Section 409A was added to the Internal Revenue Code effective Jan. 1, 2005, and applies to all nonqualified deferred compensation plans. It lays out the rules for when deferral elections can be made, when distributions can be taken, and prevents participants from receiving distributions on a faster schedule than what was originally elected. All nonqualified plans must comply with Section 409A rules or risk losing the tax-deferred status of the plan and subjecting participants to having all previous plan deferrals declared immediately taxable at a participant’s regular tax rate plus a 20% penalty tax.
Under Section 409A, deferral elections must be made by the end of the taxable year before the year in which deferrals are made. Companies generally hold open enrollment periods at the end of a year during which employees make their deferral elections for the following year. Once a deferral election is made, it cannot be changed, except under certain conditions as governed by the plan.
Under Section 409A, nonqualified plan distributions must be limited to one of these six options:
- Employee’s separation from service;
- Employee’s disability;
- Employee’s death;
- A fixed time or schedule;
- A change in company ownership or ownership of a substantial portion of company assets; or
- An unforeseeable emergency.