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.
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?
