What is a 409A Plan (Mirror 401k) and how can it lower my taxes?
409A Plans are non-qualified deferred compensation employer-sponsored retirement plans (wow, that’s a mouthful!). Don’t worry, it’s not that complicated. I offer it to my clients (businesses) when their highly compensated employees want to contribute more to their retirement (or future goals) on a pre-tax basis than their existing 401k plan allows.
Your Highly Compensated Employees (HCE) want to contribute more to their retirement for 2 main reasons:
- They need to save more for retirement because they earn more. I tell employees that they should save 15% of their salary each year. If you’re married it should be more if you both want to retire. Higher earners need to contribute more dollars than the current tax code allows
- Taxes. Employees LOVE to invest for retirement but they also LOVE the tax advantages that come with it. If your employer 401k fails testing, highly compensated employees are not allowed to contribute up to the annual limits set by the IRS.
How a 409A Nonqualified Deferred Comp Plan Works.
The employee earns the income but not yet received from their employer. Because the compensation 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 “409A” refers to the Internal Revenue Service code 409A which governs for-profit NQDCs, such as plans for employees working for a large corporation.
Key Takeaways: 409A Nonqualified Deferred Comp Plans Can Lower Taxes
- Non-qualified deferred compensation (NQDC) is earned by an employee but not yet received from their employer.
- 409A plans emerged in response to the cap on employee contributions to government-sponsored retirement savings plans like 401(k).
- An NQDC plan sponsored by for-profit plan sponsors is governed by Internal Revenue Code (IRC) Section 409A.
- An NQDC sponsored by a nonprofit or governmental plan sponsor is governed under IRC Section 457(b) or 457(f).
When do I use 409A Plans in my retirement plan practice?
NQDCs 409A plans emerged in response to the cap on employee contributions to government-sponsored retirement savings plans like 401K Plans. I tell my clients they should contribute 15% to their retirement to have a retirement income equivalent to their current income. Because high-income earners were unable to contribute the same proportional amounts to their tax-deferred retirement savings as other earners (i.e. 15% of $300,000 is $45,000 which is more than you can contribute to a 401k), 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 Jack, an Operations Manager, earned $400,000 per year, the maximum 401(k) contribution of $22,500 (for tax year 2023) would represent only 5% of earnings, making it challenging to save enough in his retirement account to replace his salary in retirement.
By deferring some of earnings to the NQDC, he could postpone paying income taxes on earnings, enabling him to save a higher percentage of income than is allowable under the 401(k) plan. Savings in the 409A are often deferred for five or 10 years, or until the employee retires.
An NQDC plan sponsored by for-profit plan sponsors is governed by Internal Revenue Code (IRC) Section 409A, while one sponsored by a nonprofit or governmental plan sponsor is governed under IRC Section 457(b) or 457(f).
NQDCs don’t have the same restrictions as 401K plans or IRAs; an employee could use their deferred income for other savings goals, like buying a vacation home, education expenses, or a Ferrari. Investment options for NQDC contributions vary by the employer and may be similar to the 401(k) investment options offered by a company. This is why I call it a Mirror 401(k).
Nonqualified Deferred Comp 409A are SO popular I even did a video on it
Limitations of 409A Plans and NQDCs
However, NQDCs are 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 (tax rates in general might go higher but yours might go lower so let’s discuss your situation. Book a consultation below.) when the employee accesses their NQDC than they were when the employee earned the income, the employee’s tax burden could increase.
NQDCs can be a valuable savings vehicle for highly compensated workers who’ve exhausted their other savings options.
Disclosures, Sources, and Footnotes
For plan sponsor use only, not for use with participants or the general public. This information is not intended as authoritative guidance or tax or legal advice. You should consult with your attorney or tax advisor for guidance on your specific situation.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.