What is a Deferred Compensation?
A plan that allows employees to defer compensation earned in one tax year to a future tax year such as employee stock options, pensions, and retirement plans. These plans are typically offered to company executives and high earners.
At the time of deferral, you would pay Social Security and Medicare taxes on the income, but would not have to pay income tax until the delayed compensation is received.
Types of deferred compensation
There are two types of deferred compensation – qualified and non-qualified compensation plans. Qualified plans comply with ERISA and consist of 401(k) and 402(b) plans. A non-qualified deferred compensation plan is a contract between an employer and employee in which the employer withholds compensation, invests it, and returns it to the employee in the future.
401(k) deferred compensation plans
The most known deferred compensation plan is a 401(k). A 401k is a tax-advantaged company-sponsored retirement account that employees can contribute to. Employees can make contributions to their retirement account through automatic payroll deductions, and the employer can choose to match some, or all of those contributions.
Some companies – typically smaller companies – require an employee to work for a year before they become eligible to participate in the company’s 401(k). This delayed 401(k) option will likely be less attractive to quality job candidates. Other companies automatically enroll employees in the plan, but require a waiting period for the employee to be able to receive employer contribution. Finally, the best 401(k) plans automatically enroll employees in the plan upon the employee’s first paycheck and require no waiting period for an employer contribution to kick in.
First and foremost, when choosing between these three options and deferred compensation, employers must evaluate their financial standing. If an employer has more budgetary restrictions, it may be best to require a full year of employment before an employee becomes eligible to participate in the company’s 401(k).
Once you evaluate your financial flexibility, you should consider your organization’s turnover rate, employee satisfaction, and ease of hiring. If these are weak points for the company you may want to consider offering one of the automatic 401(k) enrollment options.
Related Terms: 401(k)