A Deferred Compensation Plan is an agreement between the Company and the Executive/Employee whereby the latter is permitted under the terms of the plan to defer a portion of their own compensation to a later period. Deferred Compensation plans can be designed using two different approaches:
Salary Deferral Arrangement: A Salary Deferral Arrangement allows a key Employee to defer a portion of pre-tax compensation (salary, bonuses or commissions) until some specified date in the future. The Company may agree to match all or any portion of such deferrals. In addition, interest will be credited to the deferred amounts during the accumulation phase. There is no limit set by law on the deferral amount, and interest may be credited by any means agreed upon by the parties. For example, the interest-crediting rate may be set at a fixed or variable rate controlled by the Company or track the return on a fixed investment. The Company may permit the employee to suggest a fixed investment or investment portfolio whose rates of return will be tracked and credited to the account value. If the interest-crediting rate tracks the rate of return on one or more securities, the amount of the employee’s accrued benefit may increase or decrease according to the performance of the tracked security (or securities).
401k Mirror Plan: A 401(k) Mirror Arrangement is designed to remedy the “reverse discrimination” problem a highly compensated key Employee faces in the context of qualified retirement planning. In a 401(k) Mirror Arrangement, the Company allows a highly compensated key Employee to defer annually an amount equal to the difference between the amount the Employee would have been able to contribute to the Company’s qualified plan if no contribution limitation applied to the Employee. In addition, interest may be credited to the account during the accumulation phase. In a 401(k) Mirror Arrangement, the Company generally permits an Employee to suggest a fixed investment or investment portfolio whose rate of return the interest will track. If the interest-crediting rate tracks the rate of return on one or more securities, the amount of the Employee’s accrued benefit may increase or decrease according to the performance of the tracked security (or securities). The Company may choose to match all or a portion of the Employee’s deferral.
In both cases, deferrals by the Employee are immediately vested should the Employee depart from the Company. Employer matching contributions can vest over time, with no regulated vesting requirement.
Advantages of a Non-Qualified Deferred Compensation Plan:
To the Company:
- The plan can be discriminatory inasmuch as the Employer can determine which Employees participate in the Plan.
- It provides a recruiting and retention tool to the Employer by providing an additional benefit to key Employees. Vesting requirements for Employer contributions serve as a further “handcuff” to retain the Employee.
- The Employer’s portion of the contribution is unlimited.
- There are no ERISA or IRS filing requirements.
To the Executive:
- The Plan allows Employees to defer their own compensation to a later period, reducing current income tax.
- Income generated by the funds in the plan will grow tax-deferred to the Employee.
- Employer matching contributions will further add to the Employee’s benefits.
Disadvantages of a Non-Qualified Deferred Compensation Plan:
To the Company:
- The employer does not receive a tax deduction for amounts contributed to the plan until such time as those benefits are paid out.
- The Plan only serves as a “Golden Handcuff” to the extent of Company contributions, which can be set to vest over time.
To the Executive: In order for funds deferred by the Employee not to be taxed to the Employee at the time of deferral, the Employee must accept the “risk of substantial forfeiture” in the event the Company enters bankruptcy or becomes insolvent.