Section 409a and Deferred Compensation

During tax season and even after, it is important to understand all aspects of how the government will evaluate your personal financial situation. In this article, we explore what Section 409a and Deferred Compensation refer to, and how they apply to your life.

Section 409a: Definition

Section 409a outlines the treatment of a “nonqualified deferred compensation.” In layman terms, this means that any money earned in one year but that is not paid until a future year. This can include many forms of compensation, such as bonuses, stock options and retirement plans. However, Section 409a does not apply to qualified plans such as 401K, Section 403(b) or Section 457(b).

What can Section 409a be applied to?

Some examples of prime section 409a targets are: supplemental retirement plans, restricted stock, stock options, severance agreements, employee benefits, long-range commission programs. When items such as these are placed under a nonqualified deferred compensation plan, and if they fail to meet the requirements or compliance covered by section 409a, they are includible in gross income with accrued interest on the taxable amount as well as an additional 20% federal income tax penalty.

Why was Section 409a established?

Section 409a was established as a way for the government to control the exact timing of when a deferred compensation can and should be paid. One can trace Section 409a’s roots back to when large global conglomerates chose to speed up their deferred compensations as a way to move cash before declaring bankruptcy. Today, companies must have a well-laid out deferred compensation plan that denotes that before the money is legally owed to the employee, the decision must be made to defer it. Section 409a is a time sensitive and planning-intensive tax option. When careful execution is applied, the tax penalties can be avoided and both parties can feel good about their decisions to defer compensation. Section 409a illustrates six situations in which the government gives the green light to distribute money in deferred compensation:

– If an employee becomes disabled

– If an employee passes away

– If an employee leaves the company

– If listed as part of a fixed schedule in company documents

– If ownership of the company changes hands

– If there is an unforeseen emergency or crisis

If there is no violation of section 409a, there is no effect on an employee’s taxes, they are simply deferred till he or she receives the money. However, Section 409a can be violated easily simply because documentation is not written correctly, or making a withdrawal that is inconsistent with the terms of the written plans. To ensure that IRS requirements are met, consult with a tax expert at 212 Tax.