Updated 6/23/2026

Deferred compensation is income earned now and received later. A deferred compensation plan is sometimes offered to highly compensated employees to help them defer some of their tax liability. An extreme example of deferred compensation is LA Dodgers star Shohei Ohtani’s $700 million contract signed in 2023, of which $680 million will be paid in the years 2034 to 2043 to help avoid California state income tax.

And while there are several types of deferred compensation, this article will primarily focus on non-qualified deferred compensation (NQDC) plans. Non-qualified deferred compensation plans can offer high tax benefits through income tax deferral and flexible planning, but they have less liquidity and higher employer risk. 

Key Takeaways:

• Deferred compensation is income earned now and paid later.
• NQDC plans are often offered to executives and highly compensated employees.
• NQDC plans can help reduce taxes but are usually unsecured promises from the employer.
• Section 409A rules limit when elections can be made and how payouts can change.
• Deferred compensation should be reviewed with tax, retirement income, and cash-flow planning.

What is deferred compensation?

Deferred compensation is exactly what it sounds like: income you earn in one year but agree to receive in a later year. This may include your general salary, but also bonuses, incentive compensation, and certain executive benefits.

Broad deferred compensation consists of both qualified and non-qualified plans. The advantage of non-qualified plans is that they are not subject to federal regulation, allowing high-earners more flexibility in what they elect to defer.

Qualified vs. non-qualified deferred compensation

Qualified deferred compensation plans are employee-sponsored plans subject to regulation under the Employee Retirement Income Security Act of 1974 (ERISA). 401(k)s, 403(b)s, governmental 457(b)s, pensions, and similar programs all fall under qualified deferred compensation. These plans are more common and are often offered to all employees regardless of income status.

Non-qualified plans are usually designed for select high earners and executives. They are not subject to regulation, so earners have no limits on how much income they defer. However, these plans often have limited protection when compared to their qualified counterparts.

Quick comparison table

How NQDC plans work

1. You elect to defer compensation. Employees choose how much of their salary or bonus to defer. Elections generally must be made before the compensation is earned.
2. Your employer tracks the benefit. In an NQDC plan, you usually do not have a separate protected account. Instead, your contributions are tracked through bookkeeping records.
3. The money is paid later. When your money is paid depends on plan documents and Section 409A rules. However, common distribution triggers include retirement, separation from service, disability, death, change in control, unforeseeable emergency, or when the fixed schedule is met.

Why employers offer NQDC

Non-qualified deferred compensation plans are created to attract and retain executives through “golden handcuff” incentives. The “golden” part refers to the large tax deductions given and how employees can save beyond qualified-plan limits. The “handcuffs” mean employees will be subject to penalties if they leave the company, retire early, or are terminated. NQDC plans can also align your compensation with long-term company goals.

For both NQDC and qualified plans, employers may deduct deferred compensation when it is included in the employee’s income.

Deferred compensation tax rules

Federal income tax

Deferred compensation is generally taxed when you receive it, not the year it’s made, if plan rules are followed. Credited returns and earnings may also be taxable when distributed to you.

FICA and FUTA taxes

You will still need to pay payroll taxes, but it will most likely be the year your deferred compensation is made rather than the year you receive it. Payroll taxes include Federal Insurance Contributions Act (FICA) taxes like Medicare and Social Security, and Federal Unemployment Tax Act (FUTA) taxes.

If you must perform substantial services for your deferred compensation to be vested, then you’ll pay FICA and FUTA taxes in the year your deferred compensation vests rather than the year it’s deferred.

State income tax

State taxation depends on current residence, source state, former residence, and payout schedule. 

Under 4 U.S.C. §114, only your state of residence can tax your retirement income, as long as the following are true:

• You receive a series of substantially equal period payments at least once per year
• These period payments are made for your life (or life expectancy) or for at least 10 years

For example, let’s say you have $500,000 in deferred compensation and are moving from California (a state with a 13.3% top tax rate) to Texas (a state with no income taxes). If you plan to receive your deferred compensation over five years, you won’t be protected from state taxation in California. As a result, you could pay $66,500 in income taxes in California. 

If you receive your deferred compensation over a period of 10 years, you’re covered under 4 U.S.C. §114 and will avoid income taxes from California. Because Texas doesn’t impose an income tax, you won’t pay any income taxes on those dollars at all.

State tax treatment for your NQDC plans should be modeled before electing the payout schedule.

Section 409A Penalties

Section 409A of the tax code sets strict rules for many NQDC plans, and violations can cause current taxation. Penalties can include a 20% additional tax and interest, and these penalties are generally imposed on you, the employee.

Section 409A: What employees should know

Section 409A sets six events that allow you to receive deferred compensation:

• Specified time or fixed schedule (as determined at the time of the deferral)
• Separation from service (either voluntary or involuntary)
• Unforeseeable emergency
• Change in ownership or control of the company
• Disability
• Death

Section 409A sets strict creation rules for NQDC plans. Initial elections generally must be made before the year compensation is earned, and payout timing and form should be set in advance. Changing payout timing later is difficult, and accelerating payments is generally prohibited except in limited cases. 

First-year eligibility and performance-based compensation may also have special rules.

Deferred compensation payout options

Example: How deferred compensation could fit into a retirement plan

A 58-year-old executive has an annual income of $650,000. They have already maxed out all eligible 401(k), HSA, and IRA options, and decide to defer a portion of their annual bonus for five years. They elect to have a 10-year payout at the beginning of retirement.

Now the executive is benefiting from:

• Lower current taxable income
• More retirement income
• Potential state tax planning

However, this plan also has several risks, including:

• Employer credit risk
• No early access to funds
• Inflexible payout election
• Tax rates could be higher later in life, reducing savings

Benefits of deferred compensation

1. Ability to save beyond qualified-plan limits. High earners who have already maxed out 401(k)s and other accounts can invest more funds into NQDCs.
2. Tax deferral opportunities. Funds that go into NQDCs are not subject to income tax until a later date, allowing high earners to drop into a lower tax bracket.
3. Retirement income planning. NQDCs can coordinate with Social Security, portfolio withdrawals, RMDs, Roth conversions, and pension income to increase retirement savings.
4. Goal-based payout planning. Payouts can sometimes be scheduled around retirement, college costs, home purchases, or other planned liquidity needs.

Risks of deferred compensation

1. Employer credit risk. An NQDC is often an unsecured promise. If your company goes bankrupt, the money will most likely go to creditors instead of you.
2. Rabbi trust limitations. Money put into an NQDC goes into a rabbi trust, which does help the employer set aside assets. However, this trust is not protected from creditors and has risks.
3. Liquidity limits. The money put into an NQDC does not have early access. You cannot borrow from it or roll it into an IRA.
4. Concentration risk. Tying multiple streams of income, including salaries, bonuses, pensions, company stock, and deferred compensation, to one company is risky. If the company goes bankrupt, your investments are vulnerable to creditors. 
5. Tax-rate risk. The deferral may be less valuable if future tax rates are higher or payouts overlap with other taxable income.

Deferred compensation vs. 457(b) Plans

457(b) plans are another deferred compensation option, often used in government or political agencies. Government 457(b) plans are similar to a 401(k) in the private sector. Non-government 457(b) plans share more similarities with NQDC.

A non-government 457(b) is generally reserved for highly compensated employees and executives. They use rabbi trusts like NQDCs. These plans are offered by tax-exempt entities.

Unlike NQDCs, non-government 457(b) plans still have contribution limits set by the IRS.

Should you participate in a deferred compensation plan?

Deferred compensation may make sense if:

• You already max out qualified retirement accounts.
• You are in a high tax bracket now.
• You expect lower taxable income later.
• You have strong emergency savings and taxable liquidity.
• Your employer is financially stable.
• You understand the payout schedule.
• You can tolerate lack of flexibility.
• You are not overly concentrated in employer-linked wealth.

Deferred compensation may not make sense if:

• You need near-term cash flow.
• You are unsure how long you will stay with the employer.
• Your employer’s financial health is uncertain.
• You may need to access the money early.
• Your plan only offers unfavorable payout choices.
• Your net worth is already heavily tied to your employer.

The bottom line

Non-qualified deferred compensation plans can lead to great tax benefits, but they aren’t without risk. NQDC can be helpful for high earners, but only when the plan terms, employer risk, taxes, cash flow, and retirement timeline fit.

Before making a deferred compensation election, consider reviewing your plan with an advisor at Wealth Enhancement.

FAQs about deferred compensation

What is deferred compensation?

Deferred compensation is income you earn now but agree to receive later, often at retirement or on another scheduled date.

What is a non-qualified deferred compensation plan?

A non-qualified deferred compensation plan is an employer arrangement, often for executives or highly compensated employees, that lets eligible participants defer compensation beyond qualified-plan limits.

Is deferred compensation taxable?

Yes. Deferred compensation is generally taxable when paid or constructively received, assuming the plan complies with applicable tax rules.

When do you pay taxes on deferred compensation?

Federal income tax is generally due when deferred compensation is paid. Payroll taxes may apply earlier, often when the compensation is deferred or vests.

Is deferred compensation better than a 401(k)?

Not usually as a first priority. Many people should maximize qualified accounts such as a 401(k) before using NQDC because qualified plans generally have stronger protections and more flexibility.

Can I roll deferred compensation into an IRA?

Generally, no. Non-qualified deferred compensation usually cannot be rolled into an IRA or 401(k).

Can I borrow from a deferred compensation plan?

Generally, no. NQDC plans typically do not allow loans or early withdrawals.

What happens if my employer goes bankrupt?

Deferred compensation may be at risk because NQDC benefits are often unsecured promises and may be subject to employer creditors. 

What is a rabbi trust?

A rabbi trust is a trust an employer may use to help pay deferred compensation benefits, but assets in the trust generally remain available to employer creditors.

What is Section 409A?

Section 409A is the federal tax law that governs many non-qualified deferred compensation arrangements, including election timing and restrictions on changing payment schedules.

What are 409A penalties?

A Section 409A violation can cause deferred amounts to become taxable sooner and may trigger a 20% additional tax plus interest. 

What happens to deferred compensation if I quit?

It depends on the plan. You may forfeit unvested amounts, while vested benefits may still be paid according to the plan’s payout schedule and remain subject to employer credit risk.

Can I change my deferred compensation election?

Sometimes, but changes are restricted and may require delayed timing under Section 409A rules. Many elections are effectively hard to change once made.

Content in this material is for general information only and is not intended to provide individualized tax or legal advice. Discuss your specific situation with a qualified tax or legal professional.

Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment advisor and affiliate of Wealth Enhancement Group.

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