A deferred compensation plan is a plan in which employees defer part of their compensation until a later date. Usually, the date when the additional funds are disbursed to the employee is the date of retirement, although some plans enable flexibility for major expenses like children's college or buying a house.
In many circumstances, deferred compensation plans offer certain tax benefits. Here’s what happens to your deferred compensation if you quit your job before your expected retirement date.
What is deferred compensation?
The 401(k) and 403(b) retirement plans and pensions are examples of deferred compensation. The employee opts to funnel a certain amount of their salary into the appropriate retirement account each month and takes distributions from the account upon retirement.
Non-qualified deferred compensation plans differ in that the funds aren't portable if you quit or leave your job early. These plans are good for higher earners, but there are serious downsides if you want to leave the company.
What happens to deferred compensation if I quit?
Most of us don’t stay in one job forever. You have options for what to do with your 401(k) or another qualified deferred compensation plan when you quit or are let go from a job. You should check your specific plan for details.
In general, you pay income tax on withdrawals from a qualified deferred compensation plan. Early withdrawals might result in a 10 percent penalty on the money as well (although the CARES Act removed the 10 percent penalty temporarily on up to $100,000 of early 401(k) withdrawals).
With a qualified plan like a 401(k), you can take a hardship withdrawal and only pay income tax without the added 10 percent tax. You might also be able to roll over the money to an IRA or Roth IRA (but not with a non-qualified plan).
If you quit at age 55 but before 59.5, you can use the “separation from service” distribution to avoid the 10 percent penalty when withdrawing from your last qualified deferred compensation plan.
With a non-qualified deferred compensation (NQDC) plan, you can't withdraw the money before the agreed-upon date, even in the case of hardship. If you lose your job, there might be a distribution plan that starts upon separation from service.
Some NQDC plans stipulate that you could forfeit all or part of your deferred compensation if you leave the company early. Merriman says that these are sometimes used as "golden handcuffs" to maintain loyalty in higher-up employees.
Qualified versus non-qualified deferred compensation plans
A qualified deferred compensation plan offers more security for the employee, along with more limitations. They must comply with the Employee Retirement Income Security Act (ERISA), have contribution limits, be offered to all employees, and be beneficial to all.
A non-qualified deferred compensation (NQDC) plan is only offered to certain employees, usually higher-paid executives. Most companies use NQDC plans to help higher earners who can’t benefit as much from a qualified plan due to contribution limits. NQDC plans are governed by Section 409A of the Internal Revenue Code.
Benefits of deferred compensation plans
Deferred compensation plans reduce the employee’s taxable income at the time of earning the money and allow them to defer taxes on the money until retirement or whenever they take distributions. The taxes can also be lower because later in life when making withdrawals, earners are often in a lower tax bracket than during their working years.
From some qualified deferred compensation plans, the owner can take early distributions for certain life events like buying a home. This means paying income tax on the withdrawals but avoiding the added 10 percent penalty for early withdrawals.
Non-qualified deferred compensation plans are often used to supplement a qualified deferred compensation plan like a 401(k). However, you could lose some or all of the money in that plan if you quit a job before reaching retirement.