Deferred compensation is a portion of an employee’s salary that is kept aside for later payment. This is kept aside in the form of insurance, stock options, retirement funds and so on.
When an employee opts for deferred compensation, the tax on the deferred income is paid when the employee receives the money. At that point, the employee would fall under a lower tax bracket because of which they would pay a lower tax amount.
Broadly, there are two categories:
In the US, Pension plans governed by the Employee Retirement Income Security Act (ERISA) come under Qualified Deferred Compensation Plans. These would include 401(k), 403(b) and 457 plans. Businesses offer these plans to all their employees and meant for the employees benefits. Businesses cannot use these funds to pay off their debts.
Non-qualified deferred compensation (NQDC) plans, is an agreement between the employee and employer where a part of the employee’s compensation is withheld by the company, either invested and returned to the employee at a later point. Since employers can keep this money as a part of their business funds, these funds are at a risk of bankruptcy. This can be offered to just the top executives and has no caps on the contribution. Independent contractors are also eligible for NQDC plans. It is also called as “golden handcuffs” as it is used to hire and retain top talent.
Deferred compensation reduces the tax burden on the employee, since it does not consider the deferred amount to be a part of the employee’s income. Tax is not assessed on the invested earnings until the employee withdraws it. The contributions are deducted from the employee’s paycheck before taxation. As a result, the income tax paid for that year reduces.
The payment of tax occurs when the employee actually withdraws from the investment. By the time they do so, the employee would be in a lower tax bracket.
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