What is Deferred Compensation and How Does it Work?

A portion of an employee’s income is placed away for eventual distribution as deferred salary. In most cases, taxes on the profit are deferred until after it is distributed. Insurance schemes, contingency plans, and stock option plans are all examples of deferred compensation. In this article, let’s learn about the various aspects of deferred compensation in detail.

What Is Deferred Salary?

A deferred salary is an option for employees who want to save money on taxes. In most situations, income tax is deferred until after the bonus is paid, generally when the employee retires. When an employee retires and desires to be in a lower tax band than when the pay was earned, they will have the opportunity to minimise their tax burden. Employers may invest deferred income in stock options or mutual funds in specific situations.

Factors to Consider for A Deferred compensation plan?

While deciding about participation in a deferred compensation plan, the following questions need to be considered:

• What is your employer’s financial standing?  Deferred salary is considered an unsecured liability of the firm and may result in the entire loss of your contribution if the company goes bankrupt.
• What percentage of your net worth is owed to your employer? You may have stock options, restricted stock units, or stock purchase plans in addition to your pay, all of which are linked to the future of one’s business. Adding deferred compensation risk to the mix may be taking on more risk than is necessary.
• How long do you intend to work for your present company before retiring? If you’re more than 15 years away from retiring, there’s a greater chance that something may jeopardise your company’s financial health in the interim. 

Think about your  current tax bracket and what it could be in the future. Is it possible to go into a lower tax bracket by delaying now?

• The amount of one’s income that is deferred for future payment lowers current income and is not taxed until the beneficiary receives the payment. The concept is especially beneficial to people who expect to fall into a lower income tax category in the future. Furthermore, if future tax rates in the country decline, beneficiaries of deferred compensation schemes will pay less in taxes in the long run.
• What is your anticipated tax bracket in retirement, taking into account all potential sources of income? This is e specially difficult since no one knows what tax rates or brackets will exist in five, ten, or fifteen years.

Two major deferred compensation considerations

Employees who choose to join in a deferred compensation plan have two critical decisions: when and how to accept payouts. 

These two choices are linked and need considerable consideration and preparation. In most circumstances, these decisions are difficult to reverse. If modifications are permitted under Income Tax Department regulations regulating deferred compensation schemes, they must be made after a five-year waiting period.

Answer to the ‘when’ question

Although deferred salary does not have to be received in retirement, it is preferable because the primary objective is to save money on taxes. The triggers for deferred comp payout are often beyond your control. For example, upon separation from service, death, or incapacity, you (or your heirs) will almost always be obliged to receive payouts. You should collect your payouts in retirement when your other sources of income are likely to be lower.

Also Read: All About Special Allowance – its Taxation & Calculation in India

Answer to the ‘how’ question 

•  It is important to be careful while ascertaining how and when you will receive deferred compensation payouts. Most plans allow you to pay in one single sum or over time. The tactics to examine when to accept payouts are beyond the scope of this review, but this is where mistakes may cost a lot of money. 
• The date on which the deferred compensation is received is decided at the time of setting up the plan. It is normally desirable for an employee to defer compensation in order to avoid having all of the deferred income delivered at the same time, as this typically results in the employee getting enough money to put them in the highest tax bracket for the year.

The following are a few things to think about:

• When do you think you’ll be able to retire? Deferred salary should ideally be delayed until after you retire.
• Can you save enough money in deferred salary and other accounts to satisfy your expected living expenditures?
• Should you make yearly lump sum payments in a row or equal instalments over several years?

Types of Deferred Salary

Qualified Deferred Remuneration and Non-Qualified Deferred Compensation are the two types of deferred salary. Details of both these types have been given below –

Qualified Deferred Remuneration

Qualified deferred compensation is enacted to protect retirement funds. Employees have a right to free full disclosure of their retirement plans under such laws. Employee retirement funds must be maintained in a trust account by law.

The plans must be made available to all employees and are only for the benefit of the employee. It implies that if the firm fails to pay its debts, creditors will not be able to seize the cash.

The quantity of money can be put into a qualified plan. It has minimal requirements that an employee must meet to be eligible for the plan and comprehensive restrictions on how employers should provide adequate money. In general, qualified deferred compensation plans are subject to stricter regulations.

 Non-Qualified Deferred Compensation

The most notable difference is that NQDCs does not impose a maximum contribution limit on employees’ contributions to their retirement savings accounts.

Companies provide NQDCs to employees who earn a lot of money and want to save more of it. People can avoid paying taxes on a more significant part of their wages and receive bigger tax-deferred investment returns due to the schemes. Because the government requirements do not cover them, such plans are riskier than qualified deferred compensation plans. NQDCs are not secured accounts, and the business’s creditors can take over monies placed in them if the company defaults or goes bankrupt.

The following are the main differences between qualified deferred compensation and nonqualified deferred compensation:

Advantages of Deferred Salary Plans 

Beneficiaries of deferred salary schemes have the following advantages:

1. Financial stability after retirement

People who participate in deferred compensation programs receive a steady income when they retire. The money obtained from retirement accounts ensures financial security. To earn interest, beneficiaries can save their money and invest it later in mutual funds or other investment choices.

2. Tax advantages

The part of one’s income postponed for future payment lowers current income and is not taxed until the beneficiary receives the payment. The deferred salary program is especially beneficial to people who expect to fall into a lower income tax band in the future. Furthermore, if future tax rates decline, beneficiaries of deferred compensation schemes will pay less in taxes in the long run.

3. Capital Gain

Many companies put money in deferred salary accounts into mutual funds or other secure investment choices that yield a consistent interest rate. Regular interest payments increase the value of the post-retirement payout. Furthermore, if the investment’s value grows over time, the recipient will benefit from capital gains.

Taxation on deferred compensation

• Employees who postpone a portion of their pay likewise defer taxes on that income, as previously mentioned. 
• When employees postpone their salary, they do not owe income tax right away. Instead, they pay federal income tax when the deferred income is received. 
• Generally, deferred remuneration is liable to Social Insurance taxes at the time of deferral. 
• FICA tax is not due until the specified service is completed if employees are obliged to undertake future benefits to collect their deferred pay in an NQDC plan.

Accounting for deferred salary

You owe an employee in the future when they contribute a percentage of their salary to a nonqualified plan. Accounts payable is the term used in accounting to describe the amount you owe them but have not paid. Accounts payable are a type of obligation or debt. Credits add to a company’s liabilities. You must credit your accounts payable with the amount of deferred compensation to keep proper accounting records. This makes a record that the employee is still owed money.

How Does Deferred Compensation Work?

Your employer will choose how much you may defer and for how long you can postpone it—usually five or ten years, or until you retire. You must also select whether you want to get your deferred pay in one single amount or over several years after determining how long you will delay your income. A five-year or ten-year payout period is common.

Your NQDC’s next decision is which investment option you want your results to be indexed to. Your money isn’t truly invested; therefore, this is merely a bookkeeping method. In certain circumstances, the firm will decide for you by guaranteeing a “rate of return” on the remuneration, although this is uncommon.

Also Read: Leave Travel Allowance (LTA)– Its Calculation, Rules and Exemption

Conclusion

It is important to understand deferred salary in detail, along with the types and plans for deferred compensation and the benefits it provides to people. We hope this article provides you with the relevant information relating to the definition of deferred compensation, types of deferred compensation, plans for deferred compensation and its benefits, taxation, and accounting for deferred compensations. 

For more updates related to salary and taxes, download the Legaltree app.