Section 162 bonus plan vs. deferred comp — pros and cons

Two ways to reward a key executive

Businesses that want to reward and retain top people beyond a salary often weigh two tools: a Section 162 executive bonus plan and non-qualified deferred compensation. They aim at similar goals but work in almost opposite ways, and the right choice depends on whether you value simplicity and ownership or control and tax deferral.

Section 162 executive bonus plan

The employer pays the executive a bonus, which the executive uses to fund a life insurance policy they personally own. The appeal is its simplicity and clarity:

• Pros: easy to set up and explain; the bonus is generally a deductible compensation expense for the employer; the executive owns the policy and cash value immediately and can take it if they leave; no complex plan document.
• Cons: the bonus is taxable to the executive now; the employer gets little retention leverage because the benefit is the executive's from day one.

Non-qualified deferred compensation

The employer promises to pay the executive compensation in a future year — at retirement, or after a vesting period. The executive defers the income and its tax until then.

• Pros: the executive postpones income and tax, potentially to a lower-rate year; the employer keeps control and can attach vesting and forfeiture conditions that encourage the executive to stay.
• Cons: the promised money is generally an unsecured obligation of the employer — if the company fails, creditors can reach it, and the executive may be left with nothing; strict tax timing rules apply, and the employer's deduction is deferred until it pays. The benefit can be forfeited if the executive leaves too soon.

How to choose

If the priority is a clean, portable benefit the executive can count on regardless of the company's fortunes, the 162 bonus plan is hard to beat. If the priority is deferring taxes and building in "golden handcuffs" to keep the executive on board, deferred comp does more — as long as everyone understands the forfeiture and creditor risk. Some employers use both, for different people or different goals. Because taxes and plan design are central, involve your CPA and an attorney before implementing either.

Your next step

Decide what you're optimizing for — simplicity and certainty, or deferral and retention — and let that anchor the conversation. The tax and legal details follow from that choice, not the other way around.