What Is Deferred Compensation?

Introduction

When it comes to compensation packages, employees often focus on their base salary and benefits such as healthcare and retirement plans. However, there is another form of compensation that can greatly impact an individual's financial future: deferred compensation. In this article, we will explore what deferred compensation is, how it works, and why it can be a valuable tool for both employees and employers.

What is Deferred Compensation?

Deferred compensation refers to a portion of an employee's compensation that is set aside to be paid at a later date, typically after retirement. Instead of receiving the full amount of their compensation in the form of a regular paycheck, employees can choose to defer a portion of their earnings to be paid out in the future. This deferred amount can be invested and grow over time, providing employees with additional income in their retirement years.

Types of Deferred Compensation

There are several types of deferred compensation plans that employers may offer to their employees. Some common examples include:

• 401(k) Plans: Many employers offer 401(k) plans, which allow employees to contribute a portion of their salary to a retirement account. These contributions are typically made on a pre-tax basis, meaning that employees do not pay taxes on the money until it is withdrawn in retirement.
• Stock Options: Some companies offer stock options as a form of deferred compensation. Employees are granted the right to purchase company stock at a predetermined price, known as the exercise price, at a future date. If the stock price increases, employees can purchase the stock at a lower price and potentially sell it for a profit.
• Restricted Stock Units (RSUs): RSUs are another form of stock-based compensation. Instead of granting employees the right to purchase stock, RSUs provide employees with actual shares of company stock at a future date. The shares are typically subject to certain vesting requirements, meaning that employees must meet certain conditions, such as remaining with the company for a certain period of time, before they can receive the shares.
• Deferred Bonus Plans: Some companies offer deferred bonus plans, where employees can choose to defer a portion of their annual bonus to be paid out in the future. This allows employees to delay receiving the bonus until a time when they may be in a lower tax bracket, potentially reducing their overall tax liability.

How Does Deferred Compensation Work?

The specifics of how deferred compensation works can vary depending on the type of plan and the employer's policies. However, the general concept is the same: employees choose to defer a portion of their compensation, and that amount is set aside to be paid out at a later date.

When employees defer their compensation, it is typically invested in a variety of investment options offered by the employer. These options may include mutual funds, stocks, bonds, or other investment vehicles. The investment earnings on the deferred amount are tax-deferred, meaning that employees do not pay taxes on the earnings until they are withdrawn.

Once the deferred compensation becomes payable, typically at retirement or another specified date, employees can choose how they want to receive the funds. Some options may include a lump sum payment, periodic payments over a certain number of years, or an annuity that provides a stream of income for life.

Benefits of Deferred Compensation

Deferred compensation offers several benefits for both employees and employers:

• Tax Advantages: One of the primary benefits of deferred compensation is the potential for tax savings. By deferring a portion of their compensation, employees can reduce their taxable income in the current year. Additionally, the investment earnings on the deferred amount grow tax-deferred, allowing employees to potentially accumulate more wealth over time.
• Retirement Income: Deferred compensation plans can provide employees with an additional source of income in retirement. By deferring a portion of their earnings, employees can build a nest egg that can supplement their other retirement savings, such as Social Security or a traditional 401(k) plan.
• Employee Retention: Offering deferred compensation plans can be an effective tool for attracting and retaining top talent. Employees value the opportunity to build long-term wealth and appreciate the tax advantages that come with deferred compensation. This can help employers create a competitive compensation package that sets them apart from other companies.

Case Study: The Power of Deferred Compensation

To illustrate the potential benefits of deferred compensation, let's consider a hypothetical case study:

John is a 40-year-old executive who earns a base salary of $200,000 per year. He is offered a deferred compensation plan by his employer, which allows him to defer 20% of his salary each year. John plans to retire at age 65 and expects an average annual return of 6% on his deferred amount.

If John chooses to defer $40,000 of his salary each year and earns an average annual return of 6%, his deferred amount would grow to approximately $1.8 million by the time he reaches age 65. This additional income could significantly enhance John's retirement lifestyle and provide him with greater financial security.

Conclusion

Deferred compensation is a valuable tool that can help employees build long-term wealth and provide them with additional income in retirement. By deferring a portion of their compensation, employees can take advantage of tax savings and potentially accumulate more wealth over time. Employers can use deferred compensation plans to attract and retain top talent, creating a competitive advantage in the job market. Whether it's through 401(k) plans, stock options, or deferred bonus plans, deferred compensation offers a win-win solution for both employees and employers.