Deferred Compensation Plans

Deferred compensation plans refer to arrangements in which employees defer some portion of their current income until a future date. Wages earned by an employee in one period are actually received by the employee at a later date. The overall effect is to postpone taxation for the employee until compensation is received, usually in retirement.

Deferred compensation plans are either qualified or nonqualified. Qualified deferred compensation plans receive certain tax preferences under the Internal Revenue Code; most notably, employers are entitled to a tax deduction for the amount of money they contribute to the plan. While the funds remain in the plan, the benefits grow on a tax-deferred basis to the employee until they are actual paid. Qualified deferred [Page 561]compensation plans are designed mainly to provide cash payments in retirement or to defer taxation to a year when the recipient is in a lower bracket. To be a qualified deferred compensation plan, the benefits available under the plan have to be nondiscriminatory, which prohibits an employer from providing benefits for highly compensated employees to the exclusion of all other employees. In addition, the employer has to comply with regular reporting requirements and is limited in the amount of contributions it can make to the plan.

A nonqualified deferred compensation plan is also used to postpone taxation for the employee until compensation is received, but employers do not receive favored tax treatment. Employers are not entitled to tax deductions until these benefits are actually paid to the employee or the employee receives the rights to the benefits. The advantage of a nonqualified deferred compensation plans is that the employer can choose who receives the benefits without regards to years of service, salary, or any other criteria. Often the recipients of this type of plan are officers, executives, and other highly paid employees. Nonqualified deferred compensation plans are less expensive to set up, there are no significant reporting requirements, and employers can contribute unlimited amounts of money to them.