A:

A 409A nonqualified deferred compensation plan defers a portion of an employee's compensation to a future date. The compensation amount is considered held back while the employee is working for a company, and it is paid out when the employee separates from the employer, becomes disabled, dies or experiences a similar event. The reason the plan is considered "nonqualified" is the compensation is still subject to tax.

Internal Revenue Code Section 409A

Internal Revenue Code Section 409A (IRC Section 409A) is a tax code that applies to all compensation an employee earns in one year but is paid in a future year. The code is broad enough to include any compensation plan or agreement between an employer and an employee. Compensation plans are deemed by IRC Section 409A to be either nonqualified deferred compensation plans or qualified deferred compensation plans.

Qualified deferred compensation plans are defined as deferrals to qualified plans such as 401(k) plans, 403(b) plans or 457(b) plans. Qualified plans are not subject to taxes under IRC Section 409A.

Nonqualified deferred compensation plans refer to supplemental executive retirement plans (SERPs), voluntary deferral plans, wraparound 401(k) plans, excess benefit plans and equity arrangements, bonus plans and severance pay plans. Under the tax code, if a nonqualified deferred compensation plan meets the requirements of section 409A, the plan benefits are not subject to federal income tax until the compensation is paid to the participant. However, if a nonqualified deferred compensation plan does not meet the requirements, plan benefits are subject to tax and penalties as soon as the benefits are vested.

Example of a Nonqualified Compensation Plan Under IRC Section 409A

Teachers' salaries are nonqualified compensation plans that meet the requirements of IRC Section 409A. If a teacher earns $54,000 a year and works from Aug. 1, 2016 to May 31, 2017, she earns $5,400 a month. If the teacher is paid for only the months she worked, she is paid $5,400 a month for a 10-month period. If, however, she is paid over a 12-month period, she earns $4,500 a month.

In the example dates above, with a 10-month salary, the teacher earns $27,000 in 2016 and $27,000 in 2017. With a 12-month salary, she earns $22,500 in 2016 and $31,500 in 2017. Based on the hours actually worked, if she is paid a 12-month salary, $4,500 worth of work conducted in 2016 is paid out in 2016. Under IRC Section 409A, the $4,500 from 2016 is considered nonqualifying deferred compensation that meets the requirements of the code.

Congress introduced IRC Section 409A in 2004 as a way to restrict deferred income into the future. Prior to its implementation, employees were electing to be paid later to defer taxes to a later period.

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