This blog is part of a 12-part series entitled “The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.” To read the introduction to the series, click here.
The process of deferring a portion of a participant’s pay under a nonqualified deferred compensation plan (NDCP) can, at first glance, appear quite similar to how such deferral would be handled under a 401(k) plan. Participants designate a specified dollar amount or percentage of their pay they wish to defer under the plan. The plan sponsor then arranges for such amounts to be deducted from the participants’ pay and allocated to an account maintained on their behalf under the plan. However, upon delving deeper, we see stark differences that must be observed by NDCP participants and sponsors in order to comply with Internal Revenue Code Section 409A. As with many of 409A’s rules, the restrictions on deferral elections require tight timing. This blog will highlight the differences between permissible 401(k) and NDCP deferral elections while also describing some of the plan design options available to provide participants with at least some flexibility when making their NDCP deferral elections with respect to salary and bonuses. While 409A also contains specific rules governing other types of deferrals (e.g., short-term deferrals, commission, etc.), analysis of such rules is beyond the scope of this series.
NDCP deferrals: Generally “Election Day” comes just once a year
Typically, 401(k) plans permit participants to make deferral elections as soon as their first payroll periods coincident with or next following the date on which they meet the plan’s eligibility requirements. If any participant fails to defer when first eligible, a 401(k) plan could allow them to begin deferring as of any subsequent payroll period. Similarly, a 401(k) plan can generally permit participants to increase, decrease, or discontinue their rates of deferrals as of any subsequent payroll period. In contrast, while a participant’s initial deferral opportunities under an NDCP are somewhat similar to the 401(k) plan, once the first deferral chance passes, there is considerably less flexibility.
Under an NDCP, in the case of the first year in which a participant becomes eligible to participate in the plan (whether it is a brand new plan or an existing plan for which the individual has just become eligible), participants have until 30 days after they first become eligible to make their salary deferral elections. Such elections must only apply to compensation (whether in the form of salary or bonus) paid for services to be performed beginning with the first payroll period after the election. If participants pass on this initial deferral option, they will not have another deferral opportunity until January 1 of the next calendar year. Similarly, for those participants who do elect to defer a portion of their salaries when first eligible, no changes to such initial elections can be made until January 1 of the next calendar year.
Because all NDCP deferral elections (including elections not to defer) are “locked in” for the calendar year in which they are made, plan sponsors need to be sure that their corporate cultures and populations are the right fit and that they have effectively provided the appropriate caveats before deciding to offer participants “evergreen elections.” Under such elections participants have the ability to make an NDCP deferral election and then have that election automatically roll over from year to year unless they specify otherwise before the applicable January 1. Without such a fit and/or without any proactive measures in place, such a design runs the risk of participants forgetting to get decrease or discontinuance requests to sponsors on time and then being stuck for the coming year with deferral rates that they do not want, or worse, may not be able to afford, given their anticipated cash flow and expenses for such year. In order to prevent this predicament, the NDCP sponsor can instead require that the participants reenroll each year by making a new salary election prior to January 1 of each year. This design is particularly effective in decreasing potential participant complaints if combined with a strong annual communications campaign during an open enrollment period that begins as early as October and ends on whichever day in December is the last day that the plan administrator is able to accept the election in order to process it for the first payroll period in January, during which the participant earns pay attributable to services performed in the new year. (Note: any “carry-over” pay from the previous year, i.e., pay earned in the previous year but not payable until January of the current year, will be subject to the previous year’s deferral rate.)