What Is Deferred Compensation?
Deferred compensation is a form of compensation that is withheld from an employee’s current income and paid at a later date. Deferred compensation is an agreement between an employer and an employee that sets out a plan to pay the employee an amount of money, usually at the end of the employment term, that is greater than the employee’s current salary.
Deferred compensation is an attractive, but potentially risky, form of compensation for employees because it allows them to potentially increase their retirement savings while benefiting from financial incentives and tax breaks. However, there are also risks associated with deferred compensation, including periods of market volatility and no guaranteed returns.
For employers, investing in deferred compensation agreements can be cost-effective and provide excellent incentives for workforce stability and longevity. Employers also benefit from tax deductions when offering deferred compensation to employees.
Understanding How Deferred Compensation Works
Deferred compensation is a form of compensation in which an employee agrees to receive an amount of money, usually paid out at a later date. The phrase “deferred compensation” is often used to refer to an agreement between an employer and an employee. This agreement sets out the plan to pay the employee more than their current salary at the end of their employment period.
Deferred compensation can be used to supplement an employee’s income, build retirement savings, or provide them with financial incentives, including tax benefits. Many employers offer deferred compensation as part of a retirement package for employees. Some employees also choose to use deferred compensation to save for future purchases, such as a new car or a down payment on a home.
Benefits of Deferred Compensation for Employees
Deferred compensation agreements are attractive to many employees because they provide financial incentives and offer tax benefits. Deferred compensation can be used to supplement an employee’s current salary and to increase their retirement savings. This form of compensation also allows employees to defer the current taxable income to the future when they may be in a lower tax bracket.
The potential tax benefits of deferred compensation can be especially attractive to high-earning employees who are paying higher taxes. Deferred compensation can also be used to supplement Social Security income in retirement. This form of compensation is attractive to younger employees because they can potentially increase retirement savings while they are currently making a lower salary.
Benefits of Deferred Compensation for Employers
Deferred compensation agreements can be cost-effective for employers because they can offer employees financial incentives that are paid out at a later date. Employers also benefit from tax deductions when offering deferred compensation to employees. In addition, deferred compensation provides stability for employers by increasing employee retention rates.
Employers can contribute to deferred compensation agreements on behalf of their employees to provide additional incentive for long-term stability. Employers can contribute through a number of methods, such as matching contributions up to a certain percentage of the employee’s salary or providing non-elective contributions each month.
In addition to providing financial incentives for employees, deferred compensation also allows employers to set aside funds for certain goals. For example, an employer may want to set aside funds to cover potential legal costs or other financial setbacks. With deferred compensation, employers can ensure their funds remain liquid and accessible.
Risks of Deferred Compensation
While there are many potential benefits of deferred compensation, there are also risks associated with this form of compensation. The primary risk associated with deferred compensation is that the money may not be received in the future as expected.
Depending on the type of deferred compensation agreement, funds may be subject to market volatility, which can result in variable returns. In addition, investments in deferred compensation are usually not guaranteed by the government and may be subject to withdrawal penalties or other restrictions.
Finally, deferred compensation agreements generally cannot be cancelled or revoked without penalty. Once an agreement is signed, it may be difficult or impossible to cancel the agreement without incurring significant financial losses.
Deferred compensation is an attractive form of compensation for employees because it provides financial incentives and tax benefits. For employers, deferred compensation provides cost savings and employee stability and longevity.
However, there are risks associated with deferred compensation, including market volatility, not guaranteed returns, and non-cancellable agreement terms. Before and throughout the term of the agreement, it is important for both employer and employee to periodically re-evaluate the agreement to ensure it fits their current goals.