The war for talent is heating up. A record number of workers have quit their jobs this year, creating a massive problem for employers. While higher pay can help get new workers in the door of your business, wages alone may not be enough to keep them there.
Employers are getting creative in finding ways to attract—and retain—great employees. In lieu of more pay up front, employers should consider a deferred compensation plan. Deferred compensation has benefits for both companies and workers. It can be used as a retention tool for key talent and provide tax advantages to employees.
Deferred compensation plans take different forms. They can be open to all employees or offered only to specific employees, such as executives. But every deferred compensation plan must comply with vast and complex federal regulations; noncompliance could result in penalties for the employer and the employee.
What Is a Deferred Compensation Plan?
A deferred compensation plan is any plan that withholds a portion of an employee’s pay until the end of the deferral period: the end date of the deferral period is often the date of the employee’s retirement but it can vary depending on the plan.
There are two distinct types of deferred compensation plans: qualified and unqualified. Although both types of plans offer tax-deferred compensation, they have significant differences.
- Qualified deferred compensation plans include 401(k) and 403(b) retirement plans, incentive stock options, and pensions. These plans are subject to the Employee Retirement Income Security Act (ERISA), which sets strict standards. For example, a qualified deferred compensation plan must be open to all employees, nondiscriminatory, and subject to contribution limits. Plan assets are held in a trust account that puts the funds outside the reach of creditors. There are compensation deferral limits for qualified plans set each year by the Internal Revenue Service, and generally, distributions cannot be taken before age 59 ½ except in certain limited cases of financial hardship.
- Nonqualified deferred compensation plans are written agreements made between an employer and an employee in which a portion of the employee’s pay is withheld until a later date. Nonqualified plans do not have to comply with ERISA, but they are subject to section 409A of the Internal Revenue Code (IRC) and related regulations. There are no contribution limits, they do not have to be offered to everyone, and the timing of distributions is more flexible. However, the money is not protected from company creditors and could be at risk if the business files for bankruptcy.
Types of Deferred Compensation Agreements
Deferred compensation agreements are usually reserved for key talent or highly compensated employees. They include the 457 plan, a retirement plan available to state and local government employees as well as some nongovernmental institutions, such as nonprofits. They can also include the following:
- Bonus and salary deferral arrangements
- Change-in-control agreements (also known as golden parachutes)
- Commission arrangements
- “Golden handcuff” (i.e., retention) plans
- Equity-based compensation, including discounted and undiscounted stock options and stock appreciation rights
- Fringe benefits such as club memberships and vehicles
- Severance pay arrangements
- Taxable reimbursement arrangements
Complying with 409A Deferred Compensation Agreements
Compensation that is subject to section 409A must comply with the IRC’s requirements for deferred compensation plans:
- The plan must have a written document that details how much compensation will be deferred, when it will be paid, and the payment form.
- The plan must place limits on times in which the compensation can be paid, such as a specified date chosen by the employee, separation from service, disability, change of control, and an unforeseeable emergency.
- The plan must comply with rules regarding changes to the time of payment and the form of payment.
Pros and Cons of a Deferred Compensation Agreement
As an employer, you should have a definitive goal for offering a 409A deferred compensation agreement. You might like the flexibility of the nondiscriminatory rules and the ability to choose which executives or highly compensated employees are eligible to participate. Those who participate may be incentivized to stay with your company. In addition, nonqualified deferred compensation plans have low upfront costs and no ongoing management fees. And because the money you defer does not have to go immediately towards employee pay, you can set it aside for other things or invest it.
From an employee’s perspective, a nonqualified plan offers tax advantages, no contribution limits, no age-related withdrawal restrictions, and no required minimum distributions. However, these benefits come with a downside: when a participant defers compensation into a nonqualified plan, they are locked in because payment restrictions make it very difficult to get out of the plan. Unlike a qualified plan, they cannot easily change their 409A plan election once the money begins to defer. If a plan fails to comply with 409A rules, the employee is the one who pays the price in the form of a 20 percent penalty tax on the amount deferred, as well as applicable interest penalties.
This places the main burden of 409A noncompliance on the employee, but the employer also has reporting and withholding obligations related to the compliance failure. Plus, it is not a good look for an employer when one of their employees is penalized for a plan that their employer designed. This could scare away other employees you hope to incentivize and cause you to be sued for a 409A failure.
More than 400 pages of regulations have been issued under section 409A. The basic rules are simple, but there are many issues to consider when designing, implementing, modifying, and paying out a deferred compensation arrangement. Errors on your part could disincentivize employees and potential employees rather than incentivize them to stay or join your business. To avoid problems, deferred compensation agreements should be carefully set up in advance with an employee benefits lawyer.
If you are considering offering deferred compensation plans to your company benefits, schedule a call with our law firm. We can help you weigh your options and design a plan that works for you and your employees.