Most rational people don’t want to know too much about tax law. Take, for example, an individual who participates in a nonqualified deferred compensation (NQDC) plan. For decades, most participants in NQDC plans have been perfectly content to know only the following:
“So if I choose to defer $50,000 into this nonqualified retirement plan, I don’t pay taxes on it now, right? Okay, good. And I won’t pay taxes on that $50,000 or any earnings until I take a distribution years from now, right? Okay, good.”
Prior to 2005, that was essentially all that NQDC participants needed to know about taxes because, back then, the tax laws that applied to NQDC plans were rather straightforward—but no more! Effective in 2005, the government enacted Internal Revenue Code Section 409A. After a transitional period and the publication of several IRS regulations to clarify its details, Section 409A now imposes a complicated new set of tax rules that apply to every aspect of your participation in your NQDC plan.
You don’t need to become a Section 409A expert, but you do need to understand the basics of Section 409A. Doing so will help you understand why and how your plan operates as it does and make you more comfortable with the complexities of 409A. More importantly, you will want to know what pitfalls to avoid, because a violation of Section 409A generally results in the immediate taxation of your deferrals plus a 20% penalty—paid not by your employer, but by you. This article will help you better understand the beast that is Section 409A.
Section 409A: A High-Level View
Section 409A is intended to curb the abuse of NQDC plans by making participants state ahead of time exactly when deferred compensation will be paid in the future and then limiting any flexibility to later modify that scheduled distribution. The five basic rules of Section 409A are as follows:
- Elections to defer: An election to defer compensation generally must be made in the calendar year before the year in which the relevant services are performed, with certain exceptions.
- Permitted distributions: Once deferred, compensation generally may be distributed only upon the following permissible events, sometimes called triggers: a separation from service, a specified date, a change in control, your death, your disability, or an unforeseeable emergency. Section 409A defines each of those terms in exhaustive detail.
- Six-month wait: Specified employees of public companies who become entitled to distributions upon a separation from service must wait six months to receive their distribution.
- No change to time and form of payment: Once an amount is deferred and the distribution event has been selected, the compensation generally cannot be accelerated or deferred further.
- Penalties: Any violation of Section 409A causes the service provider (e.g. the employee) to recognize immediate income tax on deferred amounts, plus a penalty tax of 20% and other related penalties. Again, this tax and penalty apply to you, the participant, and not to the employer.
With those five basic rules in mind, let’s drill down a bit and examine how those rules impact your participation in your NQDC plan.
Rule No. 1: Elections To Defer
The general rule is that an election to defer compensation must be made in the calendar year before the year in which you perform the relevant services. For example, an election to defer salary payable in Year 2 for services in Year 2 must be made no later than December 31 of Year 1. This is why most companies solicit salary deferral elections in the fourth quarter of each year to apply to salary in the following year.
There are several exceptions to that general rule, but two of them come into play most often:
Performance-based compensation. If an element of your compensation is based on objective performance criteria over a performance period of at least 12 months (most commonly, a bonus), then you may make a deferral election up to six months before the end of the performance period. For example, if you participate in a bonus plan that meets the definition of “performance-based compensation” under Section 409A, then the deadline to make your deferral election with respect to your Year 2 bonus (normally payable early in Year 3) is June 30 of Year 2. Note that not all companies offer this later election deadline and instead require you to make bonus deferral elections before the performance year begins (by December 31 of Year 1). In most cases, that is either because the bonus does not meet the strict definition of “performance-based compensation” in Section 409A or simply because the plan sponsor quite reasonably does not want the burden of administering a second deferral enrollment period during the year.
Newly eligible participants. The second most common exception to the general rule is for participants who become eligible to participate in NQDC plans for the first time. A newly eligible participant may make a deferral election within 30 days after becoming eligible to participate as long as the election applies only prospectively. For example, if you are hired on May 1 of Year 1 and are invited to participate in the company’s NQDC plan, you may make a deferral election up to May 30 of Year 1 to apply prospectively to any compensation for services performed after the date when you turn in your deferral election.
Finally, note that, to comply with Section 409A, your election to defer must designate not only the amount to be deferred but also how and when the deferrals (and earnings) will be paid to you in the future. For more on that topic, keep reading.
Rule No. 2: Permitted Distributions
When you make your deferral election, you will need to designate how and when your benefit will be distributed to you. Most plans allow participants some level of discretion to choose the time and form of payment, so long as your election complies with Section 409A.
Choosing how a distribution will be made is the easy part. The choice almost always is between a lump-sum payment and a series of some number of installments. Deciding whena distribution will be made is the more difficult part. Again, Section 409A allows a distribution only upon certain distribution events, or what has become commonly referred to as triggers.The permissible payment triggers include the following:
- a separation from service
- a specified date a change in control
- your death
- your disability
- an unforeseeable emergency
Chances are one or more of these triggers was offered to you on your election form.
As noted earlier, Section 409A defines each of those terms (other than “death”) in exhaustive detail. For example, not all disabilities are severe enough to be a Section 409A disability. Not all M&A transactions qualify as a Section 409A change in control event. And not all terminations of employment meet the criteria of Section 409A separations from service. The reason we have these definitions is that the government is concerned that taxpayers will manipulate circumstances to influence when distributions are made.
Take, for example, a participant who is due to receive a distribution upon her separation from service. If she wants to receive the distribution now, she may be tempted to say to her employer: “Hey, I’ll technically quit tomorrow and then you can hire me back as a consultant next week. That way I get my money.” If she does not want to receive the distribution now, she may say: “Hey, I don’t want to incur a separation from service, so let’s say that I’ll remain technically employed and I’ll just show up one day per month. That way I don’t have to get my money.” To address these concerns, the government issued—no kidding—several pages of regulations defining a “separation from service.” For your purposes, suffice it to say that you’ll want to consult with your plan administrator about whether your future job transition will qualify as a separation from service for purposes of Section 409A.
Rule No. 3: Six-Month Wait
Interestingly, the part of Section 409A that may be best known by the general public is the six-month delay rule, which requires certain distributions to be delayed for six months. This rule is intended to keep top executives at public companies from terminating their employment to accelerate a distribution whenever they see signs that their company may be a credit risk. (Remember that nonqualified plans are generally unfunded promises to pay that are subject to the company’s creditors.)
There is an extent to which the general public has overreacted to the six-month delay rule. Many people mistakenly believe that the six-month delay rule applies universally to all deferred compensation arrangements that are subject to Section 409A. Not true. The six-month delay rule applies only to public companies (defined in detail, no surprise), only to specified employees (again, as defined), and only where the payment trigger that gives rise to the distribution is a separation from service. The six-month delay rule does not apply to private companies, does not apply to nonspecified employees, and, most importantly, does not apply when a distribution is triggered for any reason other than a separation from service, such as death, disability, a change in control event, an unforeseeable emergency, a specified date, or any other permissible distribution event.
Some employers don’t want the burden of monitoring a list of specified employees, so they simply design their NQDC plans to comply automatically. (For example, providing that all separation from service distributions are delayed by six months.) If you believe you may be a specified employee, you will want to review your plan document or ask your plan administrator to determine whether your separation from service distribution will be subject to the six-month delay.
Rule No. 4: No Change To Time And Form Of Payment
Once an amount is deferred and the distribution triggers have been identified, the time and form of payment generally cannot be modified. To understand this rule, it is helpful to remember that Section 409A, at its core, is intended to force taxpayers who want to defer compensation to declare ahead of time exactly when and how that compensation will be paid in the future. Once that declaration is made, Section 409A expects you and your company to live by that commitment.
This rule works in three ways. First, you cannot change how your deferral will be distributed (for example, from installments to a lump sum). Second, you cannot ask your NQDC administrator to accelerate your distribution and make a distribution to you early, unless have an unforeseeable emergency (again, as defined in detail). Third, you cannot ask your NQDC administrator to delay your distribution to let you defer your taxes further.
There is one important exception to the third concept above. Section 409A does allow certain redeferrals that allow you to postpone your distribution, but only if you are willing to wait five years or more. Redeferrals are discussed in detail later in this article, in the part on Section 409A tips and tricks.
Rule No. 5: Section 409A Penalties
Any violation of Section 409A causes the participant to recognize immediate income tax on deferred amounts, plus a penalty tax of 20% and other related penalties. Again, this tax and penalty apply to you, the participant, and not to the employer. If the Section 409A penalties do apply, some companies will choose to indemnify you for a portion of the taxes and penalties.
Alert: Your employer is not under any obligation to indemnify you unless it has contractually agreed otherwise.
The IRS does have a correction program that allows taxpayers to fix certain operational or documentary failures so long as they are rectified within certain timeframes. A correction in a faulty deferral or distribution election usually must be made within the calendar year when the mistake occurred or within the next following calendar year. This correction provision can help you to eliminate, or at least reduce, the potential Section 409A penalty. If there is an error that needs to be corrected with respect to your company’s NQDC plan, you almost invariably will be notified by your employer. If the error is corrected under the IRS guidelines, your employer generally will provide you with a one-page notice that you will need to attach to your tax return. That notice simply tells the IRS that there was a problem and that it was corrected in accordance with the IRS guidance.
Tips And Tricks To Consider
Earlier, we mentioned an exception to the general rule that you cannot defer your NQDC distribution beyond the date or event you elected originally. That exception is called the “redeferral” exception, and it can be a very helpful tool if you use it strategically to control your tax obligations.
As long as your plan allows redeferrals, the redeferral rule generally provides that you can elect to redefer a distribution so long as (1) you make an election to redefer at least 12 months before the scheduled distribution or the occurrence of the distribution trigger and (2) you defer the distribution for at least five years beyond the original distribution date or trigger.
Example: You are due to receive a lump-sum distribution on your 65th birthday (January 15 of Year 5). If you want to delay that distribution, you will need to make a redeferral election before January 15 of Year 4, and you will need to defer payment to a date no earlier than January 15 of Year 10. As another example, assume you are due to receive a lump-sum distribution upon your “separation from service.” If you want to delay that distribution, you will need to defer your distribution for at least five years after you separate from service, and you will need to make that election at least 12 months before you actually separate from service. If you make the redeferral election and then separate from service less than 12 months later, your redeferral election is void, and you will receive your distribution at your separation from service.
Two Strategies Using Redeferral
Now that you understand the redeferral rule, let’s examine two strategies you may want to consider. This article assumes that the terms of your NQDC plan allow you to use these strategies. Not all plans do, so you should consult the terms of your plan before you get too excited!
Strategy No. 1: Laddering Your Distrsibution
If your plan allows you to designate distributions in multiple years, or if your plan lets you choose to receive installments over a number of years that you designate, then the “laddering” technique may work for you. One way to think of this technique is that you can push a distribution that is in the front of the line to the end of the line.
Example: You elect to receive your distributions, 20% per year, in Years 16, 17, 18, 19, and 20. If, in Year 14, you can foresee that you won’t want to be taxed on the distribution of 20% of your account in the Year 16, you can make a deferral election in Year 14 (i.e. at least 12 months in advance) to move the Year 16 distribution to Year 21. Similarly, if in Year 15 you foresee that you will not want to be taxed on the distribution of 20% of your account in Year 17, you can make an election to push that distribution to Year 22. And so on…
Strategy No. 2: Lucky Number 13
Thirteen months, that is. The idea here is to elect that any distribution will occur 13 months after a distribution trigger—for example, 13 months after a separation from service, 13 months after death, etc. When the trigger occurs, that election allows you (or your beneficiaries in the case of your death) to have another 30 days to make a redeferral election to postpone the distribution for an additional five years. Again, this assumes that the terms of your plan allow this strategy.
Example: On your election form, you elect to receive your distribution 13 months after a change in control, your separation from service, or your death, whichever may occur first. If you die on May 1 of Year 8, the distribution will be scheduled to occur on June 1 of Year 9. That gives your beneficiary up to 30 days to make a redeferral election, if she chooses, to receive the money after June 1 of Year 14.
Conclusion: Know At Least The Basics
If you’re thinking that Section 409A seems way more complicated than it needs to be, this author agrees with you. But because the Section 409A taxes and penalties apply to you, the participant, it is smart for you to understand the basics. Who knows? You may one day want to become a real expert on Section 409A. Good luck!
This article appeared on myNQDC.com, a respected, independent source of education, content, and tools on nonqualified deferred compensation for participants and professionals.