409A Plans: Meaning, Overview, Limitations

What Are 409A Plans?

409A plans are a type of non-qualified deferred compensation plan for compensation that has been earned by an employee but not yet received from their employer. Because the ownership of the compensation—which may be monetary or otherwise—has not been transferred to the employee, it is not yet part of the employee's earned income and is not counted as taxable income.

The Internal Revenue Service code 409A governs for-profit NQDCs, such as plans for employees working for a large corporation. Other plans for employees of non-profits or government entities are included under IRS Sections 457(b) or 457(f).

Understanding 409A Plans

NQDCs as 409A plans reference the section of the tax code they exist in. They were created in response to the cap on employee contributions to government-sponsored retirement savings plans. Because high-income earners were unable to contribute the same proportional amounts to their tax-deferred retirement savings as other earners, NQDCs offer a way for high-income earners to defer the actual ownership of income and avoid income taxes on their earnings while enjoying tax-deferred investment growth.

For example, if Sarah, an executive, earned $750,000 per year, her maximum 401(k) contribution of $22,500 (for tax year 2023) would represent only 3% of her annual earnings, making it challenging to save enough in her retirement account to replace her salary in retirement.

By deferring some of her earnings to an NQDC, she could postpone paying income taxes on her earnings, enabling her to save a higher percentage of her income than is allowable under her 401(k) plan. Savings in an NQDC are often deferred for five or 10 years, or until the employee retires.

NQDCs don’t have the same restrictions as retirement plans; an employee could use their deferred income for other savings goals, like travel or education expenses. Investment vehicles for NQDC contributions vary by employer and may be similar to the 401(k) investment options offered by a company.

Limitations of NQDCs

NQDCs can be a valuable savings vehicle for highly compensated workers who’ve exhausted their other savings options, but they're not risk-free. They’re not protected by the Employee Retirement Income Security Act (ERISA) like 401(k)s and 403(b)s are. If the company holding an employee’s NQDC declared bankruptcy or was sued, the employee’s assets would not be protected from the company’s creditors.

Additionally, the money from NQDCs cannot be rolled over into an IRA or other retirement accounts after they’re paid out. Another consideration is that if tax rates are higher when the employee accesses their NQDC than they were when the employee earned the income, the employee's tax burden could increase.

The Bottom Line

A 409A plan is a type of non-qualified deferred compensation (NQDC) plan that allows high earners to save more for retirement. Because the compensation that goes into these accounts has been earned by the employee but not yet received by them, it is not yet taxable.

NQCD plans come with some risks. They are not protected from employer bankruptcy the way other retirement plans are, and they cannot be rolled over into an IRA. But these plans can still benefit high-earning employees by allowing them to save more than they would otherwise be able to save in a retirement account like a 401(k).