“With respect to distributions from nonqualified deferred compensation (NQDC) plans, what are the timing requirements?”
ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Texas is representative of a common inquiry related to distributions from Internal Revenue Code Section (IRC §) 409A NQDC plans.
Highlights of Discussion
Sponsors of NQDC plans must enforce strict distribution rules that are dictated by IRC §409A, the terms of the governing plan document and the elections made by participants (if permitted). Regarding the last variable, if a plan permits participants to elect how and when they will take distributions, they must execute their elections before deferring their compensation into the plan. The timing of withdrawals is an important tax consideration that requires advance planning. Once the form and timing of distributions are set (typically when deferral elections are made), there are complex rules that apply if participants want to make changes.
Under IRC §409A, payment events are limited to
- Separation from service (as defined by the plan);
- A specified time or according to a fixed schedule;
- An unforeseeable emergency; or
- A change in the ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation (as defined by the plan) (see Treasury Regulation 1.409A-3).
Sponsors can elect to include all or a subset of the above listed distributable events in their plans. A person must look at the specific plan document in order to know which payment events apply to a particular plan and whether participants are allowed any discretion in selecting from among them.
A NQDC plan may allow employee elections regarding the timing and method of payment; or it can dictate the payment regime with no elections allowed. If participants have options, they record their distribution choices when they make their deferral elections. They must elect 1) when they will receive distributions from the NQDC plan, and 2) in what form the distributions will take (lump sum withdrawal or installment payments). The deadline for these elections is typically by December 31 of the year prior to the year for which salary is deferred or for which nonelective (employer) contributions are made to the plan; or within 30 days of becoming eligible to participate in the plan. If participants fail to make distribution elections when permitted, plan terms will dictate a default.
Like the timing for distributions, the methods of payment vary for each NQDC plan. The plan may allow for lump sum withdrawals, installment payments (e.g., over five or 10 years) or both, and participants may be allowed to select the payment type. The plan document will specify the available methods of payment.
With rare exception, distributions may not be accelerated. However, there is a mechanism by which participants may delay receipt of payments beyond which they initially elected [see Treas. Reg.§409A-2(b)]. In general, a participant is allowed to change the timing and method of the payment if an election is filed with the employer at least 12 months prior to the date the first payment would be due; and the payment is postponed for at least five years. Again, it is important to review the plan document to see if the plan allows for distributions to be delayed and, if so, whether distributions are treated as a series of payments or as a single payment for this purpose.
The penalties for noncompliance with these withdrawal rules are severe. The IRS will consider any compensation deferred under an errant plan as taxable income to the participant, plus it will assess a 20 percent excise tax, including accruing interest. Taxes, penalties and interest are payable by the recipient of the deferred compensation, not the employer [see IRC §409A(a)(1)(B)].
The form and timing of payments from IRC §409A NQDC plans is an important consideration because of the potential for income tax liability. Depending on the terms of the governing plan, participants may have flexibility in selecting when payments are due and what form they take and, therefore, have more control over when the amounts become taxable income to them. Understanding the terms of each plan and advance planning are the keys to mitigating the share Uncle Sam will take.