In 2004 Congress enacted section 409A of the Internal Revenue Code, which changed the way some deferred compensation is taxed. At the end of 2010 the new law came into full effect. Though much deferred compensation is not affected by the law, its purpose was to raise the tax rate on deferred compensation that was solely intended to avoid income tax.
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As a basic starting point, deferred compensation is defined as compensation paid in a year other than which it was earned. Usually this is done to defer payment of taxes on the income until a future time, but this definition of deferred compensation includes situations where an employee who only works part of the year, such as a teacher, elects to receive his pay annualized over 12 months.
Deferred Compensation Plans
Deferred compensation plans are those in which money that would ordinarily be paid as compensation is put aside by the employer in a retirement plan. Many types of pay arrangements fit this definition, including employment agreements, severance agreements, change of control agreements, bonus plans, commission plans, certain stock options, salary deferral arrangements and other traditional deferred compensation plans like individual retirement accounts (IRAs), 401k, 457b or other retirement or pension programs. Generally, deferred compensation programs allow the employee to grow her retirement funds tax free and receive them in a future year where they may be in a lower tax bracket due to retirement.
If your deferred compensation plan does not meet the qualifications of section 409A, it is subject to a penalty of an additional 20 percent in tax. Fortunately, many retirement plans, like IRAs and 401k's, are qualified and therefore exempt from the reach of 409A. To satisfy section 409A and avoid the higher tax penalty, the deferred compensation plan must not be subject to accelerated payments and must have fixed dates for distribution. The law also contains requirements in the event an employee has the right to elect for deferred compensation.
Even if your deferred compensation plan is qualified under section 409A, another major risk to your money is the potential bankruptcy of your employer. In some cases, the assets of an employer, including money allocated to deferred compensation, can be attached by the company's more senior creditors, leaving the employees out of luck. In the case of a Chapter 11 bankruptcy restructuring, the creditors may choose to leave the deferred compensation in place to encourage employees to remain. The fact of an employer considering bankruptcy greatly complicates the deferred compensation scenario for employees.