Deferred Compensation: What It Means for Employers

What it means in practice

Qualified vs nonqualified. The section 409A regulations list the "qualified employer plans" that are not nonqualified deferred compensation: plans under section 401(a) such as a 401(k) plan, 403(a) annuity plans, 403(b) plans, SEPs, SIMPLE IRAs, and eligible 457(b) plans, among others. Everything else that defers pay is NQDC. The IRS audit technique guide (Pub 5528) says NQDC plans usually fall into four groups: salary reduction arrangements, bonus deferral plans, top-hat plans (also called supplemental executive retirement plans, or SERPs), and excess benefit plans that make up for benefits cut back by the section 415 limits.

Unfunded means a promise. Pub 5528 explains that most NQDC plans are meant to be unfunded: the employee has only the employer's "mere promise to pay," and earmarked assets stay part of the employer's general assets. Assets set aside from creditors for the employee's exclusive benefit may be current income under sections 83 and 402(b). The employer generally deducts the amount when the employee includes it in income (sections 83(h) and 404(a)(5)).

What section 409A covers and what it excludes. Section 409A applies to amounts deferred after December 31, 2004, and, per Pub 5528, to employees, independent contractors and non-employee directors. Two common exclusions in 26 CFR 1.409A-1: a short-term deferral, meaning a payment received by the 15th day of the third month after the end of the year in which it vests, and involuntary separation pay of no more than two times the lesser of the employee's prior-year annualized pay or the section 401(a)(17) limit, paid by the end of the second year after the separation year. With the 2026 limit of $360,000, that cap cannot exceed $720,000 for a 2026 separation.

Timing of deferral elections. Under 26 CFR 1.409A-2, an election to defer pay for services in a year must be made and become irrevocable by the close of the employee's preceding tax year. In the first year an employee becomes eligible for a plan, the election can be made within 30 days and applies only to pay for services after the election. For performance-based compensation tied to a period of at least 12 months, the election can be made up to 6 months before the period ends, if the employee works continuously through the election and the amount is not yet readily ascertainable.

Changing an election later. A new election to delay a payment or change its form cannot take effect for at least 12 months and, except for payments on death, disability or unforeseeable emergency, must push the payment back at least 5 years. For a fixed-date payment, it must be made at least 12 months before the first scheduled payment. Accelerating a payment is generally prohibited (1.409A-3(j)).

Permitted payment events. The six events in 1.409A-3(a) are separation from service, disability, death, a time or fixed schedule stated in the plan, a change in ownership or effective control, and an unforeseeable emergency. An unforeseeable emergency is a severe financial hardship from events such as illness, accident or casualty loss, and the payment is limited to the amount reasonably needed. An employee is presumed to have separated from service when services drop to 20% or less of the average over the prior 36 months.

Six-month delay for specified employees. Section 409A(a)(2)(B)(i) defines a specified employee as a key employee under section 416(i) of a corporation whose stock is publicly traded. Their separation payments cannot start until 6 months after separation (or death, if earlier). Under 1.409A-3(i)(2), delayed payments can be accumulated and paid on the first day of the seventh month after separation, or each delayed by 6 months. Under 1.409A-1(i), key employee status is tested over the 12 months ending on an identification date (December 31 by default) and applies for 12 months from the effective date (by default April 1 after a December 31 identification date). The IRS COLA table lists the 2026 key employee compensation figure as $235,000.

What a 409A failure costs. If a plan fails section 409A in form or operation, section 409A(a)(1) makes all vested, untaxed compensation deferred under it for that year and earlier years includible in the affected participants' income. The tax is increased by 20% of that amount plus interest at the underpayment rate plus 1 percentage point. Pub 5528 notes these taxes fall on the employee. Pub 15-A says employers must withhold regular federal income tax, but not the additional section 409A taxes, on amounts includible under section 409A. IRS correction programs are in Notices 2008-113 and 2010-6.

Rabbi trusts. Pub 5528 and IRS Notice 2000-56 explain that Rev. Proc. 92-64 contains a model grantor trust, popularly called a rabbi trust, whose assets remain subject to the claims of the employer's general creditors on insolvency. Because creditors can reach the assets, funding a rabbi trust is not a taxable transfer of property under section 83. Section 409A(b) overrides that result for offshore trusts, assets restricted because of a change in the employer's financial health, and funding for certain executives while the employer's single-employer defined benefit plan is at risk.

FICA: the special timing rule. Under 26 CFR 31.3121(v)(2)-1, an amount deferred under an NQDC plan is taken into account as wages for FICA on the later of the date the services are performed or the date the right is no longer subject to a substantial risk of forfeiture. Once taxed, neither that amount nor income on it at a reasonable rate is FICA wages again (the nonduplication rule). If the employer misses that timing, later benefit payments are FICA wages when paid. An employer may use any later date in the same calendar year, and Pub 15-A allows a reasonable estimate when the amount is not yet ascertainable. The same timing applies to FUTA.

Income tax withholding on distributions. Pub 15 (2026) says distributions to participants from nonqualified plans, including tax-exempt employers' 457(b) plans, are treated as wages and the withholding is reported on Form 941, 943 or 944, not Form 945. Under 26 CFR 31.3402(g)-1, nonqualified deferred compensation includible in wages and amounts includible under section 409A are supplemental wages. For 2026, Pub 15 gives the optional flat rate as 22% and requires 37% on supplemental wages above $1 million paid to one employee in the year. Payments to a deceased employee's beneficiary or estate are not wages and go on a Form 1099, not a W-2.

Form W-2 reporting. The 2026 Form W-2 instructions say to report distributions from a nonqualified or nongovernmental 457(b) plan in box 1 and box 11, so the Social Security Administration can apply its earnings test correctly. Vested deferrals go in boxes 3 (up to the wage base) and 5 even if not paid. If the same year has both distributions and deferrals in boxes 3 or 5, box 11 is left blank and, for employees age 61 or older, Form SSA-131 is filed. Code Y is optional; code Z reports income included under section 409A, which also goes in box 1. The box 13 "Retirement plan" box is not checked for contributions to a nonqualified or 457(b) plan.

ERISA and top-hat plans. ERISA exempts a plan that is unfunded and maintained primarily to provide deferred compensation for a select group of management or highly compensated employees from its participation and vesting, funding and fiduciary parts (29 U.S.C. 1051(2), 1081(a)(3), 1101(a)(1)). For reporting, 29 CFR 2520.104-23 lets the administrator of an unfunded or insured top-hat plan file one statement with DOL giving the employer's name, address and EIN, a declaration that it maintains such plans, and the number of plans and employees in each, and provide plan documents on request. One statement covers all of an employer's top-hat plans and is due within 120 days after a plan becomes subject to ERISA Part 1. DOL requires electronic filing and says an existing filing does not cover a new top-hat plan adopted later. Late filers can use the Delinquent Filer Voluntary Compliance Program. The IRS notes there is no formal definition of a "select group."

457(b) and 457(f) plans. State and local governments and tax-exempt organizations use section 457 plans (see 457 plans). The 2026 457(b) deferral limit is $24,500. The IRS says a non-governmental 457(b) plan must remain unfunded, must be limited to a select group, and does not allow age-50 catch-ups. Tax-exempt employers' plans that are not eligible 457(b) plans fall under section 457(f), where deferrals become taxable when the substantial risk of forfeiture lapses.

Step by step for an employer. (1) Put payment events and timing in a written plan. (2) Collect elections before the year begins, or within 30 days for new participants. (3) Track vesting dates for FICA. (4) Keep the specified employee list if publicly traded. (5) Withhold on distributions as supplemental wages and report them in boxes 1 and 11. (6) File the top-hat statement within 120 days of a new plan.

Example 1 (illustration): FICA on a vested deferral. An executive earns $300,000 in 2026 and defers $30,000 of salary into a fully vested NQDC account. Box 1 shows $270,000. Box 5 shows $300,000, because the deferral is Medicare wages when the services are performed. Box 3 shows $184,500, the 2026 wage base. Pub 15 requires 0.9% Additional Medicare Tax withholding above $200,000. When the $30,000 plus reasonable earnings is paid later, it goes in boxes 1 and 11 but not again in box 3 or 5.

Example 2 (illustration): six-month delay. A specified employee of a public company separates on June 15, 2026, under a plan paying monthly installments from separation. If the plan uses the accumulation method, the installments for the first six months are held and paid together on January 1, 2027, the first day of the seventh month after separation.

Example 3 (illustration): election deadlines. A calendar-year employee who wants to defer part of 2027 salary must make the election irrevocable by December 31, 2026. A manager first eligible on November 4, 2026 has until December 4, 2026, and the election covers only pay for services after it is made. To move a payment scheduled for January 1, 2030, the new election must be made by January 1, 2029 and push the payment to January 1, 2035 or later.

Where states differ. Federal law, 4 U.S.C. 114, bars a state from taxing a nonresident's retirement income, which includes NQDC paid in substantially equal periodic payments over the recipient's life or at least 10 years, or paid after termination under an excess benefit plan. State treatment of deferrals also varies: for example, the Pennsylvania Department of Revenue lists deferrals to a nonqualified plan as never taxable as Pennsylvania compensation and distributions from one as always taxable.

Question: Does section 409A apply to a 401(k) deferral? No. 26 CFR 1.409A-1(a)(2) excludes qualified plans.

Question: Does a regular year-end bonus paid in March count? Usually not. A bonus received by the 15th day of the third month after the year it vests is a short-term deferral under 1.409A-1(b)(4).

Question: Does a private company need the six-month delay? No. Section 409A applies the delay only to key employees of a corporation with publicly traded stock.

Question: Who pays the 20% additional tax? The employee, on Form 1040, according to the W-2 instructions.

This entry summarizes federal rules and one state example; it does not decide whether a particular plan or payment complies with them.

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