Deferred Compensation and Its Valuable Role in Total Employee Compensation

Understanding deferred compensation and its mutual benefits can help employers and HR pros create diverse, competitive employee compensation plans.

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There are different ways to compensate employees for their work. Employers may pay them by annual salaries, hourly wages, commissions, bonuses, or any combination thereof.

Deferred compensation is another method. While many forms of pay go directly into an employee’s bank account at the close of a pay period, deferred compensation doesn’t.

It’s wise for employers, HR pros, and employees to understand how deferred compensation works and its potential benefits to all. A 2022 survey found that 89% of participating employers offering deferred compensation plans do so to provide a competitive benefits package for key employees.¹ Here we’ll explore deferred compensation, common types, and its valuable role in a total compensation strategy.

What is deferred compensation?

Deferred compensation occurs when part of an employee’s compensation is set aside and paid later. A deferred compensation plan works well as part of a total compensation package. Most of the time, the employee will wait until retirement to receive the deferred pay. Federal and local government control some of these plans; the company and employee privately agree on the terms of others.

Types of deferred compensation

There are 2 main subcategories of deferred compensation: qualified deferred compensation and nonqualified deferred compensation. These plans have several key differences and benefits.

Qualified deferred compensation plans

These plans consist of the employee designating part of their income to be deferred into a retirement plan. A portion of this amount may be matched by the employer. At retirement age, the employee will then withdraw from the plan. Examples of qualified deferred compensation plans are 401(k) and 403(b) plans offered by employers.

A couple of finite rules regulate qualified deferred compensation plans:

  • They come with contribution limits. The amount of money designated as qualified deferred compensation is capped. That means an employee can’t sock every dime they make into the plan.
  • They are open to all employees. Unlike nonqualified deferred compensation, qualified plans are open to every company employee. However, they aren’t open to independent contractors.   

Nonqualified deferred compensation (NQDC) plans

NQDC plans have no contribution limits and are agreed upon by the employee and employer. These plans are usually offered only to high-income earners, which is why they’re sometimes referred to as “golden handcuffs.” These plans are also available to independent contractors.

Benefits of a deferred compensation plan to employees

Employees realize unique benefits from deferred compensation. They can enjoy lucrative investment options and greater financial stability. Here are 4 of the benefits that impact employees most.

Tax deferral

When an employee defers compensation, they don’t pay taxes on that money during that year. Tax deferred compensation can save a person thousands of dollars every year. When they withdraw the money during retirement, chances are they’ll be in a lower tax bracket. At that time, they will pay taxes at a lower rate.

Increased retirement savings

Building wealth and increasing financial stability are other valuable benefits of participating in a deferred compensation plan. This premise is especially true because of the tax savings and employer contribution to the plan. Come retirement age, many people won’t consider regular payments from Social Security a reasonable source of income. But for those who’ve invested over time, a deferred compensation plan can represent their largest percentage of wealth.

Tax bracket reduction

Deferred compensation provides more tax benefits in the form of lowering a person’s total taxable income. This scenario is especially helpful for high earners in heavy tax brackets. Deferred compensation can help move the taxpayer to a lower bracket, allowing them to pay a smaller percentage of income tax.

Sole benefit of the recipient

The money in deferred compensation plans is protected against creditors. This protection makes it a secure savings plan option. If the employee or company gets into debt or files for bankruptcy, the deferred compensation is safe.

How deferred compensation benefits employers

Employees reap big rewards with deferred compensation plans, but it’s not one-sided. Companies also enjoy advantages from the plans. Consider these 2 distinct benefits deferred compensation plans provide employers.

Increases employee loyalty

Granted, “golden handcuffs” may not be the metaphor employers most appreciate. But they do want their employees to recognize and value the opportunities offered. With deferred compensation plans, organizations can provide employees, especially high earners, a way to pad their retirement and build wealth. These plans have a lot of impact on the company culture and employees’ financial well-being.

Helps them stay competitive

In tight labor markets, employers need every available advantage to land top talent. In terms of hiring strategies, every benefit and perk counts as job candidates weigh their options. If everything else is equal, a deferred compensation plan may very well sway a desired candidate your way. Offering both qualified and nonqualified plans as part of the total compensation package can elevate talent acquisition efforts above companies that don’t.

Understanding how deferred compensation fits into a comprehensive pay strategy is crucial for HR

Compensation planning is a critical HR process. Consider the potential for deferred compensation plans to enhance your compensation strategy with affordable, mutually advantageous solutions. Weigh the costs and benefits of different options and leverage them as appropriate to maximize their positive impact.

  1.  2022 Recruiting and Retention Key Findings, Principal Financial Services Inc.
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