Deferred Compensation Plans for Retaining Valued 1099 Independent Contractors

Representing 38% of America’s workforce, independent contractors, consultants, and freelance workers fill critical needs in many industries, typically with little or no access to retirement plans or other employee benefits.[1]

Research by Upwork shows that 64 million Americans were self-employed as of December 2023. As the number of independent workers continues to rise annually, employers are challenged to find ways to retain and reward these integral members of their team.

Independent Contractors: Not Your Average Gig Worker

Unlike W-2 employees, independent contractors contract their services directly to individuals or companies and report their earnings on either Form 1099-NEC (Nonemployee Compensation) or 1099-MISC (Miscellaneous Income) rather than a W-2 tax form.

While contingent and gig workers, freelancers, consultants and independent contractors are all classified as 1099 employees for tax purposes, there are distinct differences between an independent contractor or consultant providing an employer with valued subject matter expertise or unique skills and a gig worker, who may support multiple employers almost always on a short-term or “gig-based” timeline.

Physicians, researchers, and other highly trained professionals in healthcare, finance, the arts, entertainment and subject matter experts (SMEs) with specialized knowledge may be independent contractors. As work experience increases, so can a worker’s likelihood of becoming a contract employee. Among all workers ages 55 and over, 11.5 percent are independent contractors in their sole or primary occupation, compared to just 6.9 percent among workers aged 25 to 54.

The Appeal of Deferred Compensation for Independent Contractors

Generally, independent contractors are self-employed individuals without access to traditional employer-sponsored retirement plans, such as a 401(k) plan. While retaining desirable aspects of job independence, independent contractors also retain full responsibility for paying or remitting their income, social security and Medicare taxes.

Independent contractors are, however, generally exempt from Internal Revenue Code (IRC) Section 409A. This distinction positions employers to offer independent contractors a nonqualified deferred compensation (NQDC) arrangement that would not constitute a top hat plan and not be subject to any ERISA[2] requirements because the contractor is not an employee of the company.
The option to defer compensation and income taxes on that compensation to a future time can appeal to an independent contractor. Because they are self-employed, contractors have limited options to save for retirement through investments in tax-friendly vehicles, such as an employer sponsored 401(k) plan.

Lack of access to employer-sponsored retirement plans can limit independent contractors to saving and investing for retirement through Individual Retirement Accounts (IRAs), Simplified Employee Pensions (SEPs), or Solo-401(k) Plans.). These savings plans all include a cap on how much a worker can defer annually.

Offering independent contractors access to an NQDC plan and the opportunity to defer receipt of the income and its tax obligations to a future date can help an employer secure the loyalty of a valued contractor. A deferred compensation plan can decrease the risk of losing a contractor to a competitor while providing a way to reward the contractor’s contribution to the company’s success.

Deferred Compensation for Independent Contractors: Simpler for Plan Sponsor and Plan Participant

As the plan sponsor, a company rarely has income or employment tax withholding obligations when offering deferred compensation to independent contractors. Employers that sponsor a deferred compensation plan for independent contractors are not required to collect Federal Insurance Contributions Act taxes (FICA) as they must do in deferred compensation plans for employees.

Although independent contractors are not subject to FICA and the Federal Unemployment Tax Act (FUTA), they are subject to the Self-Employed Contributions Act (SECA). While W2 employees must follow the special timing rule that requires them to pay FICA taxes immediately upon the vesting of deferred compensation, even if the contractor will not receive the compensation until later years, SECA does not have this requirement. Independent contractors find this aspect of an NQDC favorable because SECA taxes are applied only at the time the compensation is actually paid to them, even if such compensation is deferred years into the future.

Important Considerations When Working with a Consultant

Rarely should a nonqualified plan for an independent contractor be designed to trigger payment upon the contractor’s separation of service from the company. Instead, the plan should be structured to trigger payment on a specified date.

Class-year distribution elections provide independent contractors maximum flexibility in distribution management, including the ability to:

• Make a unique election each year.
• Select a different payment option each year.
• Ability to make payment modifications to an existing account, subject to a five-year delay.

Developing a deferred compensation plan for use with independent contractors or other 1099 employees calls for executive benefits consultants who are well-versed in the strategic design of class year plans, enabling options for plan participants to pivot on their payout schedules to best accommodate their savings and retirement goals. Download our deep-dive report, Deferred Compensation Plans for Rewarding and Retaining Valued 1099 Independent Contractors.

To learn about other executive benefits strategies, we invite you to read: Reasons to Reevaluate Your Rabbi Trust, How the 2025 Retirement Plan Limits Impact Highly Compensated Employees, and How Changes to Dodd-Frank Clawback Policies May Affect Your NQDC Plan.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein. The examples shown are for illustrative purposes only. The material in this report may contain financial illustrations, which may reflect hypothetical dividends, interest, rates of return, and/or expense and mortality assumptions, none of which are guaranteed.

Sam Robert is affiliated with Valmark Securities, Inc. Securities offered through Valmark Securities, Inc. member FINRA, SIPC. Investment Advisory Services offered through Valmark Advisers, Inc. a SEC Registered Investment Advisor. Registration as an Investment Adviser does not imply any certain level of skill or training. 130 Springside Drive, Suite 300, Akron, OH 44333. 800-765-5201. OneDigital is a separate entity from Valmark Securities, Inc. and Valmark Advisers, Inc. Valmark Securities, Inc. and Valmark Advisers, Inc. are independent of and unaffiliated with ODIA. California License #0I01065. Check the background of this investment professional on FINRA’s BrokerCheck.

Drew Biggs is affiliated with Valmark Securities, Inc. Securities offered through Valmark Securities, Inc. member FINRA, SIPC. 130 Springside Drive, Suite 300, Akron, OH 44333. 800-765-5201. OneDigital is a separate entity from Valmark Securities, Inc. Valmark Securities, Inc. is independent of and unaffiliated with ODIA. Check the background of this investment professional on FINRA’s BrokerCheck.

Some of the Financial Professionals associated with OneDigital are registered representatives of and offer securities through Valmark Securities, Inc. a registered broker-dealer, Member FINRA / SIPC. Additionally, some OneDigital Financial Professionals are also Investment Adviser Representatives and offer advisory services through Valmark Advisers, Inc., an SEC registered investment advisor. To help public members determine the specific registrations associated with our Financial Professionals, we recommend reviewing the Broker Check Link that provides insight to the securities registration and company affiliation of our Financial Professionals. Please note that while the individual Financial Professionals can be associated with multiple financial services organizations, the products and services of those independently owned and operated entities can be separate and segregate. OneDigital is a separate entity from Valmark Securities, Inc. and Valmark Advisers, Inc.

Sources:
[1]Upwork Study Finds 64 Million Americans Freelanced in 2023, Adding $1.27 Trillion to U.S. Economy
[2]Employee Retirement Income Security Act of 1974