Definition
Deferred compensation is a portion of an employee’s salary that is set aside to be paid out at a later date. In most cases, this money is set aside pre-tax, which can provide tax benefits for the employee. The payment of this income is typically deferred until the employee’s retirement or upon termination of employment.
Phonetic
The phonetics for the keyword “What is Deferred Compensation?” are as follows:What: wʌtIs: ɪzDeferred: dɪˈfɜːrdCompensation: ˌkɒmpɛnˈseɪʃ(ə)n
Key Takeaways
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- Deferred Compensation is a portion of an employee’s salary that is paid out at a later date beyond when the actual work takes place. This approach serves as a wealth-building and tax-saving strategy.
- There are two types of Deferred Compensation plans: qualified and nonqualified. Qualified plans, like 401(k)s, come with specific restrictions and conditions but provide certain tax advantages, while nonqualified plans are more flexible and are often offered to executives and other high-earning employees.
- The main benefit of Deferred Compensation is that it lowers the taxable income of the employee for the years in which funds are deferred. However, it also carries risks such as the possibility of the employer’s bankruptcy, which can result in a loss of the deferred income.
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Importance
Deferred compensation is important in business and finance as it allows employers to attract and retain talented employees with the promise of paying them their financial benefits in the future. Deferred compensation schemes can take many forms, such as retirement plans, pension plans, or stock-option plans. They help to motivate employees to perform to their fullest potential, thereby fostering a conducive work environment conducive to growth and productivity. This approach is particularly valuable for top-level executives whose contributions significantly impact the company’s success. Understanding deferred compensation can help both organizations and employees strategically plan for long-term financial stability and future growth.
Explanation
Deferred compensation serves a critical purpose in the financial structuring of an employee’s compensation package in the business world, particularly for executives. One principal function is to postpone the receipt of a portion of an employee’s remuneration to a future date, typically post-retirement or upon completion of a specified term of employment. There are multiple benefits attached to this arrangement, notably tax advantages, as the deferred income is not taxed until it is actually received by the employee. This allows an individual to strategically manage their income and potentially fall into a lower tax bracket during their retirement years.Additionally, deferred compensation serves as a buisness and retention tool for companies. By tying a portion of the employee’s compensation to a future date, it encourages loyalty and long-term commitment, as the employee stands to lose that deferred amount if they leave the company before the agreed-upon date. From a business perspective, it offers cash-flow advantages. Since the deferred payments are not immediately due, companies can better manage their short-term finances. These factors make deferred compensation an essential component in the overall compensation strategy of many organizations.
Examples
1. Retirement Plans: In the U.S., a common example of deferred compensation is the 401(k) plan offered by many employers. This allows employees to set aside a portion of their pre-tax salary into a retirement account. The money isn’t taxed until it’s withdrawn, usually at retirement. The same goes for 403(b) plans for non-profit organizations, 457 plans for government organizations, and Individual Retirement Accounts (IRAs).2. Stock Options: In many companies, especially startups, employees are given the option to buy company stock at a later date at a price set today. This is a form of deferred compensation, as the employees defer receiving parts of their compensation until a later date when they can buy (and possibly immediately sell) the stocks.3. Deferred Bonuses: In some industries, particularly in high-stakes areas like investment banking, a portion of an employee’s bonus may be deferred over a few years rather than being paid out all at once. This is done to incentivize employees to remain with the company and to align their incentives with longer-term goals. The deferred parts of their compensation can sometimes be paid in cash or in the form of company shares.
Frequently Asked Questions(FAQ)
What Is Deferred Compensation?
Deferred compensation is a portion of an employee’s income that is paid out at a later date after which the income is actually earned. This includes pensions, retirement plans, and stock options. The main purpose is to defer tax payment until the money is disbursed.
How does Deferred Compensation work?
In a deferred compensation plan, a portion of the employee’s income is set aside to be paid out at a future date, such as at retirement. This income is typically placed in an investment account where it grows tax deferred.
What are the benefits of Deferred Compensation?
Deferred compensation allows employees to plan for future expenses such as retirement. It also provides a tax advantage as the deferred amount isn’t subject to income taxes until it is withdrawn.
What are the risks associated with Deferred Compensation?
If the company that owes you the deferred compensation goes bankrupt, you might lose some or all of the money you deferred. It also comes with market risks, as bad investments can deplete the deferred money.
Can I access my Deferred Compensation before the set date?
Generally, early withdrawal from a deferred compensation plan may come with penalties. However, each plan has its own rules, so it’s important to read the terms carefully.
Are all employees eligible for Deferred Compensation?
Not all employees are eligible for deferred compensation. It’s often offered to executives or other high-paid employees as part of their compensation package.
How is Deferred Compensation taxed?
Deferred compensation is not taxed until it is distributed. When the funds are distributed, they are subject to income tax at the employee’s current tax rate at that time.
Related Finance Terms
- Non-Qualified Deferred Compensation (NQDC)
- Vesting Schedule
- Pre-tax Salary Deferral
- 457 Plans
- Employee Retirement Income Security Act (ERISA)
Sources for More Information
