What Are 409A Penalties? Definition, How They Work and Examples

A failure under Section 409A sits either in the document or in operation. A document failure is a plan that permits something the rules forbid. An operational failure is 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. This covers amounts that are vested and have not already been taxed. Amounts still subject to a substantial risk of forfeiture, meaning you could still lose them, are left out until they vest. Only the participants the failure relates to are affected. But “the plan” is wider than one document. The regulation groups together all of an employer’s arrangements of the same type for each person. That means every elective account plan, every severance plan and every stock right. So one defect can taint pay under several agreements.

The 20% Additional Tax

On the amount included, the employee owes an extra 20% in federal tax. This comes on top of ordinary income tax at the employee’s own rate. It is reported on the employee’s own return.

Premium Interest

The employee also owes interest at the underpayment rate, the rate the IRS charges on late tax, plus one percentage point. The interest runs on the tax that would have been due if the pay had been taxed in the year it was first deferred. If the pay vested later, the year it vested counts instead. For individuals, the IRS resets this rate every quarter at the federal short-term rate plus three points. It set it at 7% for the quarter starting October 1, 2026. So the premium rate for that quarter is 8%.

The employer’s part is reporting. The failed amount goes on the employee’s Form W-2, in box 1 and in box 12 with code Z. The additional tax and the interest are reported on the employee’s Form 1040, the personal tax return.

An executive at a private company earns a $400,000 bonus in 2025. It vests at once and is deferred until March 1, 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.” That is no permitted payment event, and nobody corrects the amendment. She has received nothing.

Compare the last two lines. For 2026, she owes $239,840 in federal tax and interest, close to 60% of the bonus. She has received no cash, and the bonus 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.

• A discounted optionA strike price below the common stock’s fair market value on the grant date turns the option into deferred compensation with no permitted payment date. This is the reason the 409A valuation exists.
• Paying on an event the rules do not allowExamples are “when the board decides,” “on a funding round” and “on a sale of 25% of the assets.” None of these is a permitted event.
• Paying earlyAccelerating a deferred payment outside the regulation’s exceptions, even at the employee’s request.
• Late electionsA deferral election made after the start of the year in which the work is done. The only exceptions are the narrow first-year and performance-pay windows.
• Missing the six-month delayPaying a specified employee of a public company on separation without the delay. See 409A specified employee.
• Missing a deadline it was relying onA bonus or RSU meant to be a short-term deferral can be paid after the deadline. It is then no longer exempt and has to meet every 409A rule.

Often, if it is caught early. Three IRS notices set out correction methods, and none needs an application. Relief is not available while the employee’s return is under IRS examination for deferred compensation. For document failures, the same applies to the employer’s return. Statements describing the failure and the fix have to be attached to the tax returns.

Notice 2008-113: operational failures

Issued in December 2008. A mistake corrected in the same tax year can avoid the penalties entirely, for example by repaying a payment made in error. Employees who are not insiders get until the end of the following year. Small amounts can be corrected by the end of the second year after the failure, with lighter consequences. The ceiling is the annual §402(g) elective deferral limit, the yearly cap on employee contributions to a 401(k). The notice also gives limited relief for options granted below fair market value. IRB 2008-51

Notice 2010-6: document failures

Issued in January 2010. It lets a company amend plan language that breaks the rules. For some failures, the corrected term may be triggered within a year of the fix. The employee then still includes 25% or 50% of the amount deferred in income. The notice does not cover stock rights. Notice 2010-6

Notice 2010-80: modifications

Issued in December 2010. It widened the plans eligible under Notice 2010-6. It added a correction method for certain document failures in payments on separation from service. It also changed the reporting rules in both notices. IRB 2010-51

• Assuming the company paysThe statute puts the tax on the employee. A gross-up, an extra payment from the employer to cover the tax, happens only if agreed. That payment is itself taxable pay.
• Waiting for the payment dateThe tax is due for the year of the failure. The year of payment does not matter. Finding the problem at payout can mean years of interest.
• Looking at one agreementPlans of the same type with the same employer are grouped together. So a defect in one arrangement can pull in the others.
• Forgetting the stateCalifornia adds 5%. Check how your own state treats the same income.
• Letting the year endCorrections made in the same year carry lighter consequences than later ones. Each year that passes narrows the options.

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, such as a payment made early, late or in 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.

Underpayment rate

The interest rate the IRS charges on late tax. For individuals, it is the federal short-term rate plus three points, reset every quarter.

Substantial risk of forfeiture

A condition, such as staying in the job, under which you could still lose the pay. Amounts under one are left out until they vest.

Insider

In Notice 2008-113, a director or officer of the employer, or a beneficial owner of more than 10% of any class of its equity. Insiders get less time to correct.

Code Z

The Form W-2 box 12 code for income under a plan that fails Section 409A.

Section 409A

The tax code section that sets the rules a plan has to meet to avoid these consequences.

Every rule and figure was checked against the statute, the Treasury regulations, the IRS and the California code on October 2, 2026. The underpayment rate is reset every quarter. The worked example is illustrative arithmetic with stated assumptions. It does not compute anyone’s actual liability.