The 5-year rule under Section 409A is a critical compliance measure that dictates how participants can make subsequent elections to further defer nonqualified deferred compensation (NQDC) payments. It is designed to prevent abusive deferrals and ensure that deferred compensation arrangements comply with strict timing requirements.
What is the 5-Year Rule for 409A?
The 5-year rule for Section 409A refers to a specific requirement for subsequent deferral elections. If a participant wants to further delay the receipt of a previously deferred payment, they generally must defer that payment for an additional period of at least five years from the date the payment would otherwise have been made.
This rule applies to payments triggered by specific events or dates, such as:
- Separation from service: When an employee leaves the company.
- A date certain or pursuant to a fixed schedule: Payments scheduled to occur on a specific date or over a defined period.
- Change of control: Payments contingent on a change in the company's ownership or control.
Essentially, if a subsequent election relates to a payment to be made on separation from service, on a date certain or pursuant to a fixed schedule, or upon a change of control, the additional deferral period must be at least five years from the date the payment would otherwise have been made.
Purpose of the 5-Year Rule
The primary purpose of this rule is to prevent employees from deferring compensation simply to avoid immediate taxation after they gain access to the funds. Without such a rule, individuals could theoretically defer payments indefinitely by making last-minute elections, undermining the intent of 409A to regulate when nonqualified deferred compensation is paid and taxed.
Key Conditions for Subsequent Deferral Elections
For a subsequent deferral election to be valid under Section 409A, it must satisfy three core conditions, of which the 5-year rule is a vital part:
| Condition | Description |
|---|---|
| 12-Month Rule | The new deferral election must be made at least 12 months before the date the payment would otherwise have been made (i.e., the original payment date). This ensures the election is not a last-minute decision. |
| 5-Year Rule | The payment must be deferred for an additional period of at least five years from the date it would have originally been paid. This is the core of the 5-year rule, ensuring a substantial delay for subsequent deferrals. |
| No Acceleration Rule | The payment cannot be accelerated. Once a payment date or event is set, it generally cannot be moved to an earlier date. This rule prevents participants from gaining earlier access to funds once they have been deferred. |
Practical Example
Imagine an executive, Sarah, is scheduled to receive a deferred bonus payment on January 1, 2028. Due to a change in her financial planning, she decides in late 2026 that she wants to defer this payment even further.
To comply with 409A's subsequent deferral rules, including the 5-year rule:
- 12-Month Rule: Sarah must make her new election by December 31, 2026 (at least 12 months before January 1, 2028).
- 5-Year Rule: The earliest she can reschedule the payment is January 1, 2033 (five years from the original payment date of January 1, 2028). She cannot elect to receive it, for example, on January 1, 2030, as that would only be a two-year deferral.
- No Acceleration: She cannot decide in 2027 to receive the payment on January 1, 2027, as that would be an acceleration.
Importance for Compliance
Compliance with the 5-year rule, along with the other subsequent deferral conditions, is crucial for maintaining the tax-favored status of NQDC plans. Failure to adhere to these rules can trigger severe penalties under Section 409A, including:
- Immediate taxation of all vested deferred compensation under the plan.
- An additional 20% penalty tax on the deferred amount.
- Premium interest penalties.
For detailed guidance and specific scenarios, it is always recommended to consult IRS resources or qualified legal and tax professionals specializing in deferred compensation arrangements.
