By Dr. Jim Dahle, WCI FounderMore and more physicians are being offered deferred compensation plans at their workplace. These often have alphabet-soup names and numbers attached to them, making the situation even more confusing. Plenty of doctors don't even know how a commonplace 401(k) or 403(b) works, so when their employer mentions a 409(a) plan or similar, it shouldn't be surprising that their eyes glaze over.
This post will explain how to think about non-qualified deferred compensation plans while discussing some of their specifics.
What Is Deferred Compensation?
A deferred compensation plan is simply a plan that allows an employee to decide to be paid in a later year instead of the current year.
Why would anyone want to do that? There are two reasons. The main one is simply that they hope to have a lower marginal tax rate in a future year when they actually receive the compensation. Not paying taxes at 37% so you can later pay taxes at 22% is a winning move. Of course, there is a time-value of money calculation that must be made. That's why these plans generally allow the money to earn some interest or even be invested into risky assets between the time the compensation is deferred and when it is received.
I'd rather get $100,000 and pay 37% on it this year than get $100,000 in eight years and only pay 22% on it. In the latter situation, I would only receive $78,000 after tax in eight years. In the former, I could potentially receive much more. I would only get $63,000 if I took the money today, but if I earned 8% on $100,000 for eight years (growing to a total of $185,000) and then paid taxes (37% of $185,000 is $68,000), I would eventually receive $116,000—far more than the $78,000 I would get in the latter scenario if the money was not invested.
More information here:
Comparing 14 Types of Retirement Accounts
What Is Non-Qualified Deferred Compensation?
Most of us are familiar with the idea of deferring compensation/taxation to a later date and investing that money in the meantime. This is how tax-deferred 401(k)s, 403(b)s, and traditional IRAs work. But those are “qualified” types of deferred compensation plans. What makes a plan “qualified”? It's qualified with the IRS so it qualifies for the IRS permitted deferred payment of taxes. In a non-qualified deferred compensation arrangement, unlike a 401(k) or 403(b), the money is not yours. It still belongs to the employer.
From an asset protection standpoint, that's good for you in that it is not subject to your creditors. However, it could be bad for you in that it is subject to your employer's creditors, and in the event of a nasty bankruptcy of your employer, you could theoretically lose some or all of that compensation you already earned but have not received.
A major benefit of non-qualified deferred compensation plans is that ERISA law does not apply to them. That means there is no non-discrimination testing ensuring that highly compensated employees and executives don't get all the benefits and leave the low-level employees hanging out to dry. These plans are often JUST for the top-level folks. Interestingly, these plans can also be used for independent contractors, not just employees.
Deferred compensation, in both 409(a) plans and 457 plans, must be deferred for a minimum of five years.
Plans can be either funded or unfunded (i.e. the employer has either set aside money for the plan or has just promised to pay). Obviously, a funded plan is safer than an unfunded one. Plans can also be wrapped in a trust to further reduce risk, although that increases complexity and makes them even harder to understand.
Governmental vs. Non-Governmental 457(b)s
The most well-known type of non-qualified deferred compensation plan is a 457(b). There are two types of these, and they're very different. A governmental 457(b) is best thought of as just an additional 401(k) or 403(b). It has a similar contribution amount [$23,500 in 2025]. It can be invested similarly. The loss of the money to a creditor of the government entity offering it is extremely unlikely, and when you leave the employer, it can be rolled into an IRA or another qualified retirement account. Just like a defined benefit/cash balance plan is really an extra 401(k) masquerading as a pension, a governmental 457(b) is really an extra 401(k) masquerading as a non-qualified deferred compensation plan.
A non-governmental 457(b) is a very different beast. You are more likely to lose the money to creditors of your employer, and you cannot roll that money into an IRA or another qualified plan when you leave the employer. Your only rollover option is into another non-governmental 457(b) plan, and what are the odds that your next employer will offer one of those as well? Not very good. So, you're mostly stuck with whatever distribution options the non-governmental 457(b) plan offers, and sometimes those aren't very good at all. Sometimes the only option is taking out the entire balance in the year you leave the employer. When deciding whether you should even contribute to a non-governmental 457(b) plan, you need to look at all of the following:
- Plan expenses
- Investment options
- Distribution options
- Financial stability of the employer
and make sure all four of them are acceptable to you in the long run. In my experience, people seem to worry a lot about the financial stability of the employer and not enough about the distribution options. I have yet to hear from somebody who actually lost money in a non-governmental 457(b). Even if the employer did go bankrupt, you're still in line with the other creditors in bankruptcy court and probably pretty close to the front. I'd still spend that money first in retirement, but the employer would have to be in financial dire straits for me to not put anything into the plan just based on that.
But lots of plans have terrible distribution options—like you have to take all the money out (and pay taxes on it) in the year you leave or over five years starting the year you leave, which might be peak earnings years for you if you're going to another job and not retiring.
Common distribution options include:
- Lump sum
- Five-year payout
- 20-year payout
- Defer to age 72
I don't find any of those very attractive. Something nice would be a five- or 10-year payout starting at a date I can specify when I leave the employer. Note that the default option (if you don't tell HR anything when you leave) is often a lump sum. Saving taxes at 32% and then paying them at 37% is obviously less than ideal.
Note also that a short distribution period of a very large account (seven figures) will ensure you're in a top tax bracket for at least a few years of retirement, a time when you may wish to be doing Roth conversions at a lower tax rate.
Very large balances (more typical with a 457(f) or 409(a) plan) mean that fees and crummy investment options matter even more than they do if you only have a low six-figure amount in the plan.
One other thing that is very different from 401(k)s and 403(b)s is that you cannot use more than one 457(b) plan in a given year, whereas you can contribute to multiple 401(k)s or multiple 403(b)s in a year.
More information here:
Can a 403(b) Be Rolled into a 457(b)?
What Is a 457(f) Plan?
The 457(b) has a much less well-known cousin called a 457(f). A 457(f) is also a non-qualified deferred compensation plan. However, a 457(f) plan is a plan where all contributions are made by the employer and none by the employee. It is usually just for a select management group or for highly compensated employees, and it involves money that is paid to the employee at the time of retirement. It is sometimes called a Supplemental Executive Retirement Plan (SERP). With a 457(f) plan, the benefits are taxed when they vest, NOT when they are paid out. This makes it an “ineligible” 457 plan. 457(f) plans may have higher contributions than a 457(b) plan. In fact, it's possible to defer 100% of your compensation into a 457(f) plan.
The taxation also works slightly differently than a 457(b). When each “tranche” of your 457(f) plan is vested, you are taxed on it (at ordinary income tax rates and also usually including payroll taxes), although gains on that money can still be deferred.
The vesting occurs when the “substantial risk of forfeiture” goes away. That means the benefits are no longer “conditioned upon the future performance of substantial services.” That's when the tax bill is due, not when the money is actually received. So, that can be a bit of “phantom income” that is hard to deal with tax-wise if you don't have enough other income or assets to pay the bill.
Plans also must carefully define “retirement” to satisfy the IRS. That usually means naming an age or a date, not just “whenever they leave employment.” These plans can actually be set up as a defined contribution plan (most common) or a defined benefit plan. Sometimes employers, like academic institutions, use a 457(f) to “restore” benefits to a highly compensated employee that it could not provide in a qualified retirement plan (like a 401(a)) due to non-discrimination testing.
There was a lot of concern that these plans offered to doctors would be changed by Secure Act 2.0, but it doesn't appear that those changes were included in the final version.
Like 457(b)s, every 457(f) is unique. You must read the plan document. They typically allow the highly paid employees to defer this compensation until they retire, die, or are disabled, but exactly how and when it is distributed is highly variable and may or may not work for your life and your financial plan.
What Are the Benefits of a 457(f)?
There are several 457(f) benefits for the company and the employee. These include:
- Lower cost than many plans
- Easier to administer than many plans
- Can help attract and retain valued executives or other highly compensated employees
- Pre-tax treatment and tax-protected growth (similar to 401(k)s)
- A potential tax arbitrage between tax rates at contribution and withdrawal for the employee (like with a typical 401(k))
- Both employer and employee may contribute to the plan (although it is usually employer-only contributions due to the way the taxation at vesting works)
Should You Use a 457(f)?
As an employer, you may or may not wish to use a 457(f). It can be a form of golden handcuffs that may keep key employees around. But those employees may prefer to be compensated in a different way. Why not ask them?
As an employee, the question to ask when offered a 457(f) plan is, “What are my other alternatives for this compensation?” If there are none, you might as well take it. It's a bit like a whole life insurance policy being purchased for you by your employer. I'm not a big fan of whole life insurance, but it certainly has value. If someone wants to give me one, I'll take it. But if they'll pay me a higher salary instead or give me another benefit I value more, I'd probably take that instead. You may or may not place high value on the opportunity to use a 457(f). If you'd rather have cash to invest in a taxable account or to just spend or give now, you can ask for that instead when negotiating a contract with your employer. You should definitely consider your likely future tax bracket when deciding whether to defer taxation into the future.
Either way, the devil is in the details. Read the plan document to get them.
Be aware that the golden handcuffs phenomenon can be very real for the employees, especially as balances climb with large contributions and solid market returns. Imagine a six-figure or even high six-figure 457 plan structured in such a way that you can't touch it until age 60 without paying a massive amount in tax. That might keep you from changing jobs or retiring whereas if you had not contributed much to the plan and invested in taxable instead, you would feel a lot more flexibility.
What Is a 409(a) Plan?
A 409(a) plan (sometimes called a 409A plan) is also a non-qualified deferred compensation plan. Rather than being governed by IRS code 457, it is governed by rules in IRS code 409. If the employer is a nonprofit or government employer, a 457 plan of some kind will typically be used. If the employer is a for-profit business, a 409 plan will be used. Otherwise, a 409(a) plan is extremely similar to a 457(f) plan. The vesting, taxation, and rollover options are essentially the same. See the 457(f) section above for details.
What Else Does Code 409(a) Cover?
Code 409(a) covers all kinds of compensation besides a 457(f)-like deferred compensation plan. It also covers
- Severance programs
- Separation programs
- Reimbursement arrangements
- Stock options
- Post-employment payments and more
A “409A Valuation” is the independent appraisal of the value of a private company used to set the strike price for employee options. When you search the internet looking for information about 409(a) or 409A, most of what you will find refers to this process and stock options. An interesting historical fact is that 409(a) was put into place after the Enron meltdown to block equity loopholes previously in place.
Code 409(a) applies to basically all forms of deferred compensation for private companies except for qualified plans like 401(k)s and welfare benefits like vacation leave, sick leave, disability pay, or a death benefit plan. There are a few other minor exceptions. Penalties for non-compliance with the code are pretty severe: all the money in the plan immediately is taxed at ordinary income tax rates, plus 20%. If you're an employer offering one of these, you'd better make sure you're doing it right.
Reducing Risk: Rabbi vs. Secular Trust
A 409(a) plan often involves a trust to reduce the risk of loss for the participants. The idea is that the plan sits in a trust, not the employer's accounts. The money is still available to creditors of the employer, but there is an additional layer of practice. Sometimes the plan is still unfunded (just a promise from the employer) despite a trust being involved. Actually funding the plan seems like a better way to reduce risk to me than just putting it in a trust, but ideally, both are done.
As a general rule, a secular trust is better than a rabbi trust in this regard. In a rabbi trust, the assets are basically unreachable by the employer but not its creditors. In a secular trust, the assets are unreachable by both. However, the taxation varies between the trusts. Like when a trust is not involved, taxation occurs in a secular trust at the time of vesting. With a rabbi trust, taxation doesn't occur until distribution, a significant advantage and likely the reason rabbi trusts are more commonly used.
The Worry Factor
Using non-qualified plans like a 409(a) plan and a non-governmental 457(b) plan can have the risk of losing money to your employer's creditors as discussed above. And it appears that at least one plan covering doctors will actually cause doctors to suffer those losses. However, even if you never lose money in those plans, there is still the worry about doing so and avoiding that hassle is worth something. For example, here is an email I received from a doc about this issue:
I wanted to share a cautionary tale based on my personal experience with a non-qualified deferred compensation plan (specifically a 409(a) plan). While my story ultimately had a positive financial outcome, it came with a significant amount of stress and anxiety…When our company first offered the NQDCP, I decided to participate. The plan allowed us to contribute up to $50,000 in addition to our 401(k) with a company match. As a W-2 employee with limited options for tax-advantaged savings beyond my 401(k) and HSA, the appeal of tax deferral was strong. The plan also offered the possibility of early withdrawal without penalty and flexible distribution options to potentially avoid the tax hit on a lump sum. My intention was to utilize these funds in early retirement.My primary concern, of course, was the risk of the funds being subject to the employer's creditors in the event of bankruptcy. Although this seemed highly improbable at the time (after reviewing numerous online resources and discussing with participating colleagues), my company's Moody's bond rating was B1, which wasn't ideal….I invested a total of $200,000, which grew to $335,000….Following the pandemic, the company suspended the plan as a precautionary measure to boost take-home pay, coinciding with relatively low participation rates due to reduced working hours impacting everyone's income….Our company officially filed for Chapter 11 bankruptcy…the company decided to terminate the NQDCP, with plans to distribute the full balances…The stated reasons included teammates' discomfort with the plans and the unlikelihood of future contributions post-bankruptcy….Did I ultimately achieve a positive financial outcome? Yes. Did I experience considerable worry, stress, and rely on a fair amount of luck? Absolutely. Would I make the same decision again? Definitely not!
Non-qualified deferred compensation plans like 457(b)s, 457(f)s, and 409(a)s can potentially save a ton of taxes for a highly compensated employee and provide some additional asset protection. However, you must understand the ins and outs of these increasingly common plans for doctors and other professionals. Know the general rules discussed here as well as the rules specific to your plan. Get the plan document and read it before signing any contracts or participating in a plan.
What do you think? Do you have a 457(f) or 409(a)? How does yours work? Any warnings for those considering one, either as an employer or employee?
So I worked for a regional corporate group. They had a supplemental 409a that you could put a small amount of money into every year (like $1000) Their written theory was if you retire early you could use this money to supplement your income. Most people used it as a severance/moving compensation.
Probably doesn’t matter much what you do with $1,000 a year eh? Hardly seems worth the hassle and cost to run that plan though for such a small amount.
457(b) plans are also great for early retirement planning, particularly if the distribution options are highly flexible. Ours allows distributions of any amount at any time after severance, pulling from the Roth or traditional balances (we have some of both) however we want. If our taxable account runs out before we reach 59,5 years of age, we can use our 457(b) assets to bridge the gap without any penalty or slightly difficult setup like a SEPP.
That’s a remarkably flexible 457(b). That’s pretty unusual.
It’s aggravating though perhaps not unsurprising that many 457 plans have lousy distribution options. Are the company committees that decide plan benefits and distribution options subject to the same fiduciary duty that other retirement plans are? It seems hard to fathom that a lump sum distribution would ever be in the best interest of the employee (aside from a company going bankrupt which is unlikely).
I don’t know that they do have the same fiduciary duty, but you’re right that a lump sum at separation is usually the worst possible option for the separater and probably doesn’t even work as golden handcuffs for the company.
nice summary Jim. do you know what happens to these plans if a private hospital gets bought out? does the summary plan document oultine what happens, or does the tax code say these plans close once the original employer is no longer in existance?
I would assume they continue with the new owner in just about every case if there wasn’t a bankruptcy or something.
As Jim has indicated it is important to read the document. Many plans have a change in control provision that dictates what happens.
The new company in many cases has the right to terminate 409A plans, however, they must follow the 409A regs for payout.
Is that a typo in the “if I earned 8% on $100,000 for eight years”? You meant $63k, right?
I don’t think so. I wrote:
I’d rather get $100,000 and pay 37% on it this year than get $100,000 in eight years and only pay 22% on it. In the latter situation, I would only receive $78,000 after tax in eight years. In the former, I could potentially receive much more. I would only get $63,000 if I took the money today, but if I earned 8% on $100,000 for eight years (growing to a total of $185,000) and then paid taxes (37% of $185,000 is $68,000), I would eventually receive $116,000—far more than the $78,000 I would get in the latter scenario if the money was not invested.
The point is I want the money invested. If it sat there uninvested and didn’t grow, it would still be 100K in 8 years. Then I’d have to pay tax on it at 22% (because it was earned but never taxed). Even if I had to pay a higher tax rate later (37%), the fact that it grew for 8 years makes it more money.
But you don’t get $100k to invest for 8 years. You get taxed up front to get access to a smaller pot now to invest for 8 years. No? Isn’t the comparison between getting the after-tax money now to invest vs. getting it later (with a smaller tax but also a smaller gain over the 8 years)?
It isn’t my best piece of writing I admit, but I did mean what I wrote. Let’s step back and think about what I was trying to communicate. The point is that getting the money invested matters because of time value of money.
So if the money isn’t going to be invested for years, I want to have it now, even if I have to pay more on tax on it now. Tax deferral without growth isn’t worth anything.
Now, while thinking about that, read again what I wrote and hopefully it’ll make more sense.
If you do the calculation it comes out the same just like the whole Roth vs traditional way of thinking. WCI just wrote it differently but it’s still valid. Taxed now or taxed later the math works to the same # as long as the tax rates are the same.
Is it common for a governmental 457(b) to be the only retirement plan offered? I work at a critical access hospital and while the plan is governmental and likely guaranteed, it does make me leery to have my only tax-advantaged retirement account (outside of an IRA) be owned by another entity.
Are in-plan distributions allowed for governmental 457b plans? The IRS site seems to make it seem like they would be but I can’t find any other mention of this possibly elsewhere.
I’ve seen it before.
Generally no. But the plan can allow them if it wants.
When you deal with non-qualified plans, they are exempt from ERISA if they are established for a “select group of highly compensated or management employees.” As you indicated they can be established for independent contractors too.
409A plans are technically “unfunded”. However, many companies have used trusts to “informally fund” the plans. A rabbi trust is the most prevalent and protects in the event of a change in control, change of heart or change in financial condition short of bankruptcy. I have had a handful of companies file for bankruptcy and in most cases, people were paid if the plan had assets and the employees were not insiders. However, as you point out you are at risk.
409A plans usually offer short term payout options as well as the ability to elect payments at retirement over a period. Many of our clients take advantage of a provision in the tax code known as the Source Tax Provision that allows people to defer compensation in a high-income tax state (i.e., California, NY) and retire in a zero or low-income tax state. If you follow the rules for distribution, you can avoid paying the high-income tax state on distribution. I deferred compensation in California and took distribution in Arizona and saved 8.80% (CA 13.3-AZ 4,5). This provision also applies to qualified pension plans.
The real challenge for those who work at not-for-profits is the taxation when one vests as you have outlined. If one doesn’t have these plans they should map out how they plan to take distributions from all of their plans and assets.
My employer’s 457(b) plan (non-governmental) allows tax-free rollovers into an IRA, so I guess I’m lucky. Everything I save in the account will be equivalent to pre-tax 401(k) or IRA money once I roll it over. I have 90 days after terminating employment to decide, so I will have to be on top of my game and not let that slip through the cracks.
I’m not sure it works like that. I don’t think it’s up to the plan. Are you sure it’s non-governmental and AND that you can roll it to an IRA? If so, you would be the first person I’ve ever run into that can do that.
Alternatively, I’m wrong. Let’s do a little Googling to see if we can determine that.
Looks like the IRS thinks I’m right:
https://www.irs.gov/retirement-plans/comparison-of-tax-exempt-457b-plans-and-governmental-457b-plans
Interesting. I work for a 501(c)3 organization which is not a government entity. Here is what the plan documents say:
“How can a rollover affect my taxes?
“You will be taxed on a payment from the Plan if you do not roll it over. If you are under age 59½ and do not do a rollover, you will also have to pay a 10% additional income tax on early distributions (generally, distributions made before age 59½), unless an exception applies. However, if you do a rollover, you will not have to pay tax until you receive payments later and the 10% additional income tax will not apply if those
payments are made after you are age 59½ (or if an exception applies).
“What types of retirement accounts and plans may accept my rollover?
“You may roll over the payment to either an IRA (an individual retirement account or individual retirement annuity) or an employer plan (a tax-qualified plan, section 403(b) plan, or governmental section 457(b) plan) that will accept the rollover. The rules of the IRA or employer plan that holds the rollover will determine your investment options, fees, and rights to payment from the IRA or employer plan (for example, no spousal consent rules apply to IRAs and IRAs may not provide loans). Further, the amount rolled over will become subject to the tax rules that apply to the IRA or employer plan.
“How do I do a rollover?
“There are two ways to do a rollover. You can do either a direct rollover or a 60-day rollover. If you do a direct rollover, the Plan will make the payment directly to your IRA or an employer plan. You should contact the IRA sponsor or the administrator of the employer plan for information on how to do a direct rollover.
If you do not do a direct rollover, you may still do a rollover by making a deposit into an IRA or eligible employer plan that will accept it. Generally, you will have 60 days after you receive the payment to make the deposit. If you do not do a direct rollover, the Plan is required to withhold 20% of the payment for federal income taxes (up to the amount of cash and property received other than employer stock). This
means that, in order to roll over the entire payment in a 60-day rollover, you must use other funds to make up for the 20% withheld. If you do not roll over the entire amount of the payment, the portion not rolled over will be taxed and will be subject to the 10% additional income tax on early distributions if you are under age 59½ (unless an exception applies).”
This seems like pretty standard stuff, not much different from rollover instructions for a 401(k). But the IRS link you provided sure looks like this shouldn’t be possible.
So can a 501(c)3 issue a governmental 547(b)?
I guess I need to contact the HR/Benefits office and ask for clarification.
Please do and let me know. I mean, it’s great for you if you can roll it into an IRA.
But typically, a non governmental 457(b) can only be rolled over into another non governmental 457(b).
OK, I heard back from HR. The plan documents at the plan provider apparently were incorrect, and the plan cannot be rolled over into an IRA. Only into another 457(b). But the distribution options are pretty good. Here they are:
“• Transfer to an eligible retirement plan that satisfies Code 457(e)(1)(B) (amounts cannot be rolled over to an IRA)
• Lump-sum
• Periodic Payments (monthly, quarterly, semi-annually, annually)
• Fixed Amount – over a period of time not to exceed life expectancy
• Fixed Period of Time – time period cannot exceed life expectancy”
And here is the specific verbiage about payment by installments on the election form:
“Installments are processed on the 17th calendar day of every month. (This is regardless of the period over which you take your installment.) I understand my election may not be revoked, however if I selected a date that is after I attain the age of 72 (or 70½ if you were born before July 1, 1949), my installments will begin by my Required Beginning Date.
• Monthly/Quarterly/Semi-Annual/Annual payments over a period of _______ years
NOTE: The period of time over which you receive these payments cannot be greater than your life expectancy.
• Monthly/Quarterly/Semi-Annual/Annual payments of $ _________
NOTE: Your final payment may vary based on account balance and market fluctuation. The period of time over which you receive these payments cannot be greater than your life expectancy.”
So it looks like I can choose my own distribution plan duration, as long as it is within my life expectancy, but I can’t change my mind once I set it up. I can throttle my distribution so that I don’t ever get a tax bomb from it. My employer has very little risk of going bankrupt, as it is a growing system that is dominant in my region.
I think this plan is worth using. I still have about 10 years before I am FI, and this account could have about $500k in it by then if I max it out every year. That would really come in handy if I retire early.
Yea, those options look good. Thanks for reporting back. I agree the plan is likely worth using based on what I know about it but check fees and employer financial stability and investment options too.
I heard some physician group provides another type of gold handcuff
Restricted Stock Units
This is another way to defer the compensation and sometimes the employer will put it under 409A