Definition
A 409A plan is a type of non-qualified deferred compensation plan that allows employees to earn wages, bonuses, or other types of compensation in one year but receive them in a future year, potentially resulting in tax advantages. Such plans are named after Section 409A of the U.S. Internal Revenue Code.
Key Features
- Deferral of Compensation: Employees can defer income to a future date, which can be beneficial in terms of tax planning.
- Non-Qualified Plan: Unlike qualified plans (e.g., 401(k) plans), 409A plans do not have to meet ERISA requirements.
- Flexibility: These plans offer more flexibility in design and implementation compared to qualified retirement plans.
- Risk: Deferred compensation is subject to the risk of the employer’s insolvency.
Tax Implications
Tax Deferral
Deferred compensation under a 409A plan is not included in an employee’s taxable income in the year it is earned. Instead, it becomes taxable when it is actually received.
Penalties for Non-Compliance
Non-compliance with Section 409A can result in severe tax penalties, including:
- Immediate inclusion of deferred amounts in gross income.
- Additional 20% tax on the deferred compensation.
- Potential interest penalties.
Limitations and Considerations
Timing Rules
Strict rules govern the timing of deferrals and distributions under Section 409A. Elections to defer must generally be made the year prior to when the services are provided.
Distributions
Distributions can only be made under specific conditions, such as separation from service, a fixed date, or unforeseen emergencies.
Risk of Forfeiture
Deferred compensation can be forfeited if certain conditions are not met or if the employer becomes insolvent.
Types of 409A Plans
Salary Reduction Arrangements
Employees elect to defer a portion of their salary into a 409A plan.
Supplemental Executive Retirement Plans (SERPs)
These are designed to supplement the retirement income of executives beyond the limits of qualified retirement plans.
Long-Term Incentive Plans (LTIP)
Plans that provide deferred compensation based on long-term performance metrics.
Examples
Scenario
An executive elects to defer a $50,000 bonus to be received in five years. Under a compliant 409A plan, the bonus is not taxed until the year it is received.
Non-Compliance Example
If the executive receives the deferred bonus earlier than allowed, they may face immediate inclusion of the amount in income, plus the 20% additional tax and possible interest penalties.
Historical Context
Introduction
Section 409A of the Internal Revenue Code was enacted as part of the American Jobs Creation Act of 2004 to address perceived abuses in deferred compensation arrangements.
Evolution
Regulations have been developed and refined over the years to provide clearer guidance on compliance and enforcement.
Applicability
High Earners
409A plans are particularly attractive to high earners who seek to defer income and associated taxes to future tax years.
Employers
Employers can use 409A plans to attract and retain top talent by offering customized compensation packages.
Comparisons
401(k) Plans vs. 409A Plans
- 401(k) Plans: Tax-advantaged, subject to contribution limits, and follow ERISA guidelines.
- 409A Plans: Non-qualified, no specific contribution limits, and not subject to ERISA.
SERPs vs. 409A Plans
- SERPs: Generally supplement retirement income above qualified plan limits.
- 409A Plans: Broader, covering various forms of deferred compensation.
Related Terms
- Non-Qualified Deferred Compensation (NQDC): Compensation that is earned in one period but paid in a future period, subject to different tax treatments than qualified plans.
- ERISA: The Employee Retirement Income Security Act of 1974, which sets standards for most voluntary retirement and health plans.
- Tax Deferral: The postponement of taxes to be paid on income, typically to a later tax year.
FAQs
What is the purpose of a 409A plan?
Who benefits most from 409A plans?
What happens if a 409A plan is non-compliant?
References
- U.S. Internal Revenue Code, Section 409A
- American Jobs Creation Act of 2004
- IRS Regulations on Non-Qualified Deferred Compensation Plans
Summary
409A plans provide a valuable tool for deferring compensation and managing tax liabilities for high earners. While offering significant flexibility and benefits, they also come with stringent compliance requirements and potential risks. Understanding these plans’ mechanics and implications is essential for both employees and employers considering their use.
