409A plans are a remarkable financial instrument for high-income earners looking to defer compensation and optimize their retirement savings. These plans are a type of non-qualified deferred compensation plan for earnings that employees have accrued but not yet received from their employers. Since the ownership of this compensation—whether monetary or otherwise—has not transitioned to the employee, it is not yet considered taxable income.
According to the Internal Revenue Service code, 409A governs for-profit NQDCs, while other plans for employees of non-profits or government entities are regulated under IRS Sections 457(b) or 457(f).
Key Takeaways:
- A non-qualified deferred compensation (NQDC) plan such as a 409A plan refers to earnings that an employee has gained but not yet received from their employer.
- These plans were developed as a response to limits on employee contributions to government-sponsored retirement plans.
- IRC Section 409A oversees for-profit NQDC plans, while plans under nonprofit or governmental sponsorship fall under IRC Sections 457(b) or 457(f).
Understanding 409A Plans
NQDCs, also known as 409A plans, reflect the tax code section in which they are defined. They were innovated to address the caps on employee contributions to government-regulated retirement savings plans. For high-income earners, who couldn’t contribute proportionally similar amounts to their tax-deferred retirement savings, NQDCs provide a way to delay the actual receipt of earnings thereby postponing taxes and enjoying tax-deferred investment growth.
For instance, consider Sarah, an executive earning $750,000 annually. Her maximum 401(k) contribution of $22,500 (for tax year 2023) would constitute only 3% of her yearly income, presenting challenges to saving sufficiently for retirement within her 401(k) plan. By deferring a portion of her compensation into an NQDC, Sarah can defer taxation on her earnings, permitting her to save a larger portion of her income than allowed under her 401(k) plan. Typically, NQDC savings are postponed for five or ten years, or until retirement.
Just as 401(k) investment options vary by employer, so do the rates and types of investments in NQDCs, providing a flexible way to meet savings goals outside traditional retirement plans.
Exploring Limitations of NQDCs
Though highly beneficial for affluent earners who’ve exhausted other savings avenues, NQDC plans carry inherent risks. These plans aren’t fortified by the Employee Retirement Income Security Act (ERISA), thus if the company fails or declares bankruptcy, the employee’s assets would be vulnerable to claims by creditors. Additionally, funds from an NQDC plan cannot be transferred into IRA or other retirement accounts after withdrawal. The deferred income might also face higher tax rates upon distribution compared to when it was initially earned.
Key Aspects of Taxation and Reporting:
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When Do I Pay Tax on an NQDC Plan?
Tax on compensation deferred into an NQDC plan is payable upon receipt, typically post-retirement, unless an alternate qualifying event occurs such as a disability.
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Deferred Compensation Taxation
Deferred compensation incurs taxes upon distribution based on the tax bracket applicable at that time, which might differ from the bracket when the income was originally earned.
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Reporting Distributions from a 409A Plan
These distributions represent previously earned income and get reported by the employer on a W-2 or potentially on form 1099-MISC.
Conclusion: Weighing the Pros and Cons
409A plans offer an advantageous pathway for high earners to enhance their retirement savings beyond the caps imposed by traditional retirement accounts like 401(k)s. Despite the downsides, including lack of protections against corporate bankruptcy and inability to roll assets into other retirement accounts, these plans significantly aid employees by providing avenues to delay and optimize tax liability, ultimately supporting more effective long-term savings strategies.
Related Terms: 401(k) plans, IRC Section 457, Employee Retirement Income Security Act (ERISA), Individual Retirement Account (IRA).
References
- Internal Revenue Service. “Publication 5528, Nonqualified Deferred Compensation Audit Technique Guide”, Page 1.
- Internal Revenue Service. “IRC 457(b) Deferred Compensation Plans”.
- Internal Revenue Service. “Publication 5528, Nonqualified Deferred Compensation Audit Technique Guide”, Page 3.
- Cornell University, Legal Information Institute. “26 U.S. Code § 409A - Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans”.
- Internal Revenue Service. “401(k) limit increases to $22,500 for 2023, IRA limit rises to $6,500”.
- Internal Revenue Service. “Publication 5528, Nonqualified Deferred Compensation Audit Technique Guide”, Page 13.
