Deferred compensation: Overview, definition, and example
What is deferred compensation?
Deferred compensation refers to a portion of an employee’s earnings or compensation that is set aside to be paid at a later date, typically upon retirement, termination, or a specific future event. Common forms of deferred compensation include pension plans, retirement accounts (like 401(k)s), stock options, and executive compensation plans. These arrangements often provide tax advantages by deferring income taxes until the funds are received.
For example, an executive may defer a portion of their annual bonus into a deferred compensation plan, where it grows tax-free until withdrawn upon retirement.
Why is deferred compensation important?
Deferred compensation is important because it allows employees to plan for their financial future while potentially reducing their current tax burden. For employers, it serves as a tool for attracting and retaining talent, especially at the executive level, by offering long-term incentives tied to the company’s performance or tenure.
For employees, deferred compensation provides an opportunity to save for retirement or other goals in a tax-advantaged manner. For employers, it aligns employee interests with the company’s long-term success and can help manage cash flow by deferring payouts.
Understanding deferred compensation through an example
Imagine a senior manager opts to defer 20% of their annual salary into the company’s deferred compensation plan. The deferred amount is invested in a portfolio of funds selected by the manager and will grow tax-free until they retire. Upon retirement, the manager begins receiving annual distributions from the plan, which are then subject to income taxes.
In another example, a tech startup offers deferred compensation to its executives in the form of stock options. The options vest after five years, aligning the executives’ incentives with the company’s growth and performance over time.
An example of a deferred compensation clause
Here’s how a deferred compensation clause might appear in an agreement:
“The Employee shall have the option to defer a portion of their compensation into the Company’s Deferred Compensation Plan in accordance with the terms of the Plan and Section 409A of the Internal Revenue Code. Deferred amounts shall be credited to the Employee’s account and invested in accordance with their elected investment options. Distributions shall be made upon the occurrence of a qualifying event, including retirement, termination of employment, or as otherwise specified in the Plan.”
Conclusion
Deferred compensation provides a valuable mechanism for employees to save for the future while enjoying potential tax benefits. For employers, it serves as a strategic tool to attract, retain, and incentivize top talent by offering long-term financial rewards. Including clear provisions in agreements or compensation plans ensures compliance with applicable laws, like Section 409A, and promotes transparency and alignment of interests between employers and employees.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.