Code Section 409A has been one of the biggest disasters ever written into the Internal Revenue Code. It was supposed to raise lots of money for the government, but to my knowledge, it has not. It was supposed to make nonqualified deferred compensation no less favorable than its qualified brother, and it certainly has done that. But, some of the pitfalls that have come up are way beyond the scope of what Congress could possibly have considered. Let's consider a not uncommon situation.
XYZ Company decides to start a new (traditional) deferred compensation plan for certain executives. Eligible executives will be able to make deferral elections (amount, timing of payment, form of payment) during year X-1 with respect to compensation earned during year X. Earnings will be credited on those amounts based on the earnings of a funds selected by an executive from the group of funds also available under the qualified 401(k) plan. Deferrals will be matched by XYZ dollar for dollar on the first 10% of compensation deferred to the nonqualified plan (NQDC). As these executives previously participated in a nonqualified cash balance plan (that plan was frozen when the qualified plan was frozen), vesting is 100% after 10 years of service, with service counting back to date of hire.
Believe it or not, all, or at least most of these executives will be in violation of Code Section 409A the moment that they make their elections. Why? How can that be? Without reading down, do you know?
Here is the catch. Vesting service starts before the effective date of the plan. This is not the first plan of this type (account balance plans) in which the executives participate. For those who are immediately vested (10 years of vesting service), making an election in Year X-1 is making an election for services already performed. Yes, the mere fact that vesting service starts before the effective date of the plan causes the problem.
How do you fix this? The good news is that it is actually fairly simple. Make the initial deferral election a default. In other words, specify it in the plan with no choices. Given that no choices are available, the rules will be interpreted so that the executives have not made an election after the date on which some services have been performed.
Do you think this is ridiculous? So do I. Do you think that Congress intended it this way? Neither do I.
This, dear readers, is the level of stupidity to which 409A has sunken.