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409A Rules Offer Opportunities For Attractive New Plan Design Features

By Louis R. Richey

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New Code Section 409A is the most dramatic change in the income taxation of executive compensation in 25 years. I like to call 409A “the code section that ate executive and director compensation.” Only a very narrow group of plans is exempted (mostly qualified and group benefits).

As to the historically popular nonqualified plans (i.e., voluntary deferral and supplemental plans), practitioners did lose the ability to use some creative techniques, such as the “haircut” walk-in provision. However, 409A has had the positive impact of making these plans more standardized while leaving us the flexibility to design plans that meet the sponsor’s objectives.

They are thus easier to design and communicate (but do require a new administrative regime). There has been little focus on new 409A provisions that offer attractive new plan design opportunities. For the sake of clarity, let’s focus on just one of these new design opportunities: using the 409A “subsequent election” rule in conjunction with voluntary deferral plans.

The 409A “subsequent election” is an optional provision that an employer may place in a plan that permits a plan participant to elect to change either the timing and/or form of a previous election. In other words, the participant may “re-defer” a prior election to a new future date and/or change the form of the distribution. 409A places some procedural requirements around this provision.

Under 409A, the subsequent election must be at least 12 calendar months in advance of the original date of distribution, and the new date of distribution must be at least 5 calendar years following the original date of distribution. In addition, if a separation of service occurs in the 12 months following the subsequent election, the prior form of distribution–not the new one–will apply. Here’s why I recommend that every voluntary deferral plan contain such a subsequent election provision, even though it sounds complicated:

First, the provision makes the ideal voluntary deferral plan better integrated and flexible. What is the ideal voluntary deferral plan? It is one that mirrors 401(k) plans with multi-fund investment opportunities but also allows participants to defer and to make separate investment allocations for distributions going to different future dates.

The plan not only allows for distributions at projected retirement but also permits distribution for pre-retirement financial needs like education, home purchase and other near-term financial objectives. Such capabilities make the plan attractive for younger executive participants and help overcome stricter 409A limitations on hardship distributions.

But what about a subsequent election? How does it fit into this deferral plan design? A subsequent election enables a participant to push back one of these pre-retirement distribution elections to a later date, perhaps to retirement, if the participant no longer needs or desires the original distribution.

For example, suppose a participant creates an election account aimed for distribution beginning with a child’s first year of college, but the child earns a scholarship, so the funds are not needed for that purpose anymore. The participant may make a subsequent election to redirect that account to begin distribution later at retirement, or any other date at least 5 years out.

Second, a subsequent election provision helps address any participant concerns about the unsecured nature of such plans, thereby acting as a security device. Participants, especially younger ones, may be reluctant to participate in a plan that requires them to make elections to far dates, like retirement, because of the potential risk of loss of benefits that accompanies the required insolvency risk in a plan.

A plan permitting pre-retirement distribution elections helps. However, a properly designed plan with a subsequent election provision would allow a participant to make a short 409A fixed-date election of 2 years into the future to be paid out in 5 annual distributions (which works nicely with the minimum 5-year re-deferral requirement).

Then, before the end of the next year (and in compliance with the rule) the participant will decide whether to continue to make a subsequent election on that first installment or to take that installment (and coming installments) into income if he or she feels insecure about the plan. If he or she elects to make a subsequent election, the concept is to push this first installment to the end of sequence of installments (5 years in the future) to keep the participant’s average exposure period on a deferral in the plan as short as possible at all times.

This concept is demonstrated in Exhibits 1 and 2. Exhibit 1 shows a $50,000 deferral for 2 years and paid out in 5 annual installments. Exhibit 2 shows the effect of a subsequent election pushing or “rolling” the first $10,000 distribution installment back 5 years (the minimum requirement) to the end of the distribution sequence.

The rolling of an installment in this fashion can be repeated annually. And this approach can be applied to the next year’s new deferral, thereby “stacking” the installments of multiple years. The employer has the flexibility to determine the limits on this ability to make a subsequent election, and might select retirement age–or age 70 1/2, for example–as the last year a subsequent election can start. There are other approaches using this concept, based on a participant’s concerns and desires.

Of course, the key to making this strategy work easily for a plan sponsor and participants is the necessary 409A administrative capability. In fact, the author does not recommend that sponsors try to take on this plan design without it. The administrator not only needs to be able to administer separate, multi-destination accounts with separate investment allocations, but also needs to be able to electronically enable and record-keep the exercise of a subsequent election option in compliance with the 409A requirements.

The complete administrative capability should also address the important communication to plan participants concerning deadlines for subsequent elections as well as the status and impact that changed distributions have on these elections.

The author’s current experience is that many third-party administrators and their advisors claiming to do 409A-compliant nonqualified plans are advising against such plan designs and a subsequent election provision. The truth is that many of them do not have the software and systems to administer such plans or such a provision.

So, the “tail is wagging the dog” currently as to recommended attractive plan designs, based upon their own software and systems limitations. Plan sponsors will need to seek out 409A-enabled plan administrators, but it is worth the effort to implement the most attractive plans possible under 409A.

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