Deferred Compensation Accounts: The Basics

Written by: Jessica Zimmer

Deferred compensation (DC) accounts have recently made the news as companies attempt to minimize debt. The payout of DC accounts to creditors can preserve a company’s reputation, but at a high cost to employees.  A DC account is a type of savings or investment account. Pensions, retirement plans, and stock options are a few varieties of DC accounts. A DC account is set up by a contract between an employer and employee. The account grows when the employer takes out a certain amount of an employee’s income after the employee’s paycheck has been issued.

The employee benefits from this arrangement because their income is taxed when they withdraw it from the account. They can also invest the deferred amount with a fund manager contracted by the employer. In addition, the employee may be able to take out loans from their account.

The employer benefits because it can use the available funds for investment immediately. It also does not have to secure the funds it promised to an employee. The unsecured nature of a DC account makes it a dangerous risk for an employee. If an employer files for bankruptcy, the employer’s creditors can file suit to claim the funds in a DC account ahead of an employee. If an employee quits so they can reach the funds in their DC account, a creditor may be able to pursue the funds if it can prove the employee knew the employer was headed for bankruptcy.

Non-profit organizations, including churches and hospitals, state and local governments, and private employers are allowed to set up DC plans. The DC plans of non-profits and state and local governments follow different rules than those of private employers. Such DC plans are divided into two groups. The first is 457 (b) “eligible” plans, in which funds may not be taxed by the federal government before they are withdrawn. The funds are secured up to a set limit by the National Credit Union Administration (NCUA), and the purpose of the funds is to build retirement accounts. The second is 457 (f) “ineligible” plans, in which funds may be taxed before the federal government before they are withdrawn. The funds are not secured by the NCUA and the purpose of the funds is similar to that of bonuses awarded in private companies. One example of funds allocated to a 457 (f) plan would be severance pay granted to a coach or president of a state university. The rules for both types of 457 plans are set by the Internal Revenue Service (IRS).

Private employers typically set their own rules for DC plans. It is common for private employers to allow only their top 5 or 10 percent earners to open DC accounts. Private employers often use DC accounts to retain cash for investment and attract lateral hires. As more companies file for bankruptcy, employees may begin to think twice about offers that involve deferring their salary, even if an employer offers a high interest rate on a DC account.

© March 17, 2012 // Copyright all material 3/17/2012 by Jessica Zimmer


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Deferred Compensation Accounts: The Basics

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