What is a Salary Deferral Agreement?
A salary deferral agreement is an agreement in place between a C corporation and its employee directing the C corporation to withhold a portion of the employee’s salary and to pay it to the employee’s physician or other provider. Unlike a wage assignment or garnishment, a salary deferral agreement is voluntary. "Salary" in this context includes wages, commissions, bonuses and other compensation .
C corporations in Massachusetts find that salary deferral agreements are an effective way to help employees pay for their medical expenses. Unlike wage assignments and garnishments, they are completely voluntary. Because they are agreements, not court orders, they can be created in several ways, including:
No matter what form the agreement takes, a salary deferral agreement is a relatively simple and inexpensive way to help employees pay for health care services with pre-tax dollars.
Advantages of Salary Deferral for Employees
A salary deferral agreement, also known as a salary deferral arrangement, is a contract between the employer and the employees under which employees agree to forgo a portion of their salaries or wages in exchange for contributions by the employer into tax-advantaged plans that include pension plans, deferred compensation plans, 403(b) annuities, cafeteria plans and qualified plans such as 401(k) plans.
There can be significant advantages for employees in entering into a salary deferral agreement. First, it is a tax-saving device. Federal income tax is deferred on salary that is "deferred." Rather than having a dollar of salary taxed at 35% or 39.6%, fifty cents or more can be set aside to invest in a tax-free or tax-deferred vehicle that is expected to earn a return.
Second, the money that is put into the tax-advantaged savings account is money that the employee can earmark for long-term savings, including for retirement, college or home ownership, as described below.
Third, salary deferral generally is not included in the employee’s income until it is actually paid or made available to the employee. This is often not the case for other benefits that may be available to the employee, such as health care coverage, which is included in the employee’s income.
Fourth, when contributed to the right arrangement, the income earned on the deferred salary also is tax-free or tax-deferred until it is withdrawn from the account.
Many people value tax-free or tax-deferred savings vehicles because it allows them to save and invest potential income taxes. Tax-free savings vehicles include 529 plans, Roth IRAs, Coverdell education savings accounts, and Health Savings Accounts. While generally not tax-free, tax-deferred savings vehicles include traditional IRAs, deferred compensation arrangements (including 457(b) plans and Section 457 agreements), qualified pension plans, 401(k) plans and simplified employee pension plans.
Employer Benefits of Having a Salary Deferral Plan
Employers have every incentive to offer a salary deferral option. Training new employees is costly for employers. In addition to going out and hiring the right talent the employer must then spend time training those new employees in their new job responsibilities. The costs can be particularly steep if the new employee leaves employment within a short time of their hiring. One of the benefits to the employer of offering the option to defer salary is that it can be an attractive tool in recruitment. Not only does deferring portions of such employees’ compensation provide them with a tax benefit as indicated above, but such deferral option enhances the value to the employee if the employee will be in a higher tax bracket in retirement.
An additional key advantage to the employer with a salary deferral option is providing its employees a direct way to boost their retirement savings. In this way, the employer is helping employees prepare for retirement. This is beneficial to the employer because employees are more productive when they do not have to worry about their long term plans. When an employee can go to work confident that they are on a path to a secure retirement, both the employee and the employer win.
Another indirect benefit to the employer from adopting a salary deferral agreement media is that it may also provide the employer with future tax benefits. Such benefit could arise out of allowing for future "credits" for the employer when it comes to state income taxes for those deferring employees. This means the employer can attract and retain key employees by assisting them in deferring their state income taxes to years when they will be at a lower state income tax rate than they currently are. This is particularly helpful for high income/medium term working employees.
Legal Aspects and Regulations
Salary deferral agreements must comply with Internal Revenue Code (IRC) Section 401(k) and Department of Labor (DOL) rules and regulations. DOL regulations set forth notice requirements to employees regarding the contributions and investment of their salary deferrals. The obligations include, generally, distributing to all employees (not just eligible employees) a copy of the plan’s summary in the form of a Summary Plan Description, or "SPD," at least once every five years, and to furnish a copy of a summary of any material modifications to the SPD within 210 days after the close of the plan year, if they have not been issued in a revised summary. There are also requirements (sometimes more broadly known as "wrap requirements") for an annual summary and disclosures concerning the plan’s annual report (e.g., the "Summary Annual Report" or "SAR"), as applicable.
In addition, in order to comply with IRC Section 410(b), plans generally must offer participation to a significant percentage of their employees. If only a small percentage of employees can participate in the plan, the plan may be considered discriminatory.
Failure to comply with applicable rules and regulations may result in penalties against the plan (usually in the form of excise taxes based on the amount of contributions involved and the period of time those contributions are outstanding) or disqualification of the plan (including potential taxation of all amounts deferred into the plan).
How to Set Up a Salary Deferral Agreement
To implement a salary deferral agreement, the process involves several key steps. An employer must first draft the salary deferral agreement, which should comply with relevant laws and regulations governing deferred compensation plans. It is then essential for both the employer and employee to review and sign the agreement to give mutual consent to the terms of the deferral.
After the agreement has been executed, the employer is responsible for maintaining accurate records of the amounts deferred, dates of deferral , and the applicable dates of payment. This record keeping is crucial for compliance with any reporting requirements that may arise under the Internal Revenue Code (IRC) or other regulations.
It is also advisable for employers to seek legal counsel or financial advice when implementing salary deferral agreements to ensure compliance with applicable federal and state tax laws and other regulatory requirements, which may otherwise affect the validity of the agreement. Cross-border consideration should be given to any salary deferral agreement where a foreign employee is involved, or where an expatriate employee is in a foreign country and in respect of foreign employees of a company operating in several jurisdictions.
Downsides and Risks Involved
Employees and employers alike should be aware of the potential risks and drawbacks when entering into an agreement that stipulates future salary payments. If not carefully considered, cash flow problems can arise. This may occur if an employer does not have adequate cash flow to pay the deferred sums at the time they are due. While it is a common practice to take into account the timing of future payments, it could be difficult for an employer to manage office expenses, new hires or compensation of current employees if a large sum is owed to an exiting employee.
There are also risks to the employee. For example, if a new peer group has been established that does not employ the same deferral compensation program, then the employee may not receive an additional 12 to 18 months of salary. Moreover, if the company is sold, the parties may have different ideas about how to implement the salary deferral program. Also, as with any other form of deferred compensation, an unfavorable change in the law could be implemented by Congress, leaving the deferring employee with lower payments than initially planned.
Case Studies and Examples
A mid-sized operations management company in Texas had several key employees looking to save for retirement but with the high salaries of industry, they far surpassed the limits of the company’s 401(k) plan. Instead of simply increasing their 401(k) contributions, the company entered into salary deferral agreements with the employees. With the company paying its executives $300,000 a year, the executives were able to effectively reduce their taxable income due to the income being deferred into other acceptable investment vehicles including an annuity product. Additionally, the company was able to offer a solution to boost employee retention because the executives’ accounts continued increasing in value while the employee was at the company , and continued increasing for several years after termination.
A large real estate investment trust (REIT) based in the Pacific Northwest had three high-earning executives that wanted to set aside part of their salary into a deferred compensation plan. The REIT had increased its corporate earnings for the past several years and exhibited a sustained ability to maintain, despite the market. The employees instead elected to defer into a combination of cash and equity investments that outperformed the S&P and large-cap stocks annually over a multi-year period. Meanwhile, the REIT enjoyed a tax deduction for the deferred compensation. Because the REIT compensation was significant, it was able to avoid Section 409A and allowed the employees to pay taxes when it was beneficial for them (e.g., lower income in the future).