What are 409A penalties? Definition, how they work and examples
What a 409A failure costs the employee, not the company — immediate income, the 20% additional tax and interest, worked through, and the correction programmes.
The short answer
409A penalties are the tax costs an employee bears when a deferred compensation plan breaks Section 409A: every vested amount deferred under the plan becomes taxable that year, a 20% additional tax is added on top, and premium interest is charged at the IRS underpayment rate plus one percentage point. They fall on the employee, not on the company that wrote the plan — and they are due on money the employee may not have received.
How do 409A penalties work?
A failure under Section 409A is either in the document — a plan that permits something the rules forbid — or in operation — a plan that is written correctly and then not followed. Either way, three things follow for the year of the failure. Income inclusion Everything deferred under the plan for that year and every earlier year becomes ordinary income now, to the extent it is vested and has not already been taxed. Amounts still subject to a substantial risk of forfeiture are left out until they vest. Only the participants the failure relates to are affected.
Example of 409A penalties: a $400,000 deferral
An executive at a private company earns a $400,000 bonus in 2025. It vests at once and is deferred until 1 March 2030 under a plan that complied. In 2026 the board amends the plan so that it may pay the bonus “at any time it decides” — a payment that is not on a permitted event — and nobody corrects the amendment. She has received nothing. The striking line is the last one. Close to 60% of the bonus is owed in federal tax and interest in 2026 on money that is not due to her until 2030. If she lives in California, the state adds its own 5% — another $20,000 — on top of its ordinary income tax.
What triggers a 409A violation in a private company?
A discounted option A strike below the common stock’s fair market value on the grant date turns the option into deferred compensation with no permitted payment date — the reason the 409A valuation exists. Paying on an event the rules do not allow “When the board decides”, “on a funding round”, “on a sale of 25% of the assets” — none of these is a permitted event. Paying early Accelerating a deferred payment outside the regulation’s exceptions, even at the employee’s request.
The 409A penalty rules, as of October 2026
Can a 409A failure be fixed?
Often, if it is caught early, through three IRS notices that set out correction methods. None needs an application. Relief is not available while the employee’s return — and, for document failures, the employer’s — is under IRS examination for deferred compensation, and statements describing the failure and the fix have to be attached to the tax returns. Notice 2008-113 — operational failures Issued December 2008. A mistake corrected in the same tax year — the erroneous payment repaid, for example — can avoid the penalties entirely.
Key risks and common mistakes
Assuming the company pays The statute puts the tax on the employee. A gross-up from the employer is possible only if agreed, and it is itself taxable pay. Waiting for the payment date The tax is due for the year of failure, not the year of payment. Discovering it at payout can mean years of interest. Looking at one agreement Aggregation means a defect in one arrangement can pull in others of the same type with the same employer. Forgetting the state California adds 5%. Check how your own state treats the same income.
The terms this page uses
Document failure A plan whose written terms break a 409A rule, whether or not anyone has been paid under them yet. Operational failure A correctly written plan that was not followed — a payment made early, late or to the wrong amount. Additional tax The 20% federal tax added to ordinary income tax on amounts included because of a failure. Premium interest Interest at the underpayment rate plus one point, measured from the year the pay was first deferred or vested.
What people ask about 409A penalties
Who pays 409A penalties, the employer or the employee? The employee. The income inclusion, the 20% additional tax and the interest are all imposed on the person whose pay was deferred. The employer reports the amount and bears the cost of correcting the plan. Are unvested amounts taxed when a plan fails? No. Amounts still subject to a substantial risk of forfeiture are left out. They are included when they vest, if the failure has not been corrected by then. How much is the 409A penalty?
Who pays 409A penalties, the employer or the employee?
The employee. The income inclusion, the 20% additional tax and the interest are all imposed on the person whose pay was deferred. The employer reports the amount and bears the cost of correcting the plan.
Are unvested amounts taxed when a plan fails?
No. Amounts still subject to a substantial risk of forfeiture are left out. They are included when they vest, if the failure has not been corrected by then.
How much is the 409A penalty?
A 20% additional federal tax on the amount included, plus ordinary income tax on it and interest at the underpayment rate plus one point. From 1 October 2026 the underpayment rate for individuals is 7%. California adds 5% of its own.
Can the IRS waive 409A penalties?
Not case by case. The route is the correction programmes in Notices 2008-113 and 2010-6, as modified by Notice 2010-80, which reduce or remove the consequences when a failure is fixed in time and in the prescribed way.
What is the difference between a document failure and an operational failure?
A document failure is in the plan’s text — a payment event the rules do not allow, or discretion over timing. An operational failure is a correct plan that was not followed, such as a payment made early. They are corrected under different notices: 2010-6 for documents, 2008-113 for operation.
Where every rule on this page comes from
Every rule and figure was checked against the statute, the Treasury regulations, the IRS and the California code on 2 October 2026. The underpayment rate is reset every quarter. The worked example is illustrative arithmetic with stated assumptions, not a computation of anyone’s liability.