Deferred compensation is an agreement between an employer and an employee in which a portion of their earnings, or compensation for work performed, is held back, or deferred, for payment at a future time. It is widely used as a retirement savings plan. An employer may offer a retirement plan to their employees as part of their compensation package, which might also include health insurance as well as actual wages. Although the value of the retirement is not specified in the hourly or yearly rate of pay, it is in fact deferred compensation that will be provided to the employee at some agreed upon rate and time.
Some employers participate in a deferred compensation program that allows a person to have a portion of their hourly or yearly wages invested by their employer rather than received as monetary compensation for work at the time that it is performed. There are a number of advantages to this.
One advantage to deferred compensation is that the portion of their compensation that is invested rather than disbursed to the employee is not subject to federal or state income taxes at the time it is earned. This is usually the time when a person’s income, and consequently their income tax liability are greater. It only becomes subject to federal and state income taxes when it is received by the employee much later.
In most cases the employee does not request disbursement of the deferred compensation until after they retire. At this point in time their income and the resulting tax liability is usually less. In addition, neither interest nor dividends earned from the deferred pay are subject to federal or state income taxes until such time that they are received by the employee.
In addition to deferred compensation used for retirement purposes, companies sometimes offer employees stock options. This is when the employee is issued the companies own stock as a form of non-cash compensation. This can be beneficial to both the employee and the company. The employee will benefit if the price of the stock is higher when it is cashed in than when it was earned. In turn the company will benefit as it gives the employee an incentive to perform their job with the company’s best interest in mind. The down side to this type of deferred compensation is when the price of the stock is less when it is sold than when it was earned.