457(b) Plans - Correction of Excess Deferrals

 

Excess deferrals made to an eligible deferred compensation plan may result in the loss of the plan's eligible status under IRC Section 457(b) unless they're timely corrected. The requirements for timely correction of deferrals are different for an eligible 457(b) plan maintained by a non-governmental tax-exempt organization (tax exempt 457(b) plan) and a 457(b) plan maintained by a governmental entity ("governmental 457(b) plan"). This Issue Snapshot discusses correction of excess deferrals under a 457(b) plan maintained by a tax-exempt entity and a government, respectively.

IRC Section and Treas. Regulations

Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)

Analysis

An "annual deferral" is compensation deferred under an eligible plan by salary reduction or by nonelective employer contribution. It is taken into account as an annual deferral in the later of the taxable year deferred or the year in which it's no longer subject to a substantial risk of forfeiture. See Reg. Section 1.457-2(b)(1). The term "annual deferral," used in this Issue Snapshot, means an annual deferral vested for the year in question.

Maximum Limitations on Annual Deferrals:

Basic Annual Limit

A 457(b) plan must provide that annual deferrals can't exceed the lesser of the applicable dollar amount in effect for the participant's taxable year or 100 percent of includible compensation. The applicable dollar amount equals $15,000, as adjusted for cost-of-living increases under IRC Section 415(d). See IRC Section 457(e)(15). For 2020, the applicable dollar amount equals $19,500.

Increased Limit for Catch-Up Contributions

The basic annual limit may be increased by amounts available under the special 457 catch-up or the age 50 catch-up. Under the special 457 catch-up, an eligible plan may provide for an increased plan ceiling during the last three taxable years ending before normal retirement age. The increased ceiling is the lesser of twice the applicable annual dollar amount, or the "underutilized limitation." The underutilized limitation is the sum of the plan ceiling for each year of participation, less the amount of deferrals made in prior years, disregarding any deferrals made under the age 50 catch-up.

The age 50 catch-up applies to governmental 457(b) plans and not tax exempt 457(b) plans. The age 50 catch-up equals the lesser of: (1) the applicable dollar amount as defined in IRC Section 414(v)(2), or (2) the excess of the participant's compensation under IRC Section 415(c)(3) for the year over any other elective deferrals of the participant for such year that are made without regard to IRC Section 414(v). See IRC Section 414(v)(2). For purposes of governmental 457(b) plans, the applicable dollar amount equals $5,000 as adjusted for cost-of-living increases. For 2020, the applicable dollar limitation for catch-up contributions to a governmental 457(b) plan for individuals age 50 or over equals $6,500. Under a governmental 457(b) plan that permits contributions under the age 50 catch-up and the special 457 catch-up, the catch-up that yields the larger amount applies.

Excess Deferrals:

Annual deferrals made in the taxable year that exceed the above maximum deferral limitations are considered excess deferrals. The regulations under IRC Section 457 distinguish between excess deferrals that arise as a result of the individual limitation and those due to the plan's failure to apply the deferral limitations. In determining whether there is an excess deferral resulting from a plan failure, all eligible plans of the employer are treated as a single plan ("plan limitation"). In contrast, the individual limitation is applied by counting annual deferrals under all eligible plans of all employers for the taxable year. See IRC Section 457(c).

Correction of Excess Deferrals Due to Plan Limitation:

Tax Exempt 457(b) Plans

Annual deferrals in excess of the plan limitation that are made to a tax exempt 457(b) plan must be corrected by April 15 of the taxable year following the close of the taxable year of the excess. If the plan distributes the excess deferrals, plus allocable earnings by April 15, the plan will continue to be treated as an eligible plan. If the plan deferrals aren't corrected by such a distribution, the plan will be considered an ineligible plan under IRC Section 457(f). See also Revenue Procedure 2019-19 for cases where a top hat-type 457(b) plan is used erroneously by a tax exempt entity to provide benefits to all employees in a case where it is treating the 457(b) plan much like a 401(a) qualified retirement plan.

Governmental 457(b) Plans

In a governmental 457(b) plan, excess deferrals arising from application of the plan limitation must be distributed, along with allocable net income, as soon as administratively practicable after the plan determines there is an excess deferral. Failure to correct the excess deferral as soon as administratively practicable causes the plan to become an ineligible plan and benefits under the plan are taxable as required under Reg. Section 1.457-11. See Reg. Section 1.457-4(e)(2).

The Employee Plans Compliance Resolution System (EPCRS) doesn't apply to 457(b) plans; however, Revenue Procedure 2019-19 provides that the IRS will accept a submission relating to a 457(b) plan outside of EPCRS through standards similar to those that apply to the Voluntary Correction Program. The availability of correction is generally limited to governmental 457(b) plans, except as outlined above.

Excess Deferrals Due to Individual Limitation:

All excess deferrals are includible in gross income in the taxable year of the excess deferral. See Reg. Section 1.457-4(e)(1). An eligible plan may be written to provide that an excess deferral that results solely from a failure to comply with the individual limitation for a taxable year may be distributed to the participant, with allocable net income, as soon as administratively practicable after the plan determines that the amount is an excess deferral. Such a distribution of excess deferrals will not cause a plan to fail to comply with IRC Section 457(b). See Reg. Secton 1.457-4(e)(4). When excess deferrals caused by application of the individual limitation aren't distributed, a plan will still maintain eligible status; however, the participant must include the excess deferrals in income. See Reg. Section 1.457-5(a).

Tax Treatment and Reporting:

Excess deferrals, when corrected timely, are taxable in the year of deferral. The earnings on the excess are taxable in the year of distribution.

In an eligible 457(b) tax exempt plan, the excess deferrals are taxable in the year of deferral and must be distributed prior to April 15th of the following year. Only the earnings on the excess deferrals are subject to income tax in the year of distribution, and such earnings should be reported on Form W-2 for the year of distribution. If an eligible plan becomes ineligible because excess deferrals aren't timely distributed, amounts become taxable in accordance with Reg. Section 1.457-11.

See Notice 2003–20, 2003–19 I.R.B. 894, for information regarding the withholding and reporting requirements applicable to eligible plans in general.

Issue Indicators or Audit Tips

  • Review W-2, Box 12 to determine if deferrals exceed the IRC Section 457(b) dollar limit in effect for the year. Verify if these excess amounts were due to allowable catch-up contributions. Annual deferrals made to eligible 457(b) plans are reported in Box 12 of Form W-2, using Codes G and EE (Roth contributions).
  • Request documentation to verify timely distribution of excess deferrals.
  • Review Forms W-2 and 1099-R for proper reporting of distributions.