Deferred Compensation Tax Rules

With a 401(k) or an IRA, the IRS only allows you to put away so much tax-free money a year. With deferred compensation, there's no limit to how much the federal government will let you save, although specific plans and companies may impose a cap. If you're already in the top tax bracket, you can use deferred compensation to postpone some of your pay until you leave the company and slide into a lower tax bracket.

One drawback to deferred compensation is that it's riskier than a 401(k). If your employer goes bankrupt, creditors can't touch a 401(k) but they can seize on deferred compensation. Many companies don't even set up special accounts for deferred pay, keeping it with general revenue. Unfortunately, that's necessary to protect it from the IRS. Money that's "under your control" in the words of the "CPA Journal" is taxable when you earn it -- and because deferred compensation is only a promise to pay you, the taxman can't collect on it.

Some employers play it safer and place deferred compensation in a reserved account or trust that protects it from creditors. In that case, you do have to pay tax on the income as soon as you're fully "vested" -- that is, when you become entitled to it. You also pay Social Security and Medicare on deferred pay once there's no longer a serious risk of not receiving the money. If the risk exists until you actually collect your pay, you pay the taxes then.

Your agreement with your company specifies how long it defers paying you -- and once it's set up, you're stuck with it. The government only allows you to cash in early in a few special circumstances, such as when you pay your spouse part of the money in a divorce settlement. If your company set up a tax-deferred compensation plan, the money you take out becomes subject to all the usual taxes on pay. You may, however, be able to draw out a little extra to pay the added taxes.