employers are subject to different withholding requirements and regulations depending on how the deferred compensation plan is structured.
For example, employers cannot withhold income tax until the employee receives their compensation, but FICA (Federal Insurance Contributions Act tax) and FUTA (The Federal Unemployment Tax Act) taxes must be withheld and paid when employees defer income. However, if an employee deferred compensation agreement is dependent on future services, FUTA and FICA taxes are only withheld once the employee performs those services.
Deferred compensation accounting may be based on the performance of the employee. Highly compensated employees may have performance-based compensation in which the cost of the deferred compensation is accrued during a predetermined period of time. Deferred compensation accounting may also be based on both future and current employee performance. In such a case, only the portion of compensation based on the employee’s current service is accrued.
An example of deferred compensation accounting looks like this:
A deferred compensation plan is created for the CEO of a company. The company has an agreement with the CEO that makes him eligible to receive his deferred benefits after he has worked with the company for 5 years. During the 5 years, the company accrues the cost of the CEO’s contract until he fulfills the terms of his employment agreement and is eligible to receive his funds.