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.
What Your Peers Are Reading
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.