Under a deferred compensation arrangement, an employee or business owner agrees to defer part of his or her income until a specific date, usually near retirement age. For example, you might pay a top employee $200,000 per year, $150,000 of it as regular salary and $50,000 as deferred compensation. In 20 years, the employee will be able to receive that $50,000 in annual deferred compensation as an income stream or as a lump sum, depending on the plan.

Deferred compensation allows executives to put aside more tax-deferred money for retirement than a qualified retirement plan would allow. Most people will fall into a lower tax bracket once they retire, which means the key employee will get taxed on that money at a lower rate than he or she would have if it was paid as regular salary during the working years. Employers get a tax deduction for deferred compensation when the funds are paid to the employee.

There are two types of deferred compensation:

Deferred savings plans

Employees fund these plans by having a percentage of their salary deducted from their paychecks or by contributing their annual bonuses. You would agree to either provide a fixed return on the contributions or invest the money in mutual funds chosen by the employee. These types of plans are not offered very often, and are typically only offered to employees at the highest levels of responsibility and compensation.

Supplemental executive retirement plans (SERPs)

SERP's are funded by the employer and are more widely used by businesses today to recruit and retain senior management. There are two classes of SERPs:

1. Defined benefit, in which the key employee receives a flat dollar amount or a specific amount defined by a formula at the time of payout. Typically, the amount is determined s a percentage of projected final pay at the time of the executive's retirement.
2. Defined contribution, in which a set amount is contributed by the employer to the executive's account, which then increases with interest until the time of payout. These also may be funded with periodic contributions to the participant's account, such as signing bonuses, retention bonuses, performance awards, or other specific amounts. Participants usually invest and manage their own funds, which accumulate interest tax-deferred. Unlike 401(k) plans, SERPs are not portable.

SERPs are also sometimes funded with a life insurance policy. The key employee takes out a cash-value life insurance policy and names himself or herself as the owner. You then pay the employee's bonuses to the life insurance company as premiums. Later, the executive can borrow against the cash value of the policy, make a withdrawal, or terminate the policy. This type of arrangement is often "vested," meaning the employee is entitled to the funds after working for the company for a set number of years.

Administrating deferred compensation plans is not as complicated or time consuming as plan administration for qualified retirement plans, but there is some financial accounting and reporting that must be performed. You can opt to have your third-party plan administrator take care of these duties.