A deferred compensation plan is an arrangement in which a portion of an employee’s income is deferred until a specified future date. Wages earned in one period are actually paid at a later date. Examples of deferred compensation plans include pensions, retirement plans, and stock options. The primary benefit is the deferral of tax payment.
A qualified plan receives certain favorable tax treatment under the Internal Revenue Code:
The employer is entitled to a tax deduction for the amounts contributed to the plan.
The benefits grow on a tax-deferred basis until they are actually paid under the plan.
Distributions are generally eligible for rollover to an Individual Retirement Account (IRA) or other qualified plan that permits further tax deferral.
Disadvantages of a qualified plan:
Nondiscrimination requirements prohibit an employer from providing benefits for highly compensated employees to the exclusion of other employees.
The amounts of the employer’s contributions are limited.
There are regular reporting requirements.
Examples include 401(k) and 403(b) plans.
A non-qualified plan does not receive favorable tax treatment:
The employer is not entitled to tax deductions until the benefits are actually paid to the employee.
Under constructive receipt rules, the benefits are taxable to the employee when the employee has the right to receive the benefits, without regard to when the benefits are actually paid. The employee does not actually have to take possession of the funds.
Advantages of a non-qualified plan:
The employer can pick the recipient employees without regard to years of service, salary level, or any other criteria.
The plan allows a business to provide benefits to officers, executives, and other highly paid employees.
The amounts of the employer’s contributions are not limited.
A non-qualified plan is less expensive to set up than a qualified plan.
There are no significant filing or reporting requirements.
A section 457 plan is a non-qualified deferred compensation plan provided by states, counties, cities, towns, and special governmental districts.