Understanding Deferred Compensation- The Basics of What you Need to Know

by | September 13, 2012

Guest blog provided by Kristofer Gray, Principal of Integrity Financial Corporation

Millions of employees save for retirement by deferring a portion of their compensation into an employer-sponsored, tax-deferred savings plan. The majority of these are known as qualified plans and fall under the jurisdiction of ERISA guidelines, which means they are subject to certain limiting requirements.

For example, these requirements can pertain to the type and number of employees who participate, as well as the amount of money that is placed in the plan by rank-and-file employees as compared to executives and owners.

However, there are times when a qualified plan won’t accomplish an employer’s goals. For instance, a company may want to defer a greater amount for retirement than is permitted inside a qualified plan, or reward either themselves or a key employee with additional benefits and compensation that will not be offered to the majority of employees. In cases like these, non-qualified plans are used to achieve specialized objectives.

Characteristics of Non-Qualified Plans

Because of their flexibility, non-qualified plans have very few set criteria they must meet. These plans are usually tailor-made on a case-by-case basis and come in all shapes and sizes.

They can be relatively simple or quite complex depending upon various factors, such as the employer’s objectives and the number of employees that are included. Moreover, the funds that are placed inside them can grow tax-deferred so long as certain conditions are met.

The Deferred Compensation Plan is a contractual arrangement whereby a key employee, usually in a high income tax bracket, will receive a guaranteed number of fixed payments, beginning at retirement, in place of current salary increases or cash bonuses.

Deferred compensation plans come in two forms: deferred savings plans and SERPs (Supplemental Executive Retirement Plans). These two types are similar in many respects, but deferred savings plans are funded from employee contributions, while SERPs are funded entirely by the employer.

SERPs are generally structured as a private form of defined benefit plan and are funded with either some sort of side fund or corporate-owned life insurance (COLI). Plan benefits may also be paid directly from the company’s assets, according to an agreement. “Golden Handcuff” provisions in the agreement create a scenario whereby employees who do not complete their tenure with the company or do not fulfill other requirements specified within the plan will generally forfeit their rights to the benefits that they would otherwise have been paid.

With a deferred compensation arrangement, you agree to continue an employee`s salary for a specified period of time after retirement. Although the company`s contribution to the plan is not currently tax deductible, deferrals grow tax free provided the company uses a tax-deferred investment vehicle, such as life insurance. The advantage of a deferred compensation plan is that it gives your company control of the funding vehicle.

In the deferred compensation contract, prepared by an attorney:

The employer usually agrees to:

  1. Pay the employee a specified salary at retirement for a specified number of  years.
  2. Continue payments to the employee’s beneficiary if the retired employee dies before receiving the full number of payments.
  3. Pay a death benefit to the employee’s beneficiary in the event of death prior to retirement.

The employee usually agrees to:

  1. Remain with the employer until retirement.
  2. Refrain from competing with the employer after retirement.