Salary Deferral Agreement

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on May 23, 2023

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What Is a Salary Deferral Agreement?

A salary deferral agreement is a legally binding contract between an employee and their employer. It outlines the terms by which a portion of the employee's salary is withheld and invested on their behalf.

This deferred compensation is typically allocated to retirement savings plans, stock options, or other investment vehicles.

Salary deferral agreements offer employees an opportunity to save and invest for their future while taking advantage of various tax benefits.

Employers may also benefit from these agreements by offering competitive benefits packages that help attract and retain top talent.

Salary deferral agreements are commonly used in conjunction with employer-sponsored retirement plans, such as 401(k)s, 403(b)s, and deferred compensation plans.

They may also be used in situations where employees receive stock options or other forms of equity compensation.

Components of a Salary Deferral Agreement

There are several components to a salary deferral agreement.

Parties Involved

Employee

The employee is the individual who agrees to defer a portion of their salary for investment purposes.

Employer

The employer is the organization responsible for withholding and investing the deferred compensation according to the terms of the agreement.

Deferral Amount and Frequency

Fixed Amount

The salary deferral agreement may specify a fixed dollar amount to be withheld from each paycheck.

Percentage of Salary

Alternatively, the agreement may stipulate that a percentage of the employee's salary is deferred.

Deferral Period

Short-Term

Short-term deferral periods typically last for a few years and may be used for specific financial goals, such as saving for a down payment on a home.

Long-Term

Long-term deferral periods often span decades and are generally geared toward retirement savings.

Investment Options

Employer-Sponsored Retirement Plans

Deferred funds may be invested in an employer-sponsored retirement plan, such as a 401(k) or 403(b).

Stock Options

Some salary deferral agreements involve allocating deferred compensation to stock options or other equity-based incentives.

Deferred Compensation Plans

Non-qualified deferred compensation (NQDC) plans are another option for investing deferred salary, typically used by highly compensated employees.

Advantages of Salary Deferral Agreements

There are several advantages to salary deferral agreements.

Tax Benefits

Pre-Tax Contributions

Salary deferrals are often made on a pre-tax basis, reducing the employee's taxable income and lowering their current tax liability.

Tax-Deferred Growth

Investments in deferred compensation plans typically grow tax-deferred, allowing for potentially higher returns over time.

Retirement Savings

Forced Savings Mechanism

Salary deferral agreements create a structured savings plan, ensuring that employees consistently set aside funds for their future.

Employer Matching Contributions

Many employers offer matching contributions for deferred compensation, effectively increasing the employee's overall compensation.

Financial Planning

Budgeting and Goal Setting

Salary deferral agreements help employees develop disciplined saving habits and work towards their long-term financial goals.

Long-Term Financial Security

By consistently saving and investing through salary deferral, employees can work towards achieving financial security in retirement.

Potential Risks and Limitations

Salary deferral agreements also come with several risks and limitations.

Liquidity Concerns

Limited Access to Deferred Funds

Salary deferral agreements may limit an employee's access to their deferred funds, potentially creating liquidity issues in case of financial emergencies.

Penalties for Early Withdrawal

Withdrawing funds from deferred compensation plans before a specified age or event may result in taxes and penalties.

Investment Risk

Market Volatility

Investments made through salary deferral agreements are subject to market risk, and the value of the investments may fluctuate over time.

Employer Financial Health

In some cases, deferred compensation may be tied to the financial health of the employer, exposing the employee to company-specific risks.

Regulatory Changes

Tax Law Revisions

Changes in tax laws may impact the tax benefits associated with salary deferral agreements, potentially affecting an employee's financial planning.

Changes in Retirement Plan Rules

Regulatory changes may impact retirement plan rules, affecting the structure and benefits of salary deferral agreements.

Advantages and Disadvantages of Salary Deferral Agreements

Legal and Regulatory Considerations

Salary Deferral agreements must follow several legal and regulatory considerations.

ERISA Guidelines

The Employee Retirement Income Security Act (ERISA) governs many aspects of employer-sponsored retirement plans and may influence the terms of salary deferral agreements.

IRS Regulations

The Internal Revenue Service (IRS) sets rules and regulations for tax-qualified retirement plans and non-qualified deferred compensation plans, which must be adhered to in salary deferral agreements.

State and Local Laws

State and local laws may also influence the terms and conditions of salary deferral agreements, particularly in the case of public sector employees.

Negotiating a Salary Deferral Agreement

There are several points that must be considered when negotiating a salary deferral agreement.

Employee Considerations

Financial Goals and Risk Tolerance

Employees should carefully consider their financial goals and risk tolerance when negotiating a salary deferral agreement, ensuring that the terms align with their long-term objectives.

Assessing Employer Stability and Investment Options

Before entering into a salary deferral agreement, employees should evaluate their employer's financial stability and the available investment options to minimize potential risks.

Employer Considerations

Plan Administration and Compliance

Employers must ensure they can effectively administer the salary deferral agreement and comply with all relevant regulations.

Employee Retention and Benefits

Offering competitive salary deferral options can help employers attract and retain top talent, contributing to the organization's overall success.

Drafting and Reviewing the Agreement

Both parties should work together to draft and review the salary deferral agreement, ensuring that it accurately reflects their agreed-upon terms and conditions.

Conclusion

Salary deferral agreements play a crucial role in helping employees save for their future while providing tax advantages. They also contribute to effective financial planning and long-term financial security.

Both employees and employers must weigh the benefits and risks of salary deferral agreements, taking into consideration factors such as liquidity, investment risks, and regulatory changes.

To get the most out of your agreement and ensure that it aligns with your financial goals, it is recommended to consult with a retirement planning professional.

They can provide personalized guidance and help you navigate the legal and regulatory considerations involved.

Salary Deferral Agreement FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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