How Does Deferred Compensation Work? With Examples

How does deferred compensation work, and why is it important for your organization? For HR professionals and organizational leaders, it plays an important role in designing competitive compensation packages, managing taxes, and supporting long-term financial planning for employees.

This article will provide a detailed answer to the question, “How does deferred compensation work?” It also explains what deferred comp plans are, the different types of plans, and deferred compensation examples to help you understand how to incorporate them into your organization’s compensation strategy.

What are deferred comp plans and how do they work?  

Deferred comp plans are typically divided into qualified deferred compensation plans and nonqualified deferred compensation plans. Each type has distinct rules, tax implications, and payout mechanisms. Choosing the right plan helps employers manage cash flow, reward employees, and support long-term organizational objectives.

Qualified Deferred Compensation Plan

Qualified deferred compensation plans, such as 401(k)s and traditional IRAs, allow employees to contribute pretax dollars through payroll deductions. Contributions are subject to IRS annual limits, and employees can select from various investment options to grow their deferred income over time.

Employers often provide matching contributions, which add value for employees while offering tax deductions for the company. Qualified deferred comp plan participants typically receive distributions at retirement, either as a lump sum or installment for over several years. Taxes are paid at the time of distribution, often placing employees in a lower tax bracket than during active employment.

Nonqualified Compensation Plan

Nonqualified deferred compensation plans are usually reserved for higher-earning employees or executives. Employers and employees must agree on the deferral amount, distribution schedule, and deferred comp plan provisions, which may include conditions like forfeiture if an employee leaves or joins a competitor.

Unlike qualified plans, NQDC plans are not limited by IRS contribution rules, giving employers flexibility in rewarding select employees. Deferred amounts are typically tracked through a system, and employees may have investment options tied to company stock, market indexes, or guaranteed rates of return. Taxes are paid when distributions are received, and employers can manage cash flow through options like lump sum or structured payouts over several years.

For organizations looking to simplify this process, tools like Salary.com’s CompAnalyst provide accurate market data to help your HR teams design competitive plans that motivate employees, support retention, and offer flexible financial benefits.

Deferred compensation examples

Below are some common deferred compensation examples that employers can offer to employees. These plans can be classified into qualified deferred compensation plans and nonqualified deferred compensation plans, each with unique rules, tax treatment, and payout options for plan participants.

Plan Type	Examples	Key Features	Applicable To
Qualified Plans	401(k), 403(b), 457(b), Traditional IRA	Pretax contributions; tax-deferred growth; subject to IRS contribution limits; ERISA-compliant; flexible investment choices; distributions typically begin at retirement age (lump sum distribution or periodic withdrawals)	All employees/plan participants
Nonqualified Plans	NQDC, SERPs, Top Hat Plans, Executive Bonus Plans	No IRS contribution limits; not ERISA-covered; plan provisions govern distribution timing and conditions; funds may be lost if employee leaves or company faces insolvency; flexible payout options (lump sum or over multiple years)	High-earning employees, executives

Qualified Deferred Compensation Plans

401(k) Plans: Employees contribute a portion of their salary on a pre-tax basis, with potential employer matching. Contributions are subject to annual IRS limits, and the funds grow tax-deferred until withdrawal, typically at retirement. These plans are governed by the Employee Retirement Income Security Act (ERISA), ensuring certain protections for participants.

403(b) and 457(b) Plans: Similar to 401(k) plans but tailored for employees of public schools, certain non-profit organizations, and government entities. They offer tax-deferred growth and are also subject to ERISA regulations.

Traditional IRAs: Individual Retirement Accounts that allow employees to contribute pre-tax income, with growth deferred until retirement. While not employer-sponsored, they are commonly used in conjunction with employer plans.

Nonqualified Deferred Compensation Plans

NQDC Plans: These plans are another deferred compensation example that allow executives and select employees to defer a portion of their income beyond the limits of qualified plans. They offer greater flexibility in contribution amounts and timing but do not provide the same legal protections as qualified plans.

Supplemental Executive Retirement Plans (SERPs): Employer-sponsored plans designed to provide additional retirement benefits to executives, supplementing other retirement plans. They are typically unfunded and subject to the employer's financial stability.

Top Hat Plans: Unfunded, nonqualified deferred comp plans offered to a select group of management or highly compensated employees. They are exempt from most ERISA requirements but must comply with certain reporting and disclosure rules.

Executive Bonus Plans: Employer-funded plans where the company provides a bonus to an executive, who then uses the funds to purchase a life insurance policy or invest in other vehicles. These plans are flexible and can be tailored to individual needs.

What are the pros and cons of deferred compensation?

Deferred compensation plans offer several advantages for employers, particularly when aiming to retain talent and reward high-performing employees. Understanding how deferred compensation works helps HR leaders balance competitive pay with long-term retention goals, especially when supported by advanced compensation benchmarking insights.

Pros

• Tax deferral on income: With a deferred comp plan, employees defer a portion of their salary or bonuses to a future date, reducing taxable income during high-earning years. They only pay taxes when distributions start, often at retirement when employees may be in a lower tax bracket.

• No contribution limits: Unlike 401(k)s or traditional retirement plans, NQDC plans allow high-income employees to defer large portions of their salary or bonuses, offering significant additional savings potential.

• Flexible payout options: Employers can structure distributions as a lump sum distribution or over multiple years. This flexibility allows employees to plan income strategically and can act as a bridge to other retirement savings and benefits.

• Retention and motivation: Offering deferred compensation, particularly NQDC plans, encourages employees to stay longer and rewards them for meeting long-term organizational goals.

• Tax-deferred growth and financial planning: Funds in both qualified and nonqualified plans grow tax-deferred, allowing participants to leverage pretax contributions and investment choices to support retirement and financial goals.

These benefits help employers and organizations create effective strategies and strong compensation structures that attract and retain key employees and executives.

Cons

• Financial liability: Deferred compensation creates a future obligation. If employees leave, retire, or take payouts, the company must ensure funds are available. Organizations offering NQDC plans carry the risk of large future cash outflows.

• Credit and bankruptcy risk: While employees are technically unsecured creditors in nonqualified plans, organizations must consider how deferred compensation obligations impact their cash flow and long-term financial stability.

• Administrative complexity: Designing and managing deferred comp plans requires clear plan provisions, tracking deferrals, and coordinating with payroll, legal, and finance teams to ensure compliance with tax and regulatory rules.

• Regulatory and compliance considerations: Employers must adhere to IRS rules and reporting requirements. Mismanagement or errors can lead to penalties or disputes with plan participants.

• Plan communication challenges: Ensuring employees understand the benefits, restrictions, and distribution schedules is essential. Poor communication can reduce plan effectiveness and impact employee satisfaction.

When weighing the benefits and risks of deferred compensation, HR leaders need clear, data-backed insights. Using compensation benchmarking tools that deliver real-time market data and analytics ensures that pay structures are not only competitive but also aligned with industry standards. This helps reduce the risk of over- or under-valuing executive compensation packages.

FAQs

Here are the most common questions people ask about deferred compensation with defined answers:

Is deferred compensation a good idea?

Yes, deferred compensation can be a very good idea for certain employees and employers. Offering a deferred comp plan helps retain highly compensated employees and reward long-term performance. For employees, it acts like a bonus paid at a future date, providing tax-deferred growth. NQDC plans also allow high earners to save beyond 401(k) or IRA limits, making them a useful tool in total compensation strategies.

Can I cash out my deferred compensation?

Yes, but with limitations. Deferred compensation paid follows the plan provisions set at enrollment, usually at retirement or a specific future date. Early access is generally not allowed, and distributions cannot be rolled into a 401(k), so taxes are due when received. Employers should clearly communicate payout options, including lump sum distribution or multi-year schedules.

What is the maximum amount for deferred compensation?

It depends on the deferred comp plan type. Unlike qualified deferred compensation plans with IRS annual contribution limits, nonqualified deferred compensation plans often have no limit on the amount employees can defer. This makes NQDC plans valuable for high earners while requiring employers to manage long-term financial liability.