Deferred Compensation: What It Is and How It Compares to a 401K

401(k) | Equity Compensation | Stock Options

 Brian Watson By: Brian Watson
Deferred Compensation: What It Is and How It Compares to a 401K
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Saving enough for a comfortable retirement in a way that is tax-advantaged can require getting creative at times. Numerous options exist for stashing your discretionary money in a retirement account, but not all options are created equal, nor are they taxed the same.  
 
An often-overlooked option, particularly for well-compensated employees, lies within what might broadly be called their executive compensation package.  

In recent decades, equity compensation or employee stock purchase plans have gotten a lot of attention, but deferred compensation plans can unlock additional opportunities to minimize your lifetime tax liability beyond the contribution limits on things like 401(k) programs. 

In this article, we’ll be covering how deferred compensation plans work, the benefits for your financial plan, and whether they're better than a 401(k). 

What Is Deferred Compensation?  

Deferred compensation plans are broadly defined as any program set up through your employer to set aside a portion of an employee's earnings from the current year to be paid out at a later date, at which time it will be taxed.  

Companies tend to implement these plans to incentivize talent to join or to hold onto talent longer by maximizing their earning and saving potential as well as offering additional employer matching. 

Using this broad definition, 401(k) plans or even pensions are included, but the term Deferred Compensation typically refers to the more selective programs offered to top talent or executives to extend those benefits beyond traditional contribution limits. 

Types of Deferred Compensation Plans  

There are different types of deferred compensation plans that your employer may offer, some of which you might not even think of as a deferral, but act in similar ways.  

Qualified Deferred Compensation (QDC) 

A qualified deferred compensation plan is governed by the Employee Retirement Income Security Act (ERISA) and is therefore backed by the government and generally available to all full-time employees.  

For example, they may be available as more common retirement plans like 401(k) programs or pension plans. These are more commonly thought of as savings accounts (which is true) but this is another form of deferring (and then investing) income to support yourself in retirement.  

The rules for QDC plans are quite simple and similar to “regular” employer sponsored plans. The next plan type we’ll outline below is what we will spend the remainder of this article discussing. 

Non-Qualified Deferred Compensation (NQDC) 

A deferred compensation program can also be structured under federal regulations as nonqualified deferred compensation plans (NQDC).  

The main difference is that NQDC plans allow employers to choose which employees can receive benefits, offer more flexibility in vesting schedules, and permit independent contractors to receive benefits if desired.  

As the name implies, these plans do not qualify for protection under ERISA laws but offer similar benefits like tax-deferred contributions.  

Although a 401(k) and a company-specific executive compensation plan are technically both deferred compensation plans, the term is most generally used to describe the unique abilities of a NQDC, which we’ll go into more detail on below. 

How Does a Non-Qualified Deferred Compensation Plan Work?  

Contrary to what the name might imply, this doesn’t mean that your employer is simply deferring their responsibility to pay you your full paycheck today.  

Deferred compensation plans work by allowing employees to set aside part of their paycheck before taxes are taken out, just like a 401(k) account, but without the standard contribution limits 

Although you can contribute beyond those limits, this money can't be withdrawn unless certain conditions are met—conditions that are often unique to each plan and agreed to in advance.  

In some cases, you might be able to withdraw money while you're still working or after you leave a company, but it will depend on your elections going into the plan. 

Generally, there is a deferral to retirement age, at which point you’ll be given a lump sum or installments over a specified number of years (usually up to 15 years).  

For NQDC plans primarily used to defer salary income, the installment options tend to be more tax-advantaged, whereas plans primarily used to hold smaller bonus pay outs may be simpler to pay out in lump sum format. 

Deferring your income may sound counter intuitive, but the strategy comes down to a deep understanding of retirement plan contribution limits and the way the IRS implements our progressive tax rate.  

We’ll go into more detail below, but long story short: by deferring that income for a future year where your marginal tax bracket is potentially lower, you could significantly lower your tax bill on the same amount of income.  

Of course, there are factors to consider like your expected income from social security and other savings accounts that may require minimum distributions at set dates, but the strategy operates on the premise that your retirement income can be made lower, reducing your tax burden. 

That sounds like a pretty sweet deal, which is why some employers will use NQDC plans as an employee benefit to attract and retain key talent during their peak earning years.  

As part of an agreement, the income is deferred into an account pre-tax for a set period (which can vary from a few years all the way to retirement age). 

Deferred Compensation Vs. 401K  

These plan types share some similarities like both offering contributions and investment returns tax-deferred, employer contributions being allowed, or the simple ability to select from investment options for the deferred income in the account. But there are many differences.  

As compared to a traditional 401(k) plan, withdrawals from a NQDC often come with different stipulations.  

There are no RMDs (required minimum distributions), but you're bound to distribution elections made prior to contributions being made, meaning you may be held to elections you set when you were 45 at 65.  

You can sometimes change these elections and postpone a planned distribution, but there are often strict rules such as, the request being put in at least 12 months before the original distribution date, or agreeing to delay at least 5 additional years.  

These complex rules make working with a financial planner key for those with a NQDC plan to map out their cash flow and tax planning during these payout periods.  

If allowed by the plan, you can withdraw funds from an NQDC whenever you want rather than wait until retirement but if you leave the job, get fired, or retire early, this could impact the ability or timing to take money out. For this reason, NQDC plans are sometimes called "golden handcuffs."  

Non-Qualified Deferred Compensation Plan Benefits  

Many employers offer NQDC to allow you to defer taxes on salary and/or a cash bonus beyond 401(k) annual contribution limits, which are fairly low if you have high retirement savings goals.  

These programs offer a myriad of benefits, making them an attractive savings option for many who find themselves in their peak earning years. These benefits include:  

  • No state or federal income tax is taken from the deferred contributions  
  • Investment growth and income are tax-deferred 
  • More potential to grow earnings that are tax-deferred  
  • Provides an additional retirement vehicle when 401K plan contributions are maxed out  
  • Ability to pay taxes on this income at a lower tax rate in retirement as opposed to today. For example, a married individual making $350,000/year today would have a top tax bracket of 32%. That same person could defer some of that income into retirement where their top tax bracket may be as much as 10% lower. 

Disadvantages to Non-Qualified Deferred Compensation Plans  

These types of plans do not come without opportunity costs beyond not being able to immediately access your funds.  

One of the most important to consider is the risk you’re taking on by having a plan backed by your employer, not the government.  

Put plainly, if the company goes bankrupt, you risk losing your contributions. This is because your deferrals in a NQDC plan are not held in a separate account like 401(k) or other qualified plans. They are co-mingled with the company’s assets.  

Therefore, they are exposed to the company’s creditors. You may be able to “invest” your dollars, however this is just used for accounting to track how much the company owes an employee when their payout begins. 

While the price of this risk is the benefit of deferred taxes, it is also why a savvy financial planner might advise against concentrating assets within a single company’s deferred compensation plan.  

Additionally, it’s important to know that you are unable to borrow against amounts in a NQDC plan, you cannot rollover assets into this plan type, and there are heavy IRS penalties for taking early distributions.  

One last potential disadvantage is the strings that might be attached. While these plans may be helpful to minimize your tax burden, their primary motive is to increase employee retention.  

They may come attached to non-compete clauses that tie you to an employer or give you less flexibility in your career.  

If you’re employed where you plan to retire from this may not be a concern, but for those with a decade or more left of working, it’s worth considering whether you’re locked in golden handcuffs.  

Is a 401(k) or Non-Qualified Compensation Plan Better? 

We aren’t trying to sound like lawyers when we say this, but it depends. Because every situation is different and the NQDC at each company looks different, there is no universal answer.  

What we can say is that a balanced approach to financial planning would give the guidance that this is more of an additive solution, not a replacement.  

Meaning it’s not about only contributing to one, but it’s more about identifying the proper balance of all your available options to maximize your savings potential to fuel a happy retirement.  

Because you might be asked to enroll in a variety of savings plans, and the savings potential or risk can get complex, the guidance of a professional financial advisor can help demystify things so you can lay all your options out on the table and make the optimal selection. 

Get the Most Out of Your Compensation Plan  

It can be confusing to navigate the various savings plans. While little is truly tax-free—only tax-advantaged—it's vital to understand how everything from a Roth 401(k) or IRA compare to executive compensation options so you can make the most of them..

Deferred compensation is a great way to reduce your tax liability and save for retirement, especially if you have reached the limit of your 401K contributions, but they come with their own unique set of rules that require thoughtful consideration.  

Although there are a plethora of plug-and-play calculators out there to help you decide how much to contribute, nothing quite covers the nuance of a conversation with a financial advisor. 

Plancorp offers comprehensive wealth management, with a specialty in helping those with higher incomes or access to tools like NQCDs make the most of their opportunity. As part of your overall financial plan, we can help ensure all investments support your life goals.  

If you're not sure you've been making the right financial decisions, our financial plan analysis is a great (and simple) place to start. Invest a few minutes of your time and we’ll let you know where you’re on track and where you might benefit from support. 

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Brian joined Plancorp in 2020 as a financial planner. Prior to Plancorp, he worked at Edward Jones and had his own office in Litchfield, Illinois. His experience taught him how to build relationships and truly get to know clients as people first. He believes that is how you can truly impact clients' lives. Brian came to Plancorp because of the more collaborative and team-driven environment. He enjoys turning advanced financial concepts into easy to understand strategies for his clients. He especially enjoys helping clients navigate equity compensation! More »