Deferred Compensation
Decoding Deferred Compensation: A Comprehensive Guide
Understanding Deferred Compensation
What Is Deferred Compensation?
Deferred compensation is a strategic compensation plan that empowers employees to postpone earnings from one tax year to a subsequent tax year. This may include portions of payments and bonus payments. Notably, the deferred compensation is not deemed taxable income until employees receive it in the designated future tax year.
Types of Deferred Compensation Plans:
Deferred compensation plans come in two main types—non-qualified and qualified. Non-qualified plans, also known as Section 409A or NQDC plans, are typically designed for key or high-earning employees. Employers must outline conditions for accessing deferred funds and adhere to specific IRS rules to avoid penalties.
Diverse Forms of Deferred Compensation
Excess Benefit Plans:
Allow employees enrolled in qualified benefit plans to contribute additional funds to retirement plans as an excess benefit.
Salary Reduction Arrangements:
Enable employees in deferred compensation plans to defer a portion of their salary to a future year, postponing tax obligations until funds are received.
Supplemental Executive Retirement Plans (SERPs):
Companies contribute non-qualified funds to a supplemental retirement fund for key or highly compensated employees, accessible upon retirement and meeting specific plan conditions.
Bonus Deferral Plans:
Enable employees to defer bonus payments until a future date, delaying tax liability until the receipt of funds.
Qualified vs. Non-Qualified Deferred Compensation Plans
Qualified Deferred Compensation Plan:
Includes plans like a 401K, with contribution limits and exclusivity to company employees. Separate fund segregation is mandatory.
Non-Qualified Deferred Compensation Plan:
Encompasses any deferred compensation plan between an employer and employee, allowing the deferral of taxable income until a future year. No fund separation is required, and there are no limits on employee contributions.
Navigating Deferred Compensation Taxation
Tax Considerations:
Employers must carefully navigate tax forms for deferred compensation to avoid IRS audits and penalties. While income tax withholding occurs upon the receipt of compensation, FICA and FUTA taxes may be withheld when employees defer income. The timing of withholding depends on the nature of the deferred compensation plan.
Insights into Deferred Compensation Accounting
Performance-Based Accounting:
Deferred compensation accounting may hinge on employee performance, especially for highly compensated individuals. Costs are accrued over predetermined periods, reflecting the agreement terms.
Example of Deferred Compensation Accounting:
Consider a CEO with a deferred compensation plan. The company accrues the cost of the CEO’s contract over five years, aligning with the employment agreement’s terms. Accrual occurs during this period, and the CEO becomes eligible to receive the funds upon fulfilling the agreement terms.
Understanding deferred compensation involves navigating diverse plans, tax considerations, and accounting practices, each tailored to the unique needs of employers and employees.