Recent changes in federal tax laws have made it potentially more difficult to optimize the tax benefits of nonqualified deferred compensation plans. These changes, which comprise Section 409A of the Internal Revenue Code, generally apply to amounts deferred after December 31, 2004. The changes pertain largely to a) the timing of decisions (“elections”) to defer income and b) the circumstances under which the income can be distributed.

Under the new rules, compensation deferred under a plan may not be distributed until after one of the following events has occurred: termination of employment; disability; death; change in company ownership; “unforeseeable emergency” (as defined by the tax code); or a time specified by the plan at the time of deferral. This is significantly more restrictive than the previous regulations, which allowed, for example, distribution of deferred income prior to an employee’s separation from service.

In the past, recipients could obtain early distribution if they were willing to pay a penalty, usually 10%. Now, however, no early payments may be made except as specifically allowed by IRS provisions. In addition, any amount includable in gross income as a result of these changes will be subject to withholding requirements.

The new law also sets specific timetables for making the election to defer compensation. These affect both the initial election and any subsequent elections to delay or change the form of payment.

Except for certain specified types of retirement plans, any deferred compensation plan or arrangement must comply with the new rules. Plans not affected by the changes include qualified retirement plans, tax-deferred annuities, 401(a) and 457(b) plans, vacation and sick leave, compensatory time, disability pay and death benefit plans.

Failure to comply with the new regulations could have serious consequences for you as a plan participant, including immediate taxation of all benefits, payment of interest, and a 20% penalty tax.