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Deferred compensation plans help businesses potentially retain key employees by offering tax-deferred income, performance incentives, and long-term financial benefits.
Retaining Key Employees with Deferred Compensation Plans
Finding and keeping top talent is more challenging than ever, especially in competitive industries where high performers have plenty of options. While a strong salary is important, it may not be enough to secure long-term commitment from key employees. One strategy business owners can explore to encourage retention is a Deferred Compensation (DC) Plan—a flexible tool that allows employees to delay income and potentially build wealth while helping businesses manage compensation costs.
By structuring a DC plan effectively, companies can offer key employees incentives tied to long-term service and performance, creating a win-win scenario for both parties.
What Is Deferred Compensation?
A deferred compensation plan is an agreement between an employer and an employee to postpone a portion of earnings to a future date. Unlike traditional salary payments, deferred income is typically paid out later, such as at retirement or upon reaching a specific milestone.
Two Types of Deferred Compensation Plans
- Qualified Plans – These include 401(k) and pension plans, which follow strict IRS regulations, contribution limits, and nondiscrimination rules.
- Non-Qualified Deferred Compensation (NQDC) Plans – Designed for executives and key employees, these plans allow businesses to structure compensation with more flexibility, without the same contribution caps as qualified plans.
IRS Requirements and Compliance
For businesses considering deferred compensation, Internal Revenue Code (IRC) Section 409A outlines strict rules regarding plan design, payout timing, and tax implications. Non-compliance may result in immediate taxation and penalties. Careful planning and legal guidance are essential when structuring these plans.
Some Employee Benefits of a Deferred Compensation Plan
A well-structured plan may offer valuable benefits for executives and other highly compensated employees, including:
- Tax Deferral – Employees postpone taxation until they receive the deferred income, potentially reducing their tax burden in high-earning years.
- Supplemental Retirement Savings – Since non-qualified plans aren't subject to IRS contribution limits, they can provide additional long-term savings opportunities.
- Wealth Accumulation Potential – Earnings on deferred compensation may grow tax-deferred until withdrawal.
- Vesting Schedules – Businesses can set up a vesting timeline that aligns with retention goals, rewarding employees for long-term service.
- Flexible Distribution Options – Employees can often choose between lump-sum payouts or scheduled distributions at retirement.
Employer Advantages of Deferred Compensation Benefits
For business owners and leadership teams, deferred compensation plans serve as a strategic tool for retention and financial management.
- Retention and Loyalty – Employees with deferred compensation are incentivized to remain with the company long-term.
- Performance-Based Compensation – Plans can be structured to reward key employees for meeting business goals.
- Cost-Effective Benefits Strategy – Unlike traditional bonuses, deferred compensation can be structured to align with cash flow and business priorities.
- Selective Participation – Unlike qualified plans, non-qualified deferred compensation plans allow businesses to offer benefits exclusively to executives and key employees.
- Corporate Tax Considerations – Businesses can defer certain tax liabilities until payouts occur, aligning tax strategy with financial planning.
Funding Deferred Compensation Plans: Corporate-Owned Life Insurance (COLI) & Other Methods
Since non-qualified deferred compensation plans are typically unfunded liabilities, businesses need to plan how they will meet future payout obligations.
Corporate-Owned Life Insurance (COLI)
One common funding strategy involves purchasing a life insurance policy on key employees. The business owns the policy, which accumulates cash value over time, potentially providing tax-deferred growth, liquidity to cover deferred compensation payouts, and protection from unexpected financial strain.
Rabbi Trusts
Assets are set aside for deferred compensation but remain subject to company creditors. This approach provides some financial security while keeping funds available for future payouts.
Mutual Funds & Investments
Some businesses allocate investment accounts to cover future deferred compensation obligations. This strategy allows funds to potentially grow before they are distributed.
Pay-as-You-Go
The company funds deferred compensation payouts from future cash flow instead of setting aside assets in advance. While flexible, this method carries more financial risk if cash reserves become limited.
Structuring a Deferred Compensation Plan
When setting up a DC plan, businesses have flexibility in certain areas:
- Eligibility Criteria – Typically reserved for executives and highly compensated employees.
- Contribution Limits – No set caps for non-qualified plans, allowing for customized contributions.
- Vesting Schedules – Employers can determine when employees gain access to deferred funds.
- Distribution Triggers – Payouts can be structured around retirement, performance milestones, or business events like mergers.
- Investment Options – Some plans allow deferred earnings to be invested for potential growth before distribution.
Managing Risk: Considerations for Employers
While deferred compensation plans offer flexibility, businesses need to anticipate challenges, including:
- Long-Term Financial Commitments – Making sure the company has the resources to meet payout obligations.
- Change in Control Provisions – Addressing how the plan is handled in mergers or acquisitions.
- Regulatory Compliance – Adhering to IRS guidelines to potentially avoid tax penalties.
Is a Deferred Compensation Plan Right for Your Business?
For companies looking to retain top talent, deferred compensation plans offer a customizable approach to executive benefits. Speak with an EP Wealth business planning advisor to explore how deferred compensation fits into your broader business strategy.
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