What Is a Deferred Compensation Plan? Here's How It Works.

After job searching and interviewing, there’s nothing more rewarding than receiving that new job offer. If you’ve moved jobs, you’ve likely seen benefit packages that include some combination of health insurance, life insurance and a retirement savings plan (like a 401(k)). If you’ve done well professionally, your offers may now include additional benefits that you’re less familiar with—like a deferred compensation plan.

A deferred compensation plan might be a great addition to a retirement savings plan (though it can come with some added risk), especially if you’re already maxing out your 401(k) contributions each year.

We’ll help you understand what a deferred compensation plan is, how it works and how it might fit into your overall retirement savings strategy.

What is a deferred compensation plan?

A deferred compensation plan sets guidelines for how you’ll receive a part of your income (and any investment growth on it) at a later date. Deferred compensation plans are beneficial to employers because they can help attract and retain quality talent. They’re beneficial to employees because employees can reduce their current taxable income and withdraw funds, which have been able to grow tax-deferred when their income is likely lower (like in retirement). A 401(k) or pension a few common types of deferred compensation plans.

Types of deferred compensation plans

Deferred compensation plans are usually one of two types: qualified deferred compensation plans or nonqualified deferred compensation plans.

Qualified deferred compensation plans

A qualified deferred compensation plan is subject to the Employee Retirement Income Security Act (ERISA), which defines certain regulations a retirement plan must follow. Some of these regulations include making plans available to all employees, protection of the funds in case the company goes bankrupt, and annual contribution limits. Some of the most common examples of qualified deferred compensation plans are a 401(k), a 403(b) and a pension plan.

Nonqualified deferred compensation plans

A nonqualified deferred compensation (NQDC) plan is not subject to the Employee Retirement Income Security Act (ERISA) and therefore has a bit more flexibility than a qualified plan. Employers are not required to offer these plans to all employees—in fact, they often offer them only to top-level executives or exceptional talent they’re looking to attract. There are also no limits on how much an employee (or employer) can contribute to an NQDC plan; however, the employer is subject to the IRS reasonable compensation requirement for deductibility purposes.

Some NQDC plans require that an employee stay with the employer for a set period of time to receive the deferred income, a requirement that can help retain key talent. These plans are sometimes referred to as “golden handcuffs”: the reward is “golden,” but you’re “handcuffed” by certain requirements. Supplemental executive retirement plans (SERPs), executive bonus plans and excess benefit deferred compensation plans are some of the more commonly known NQDC plans an employer may offer.

What is a 457 nonqualified deferred compensation plan?

A 457 nonqualified deferred compensation plan (also referred to as a 457(b) retirement plan, a 457 plan or a 457 “def comp” plan) is a deferred compensation plan available to public employees (like state and municipal employees) and employees of some tax-exempt organizations. These plans are a unique version of a nonqualified plan because, unlike other nonqualified plans, they have contribution limits. They should not be mistaken for qualified plans because they do carry a few added perks that qualified deferred compensation plans don’t—like the absence of the 10 percent early withdrawal tax penalty or an added option to take out money for certain emergencies.

How does a deferred compensation plan work?

Because a deferred compensation plan is tied to an employer, you’ll work with your employer on the terms of your plan. You'll likely have to decide how you’ll contribute and how you’ll receive the benefit down the road.

Setting up and managing deferred compensation

The first step in taking advantage of a deferred compensation plan is deciding how much of your paycheck you’ll invest. With a 401(k), for example, you’d have to let your employer know how much of your paycheck you want withheld. As part of your benefits package, your employer may also offer a match—where they’d also contribute to your savings.

Some deferred compensation plans (like a 401(k)) may also have options for how you can invest your savings. Others (like a pension) don’t. If you do have a plan with options, you’ll be responsible for managing the portfolio and keeping it balanced at your preferred risk level.

Nonqualified compensation plans are often tied closely to the company, meaning that you’re investing your savings in the company itself. In this event, how much your funds grow will be dependent on the financial success of the company. This is where an NQDC can get a bit risky: If the company performs poorly, you could end up losing some or all of the money in the plan.

When can you withdraw from a deferred compensation plan?

When you’re able to withdraw from your plan will depend on what kind of plan it is. For a qualified plan, such as a 401(k), you generally need to wait until you are 59½ to take distributions in order to avoid a 10 percent tax penalty. (There are a few circumstances, however, in which you could take an early distribution without penalty.) You’ll have to take required minimum distributions when you turn 73.

Nonqualified plans can have some flexibility here—so you and your employer may agree upon the terms on your own. You could have the option of a single payout or receiving money gradually over a span of several years, but when you agree upon the terms, it’s very challenging to change them. Working with a financial advisor can be helpful in designing these terms; they can help you understand how all of your savings can work together and design a financial plan with a range of options that reinforce each other.

Pros and cons of a deferred compensation plan

Any added employer benefit may seem like a perk, but deferred compensation plans can come with some additional risk. Here are the pros and cons of a deferred compensation plan.

What are the advantages of a deferred compensation plan?

A deferred compensation plan can be beneficial to you now because it lowers your taxable income, and it’s helpful to you down the road because the compound growth on your funds can result in some significant savings. By collecting income after you’ve stopped earning your larger income, you could also put yourself into a lower income tax bracket, which may help you pay less tax on the money in the long run.

A deferred compensation retirement savings plan can also complement other savings accounts—like a Roth IRA, which grows tax-free—quite well. And if you’ve done a good job saving for retirement, you may also be able to delay taking your Social Security benefit, which could increase your total Social Security benefit amount by 8 percent for every year you wait (until you reach age 70) beyond your Social Security full retirement age.

What is the downside of deferred compensation?

You’re usually not able to touch funds you put into a deferred compensation plan until many years down the road. So, a deferred compensation plan lowers the amount of your income available to you right now. If you have a qualified deferred compensation plan, you’ll also be subject to contribution limits, meaning you’ll only be able to put so much money into your account at one time. While a nonqualified compensation plan has no limit to how much you can contribute, your growth potential may be dependent on one source (like the company you work for), making it a riskier investment.

Are deferred compensation plans a good idea?

If you have a deferred compensation plan available, it’s usually going to be a good idea to take advantage of it, but you’ll want to take a look at your bigger financial picture. Are you already deferring to a 401(k)? Do you have an IRA? How long have you been working? Here are some questions you’ll want to consider when deciding whether to contribute and how much:

• What is your projected income now and in the future? Weigh what your income is now against what your income may be in retirement. Then calculate whether it makes sense to pay the income taxes on your earnings now versus paying later.

• How many years do you have left until you retire? If you’re just starting out in your career, a deferred compensation plan that’s tied to the company stock could be riskier—there’s a lot that can happen in the next 30 years. There also may be requirements that you stay with the company a certain length of time, which is something you’ll want to consider.

• Are you working for a financially stable company? If you’re investing in profit sharing, you’ll want to have a good idea of how the company is doing financially, since your savings will grow or shrink depending on the success of the company.

• Which type of savings is most advantageous? A traditional 401(k) will grow tax-deferred, whereas a Roth 401(k) uses after-tax dollars but grows tax-free. If your company offers both plans, it’s important to review which option is best for your situation.

How much should I put into deferred compensation?

The answer to this question is a personal one, and it depends on what else you’re doing to save for retirement. If you’re trying to decide whether to begin investing in a deferred compensation plan, you may want to consider consulting a financial advisor who can help you look at your overall retirement strategy.

A Northwestern Mutual financial advisor can help you take a look at what savings vehicles you already have and make recommendations that align with your retirement savings strategy. Whether you enroll in a new savings plan or rebalance what you’ve got, a financial advisor can help you make the most of your savings and build the life you want in retirement.

This publication is not intended as legal or tax advice. This information was compiled by The Northwestern Mutual Life Insurance Company. It is intended solely for the information and education of Northwestern Mutual’s financial representatives, their customers, and the legal and tax advisors of those customers. It must not be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to avoid any penalties that may be imposed on a taxpayer. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting, or tax advisor. Tax and other planning developments after the original date of publication may affect these discussions.