Deferred Compensation Plans: A Tax Strategy for High-Income Professionals

For high-income earners and executives, tax strategy plays a critical role in building and preserving wealth. One tool often considered in advanced financial planning is the deferred compensation plan – sometimes referred to as a non-qualified deferred compensation or NQDC plan. 

While deferred compensation plans can offer meaningful tax advantages, they also come with complexities and potential risks. Investopedia provides a helpful overview of how deferred compensation plans work. 

Here’s what you need to know:

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What Is a Deferred Compensation Plan?

A deferred compensation plan is an arrangement between an employer and employee where a portion of the employee’s income is withheld and paid at a later date. Instead of receiving all of your salary or bonus in the year it’s earned, you agree to defer a portion until a future event—such as retirement, termination of employment, or a specific scheduled date.

This delay can create valuable tax advantages, since the income is not taxed until it’s received. However, deferred compensation also comes with restrictions and risks that make it different from standard retirement accounts like 401(k)s.

Types of Deferred Compensation Plans

Not all deferred compensation plans are the same. The two broad categories are:

1. Qualified Deferred Compensation Plans
   • Examples include 401(k)s, 403(b)s, and pensions.
   • Governed by ERISA rules, which provide protections like employer funding requirements and fiduciary obligations.
   • Contribution limits apply (e.g., annual IRS caps on 401(k) deferrals).
   • Assets are held in trust and generally protected if the employer becomes insolvent.
2. Nonqualified Deferred Compensation (NQDC) Plans
   • Often used for executives, highly compensated employees, and business owners.
   • Sometimes called “top-hat plans” or “salary deferral agreements.”
   • No IRS contribution limits, allowing for much larger deferrals than a 401(k).
   • Assets are typically unfunded and remain subject to employer creditors—making them riskier.
   • Must comply with strict IRS Section 409A rules on timing of deferrals and distributions.

Within NQDCs, there are further distinctions:

• Elective Plans: Employees choose to defer a portion of salary or bonuses.
• Non-Elective Plans: Employers promise additional future benefits, often as a retention or incentive tool (sometimes called Supplemental Executive Retirement Plans, or SERPs).

The Tax Advantages of Deferred Compensation Plans

The Potential Downsides of Deferred Compensation Plans

1. No Immediate Deduction for Employers

Unlike contributions to qualified plans, employers generally cannot take a deduction for deferred compensation until the employee recognizes the income.

2. Future Tax Rate Uncertainty

If tax rates rise or you end up with significant other retirement income (e.g., pensions, Social Security, RMDs), deferring compensation could push you into a higher bracket in retirement.

3. Employer Credit Risk

Deferred compensation plans are often unfunded. If your employer becomes insolvent, your deferred earnings could be at risk.

4. Limited Liquidity

Once you elect to defer income, those funds are typically inaccessible until a specified date or event (e.g., retirement). That limits flexibility if unexpected financial needs arise.

As Fidelity Investments explains, NQDC plans may also offer scheduled distributions beyond retirement, which can provide some planning flexibility—but they carry risks like potential loss of access to funds and exposure to your employer’s financial health.

5. Section 409A Compliance Risks

The IRS imposes strict rules under Section 409A on deferral elections and distribution timing. A misstep can lead to severe penalties, including immediate income recognition, additional taxes, and interest charges.

When Deferred Compensation Plans Might Make Sense

• You expect to be in a lower tax bracket during retirement.
• You’ve already maxed out qualified plan contributions and want to save more tax-deferred income.
• You have a high level of confidence in your employer’s long-term financial stability.

When It Might Not Be Ideal

• You expect to be in a higher tax bracket later due to other income streams.
• You have concerns about your employer’s solvency.
• You anticipate needing access to funds sooner for liquidity or investment purposes.

Final Thoughts on Deferred Compensation Plans

Deferred compensation plans can be powerful tools for high-net-worth individuals, but they require thoughtful evaluation and proper planning. The potential benefits—tax deferral, additional retirement savings, and tax-deferred growth—must be weighed against the risks, particularly around liquidity and employer stability.

If you’re considering a deferred compensation plan, we recommend working with a tax advisor to determine how it fits into your broader wealth strategy.

Need Help Evaluating a Deferred Compensation Plan?

Our team at Beckley & Associates works closely with high-income earners and business owners to develop tax-efficient wealth strategies. 

Contact us to discuss whether deferred compensation is right for your financial goals.

Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Please consult with your tax advisor regarding your specific situation.