Generally, both plan formats defer compensation because the employee has elected to defer taking cash in hand to obtain some additional benefit, such as deferring taxes on the money or investing on a tax deferred basis. Under more specific legal definitions, there is a distinction between how these different plans work.
401k plans are governed by the Employee Retirement Income Security Act (ERISA). They must be offered to all employees that meet the plan rules and those rules must conform to ERISA guidelines. In a 401k plan you have earned the wages or salary and you been paid the money but rather than taking the income in hand as part of your paycheck you have deferred taking the money in-hand by putting it in your 401k. Although you do not pay income tax on the income deferred to your 401k plan until it is paid out of the 401k in a taxable event (such as a withdrawal), you do pay FICA on it up front. According to the IRS, you have “received” the income, even though you chose to defer it to the 401k plan and make it subject to the plan’s rules, because your employer has paid it out to you and it is under your control (subject to the plan rules). Your employer cannot legally take the money back (unless there was an erroneous overpayment to you or your 401k account). For more details on how a 401k plan works, click here.
Deferred compensation plans are governed by Internal Revenue Code section 409A. Deferred compensation plans can be offered to select employees or classes of employees but not offered to others. A deferred compensation plan looks a lot like a 401k plan because you make deferrals, invest elections and pay taxes when it is paid out. However, a very important distinction is how the compensation is deferred. In a deferred compensation plan the employee (or director) makes an election to defer compensation and there is no receipt of the compensation. The employer never pays it out of its assets. (They may segregate the funds for the plan to a trust but they are generally not required to.) The employee does not “receive” the funds. The employee pays no taxes at the time the compensation could have been paid. Instead, the employee will pay income tax plus FICA at the time of distribution. The employee is usually locked in to distributions based on prior elections given to the company.
A critical point about deferred compensation plans is that the employee does not “receive” the funds. Unlike a 401k where the contributions are put in a trust and protected from the employer’s (and the employee’s) creditors, a deferred compensation plan (generally) offers no such protections. Instead, the employee only has a claim under the plan for the deferred compensation. The employee takes the risk that the employer will be solvent and able to pay the deferred compensation at the time distributions are due. If the employer is not solvent, the employee will have to sue to recover or if the employer is in bankruptcy, line up as a creditor against the employer.
So why would an employee want to participate in a 409A deferred compensation plan if there is a risk of losing the income? There are many reasons why an employer may offer a plan and why an employee may want to participate. One key benefit for the employee is that the income limits and deferral limits in 401k plans do not apply to deferred compensation plans. So an employee may be able to defer as much as 100% of her income in a given tax year and pay no taxes. The employee can defer enough income, if highly compensated, to fit in a lower tax rate and spread that income out across retirement and possibly lower the tax rate in retirement. The deferrals may be part of an overall financial plan or retirement plan. Additionally, the employer may offer a higher return or reduced risk of return in the deferred compensation plan over the 401k investment options. The decision to participate in the deferred compensation plan is highly individualized and should be carefully considered with legal and/or financial counsel.