Tax-Exempt 457(b) Plans: Key Characteristics and Common Mistakes
Eligible 457(b) plans maintained by state or local governments (governmental 457(b) plans) share many characteristics with qualified plans, such as 401(k) plans. In contrast, eligible 457(b) plans maintained by non-governmental tax-exempt entities (tax-exempt 457(b) plans) are very different from qualified plans or governmental 457(b) plans. Compare a tax-exempt 457(b) plan and a governmental 457(b) plan using this chart.
Some unique features of a tax-exempt 457(b) plan include:
Plan must be unfunded.
The plan may have separate bookkeeping and accounting to determine amounts owed to participants, but the amounts must be subject to the claims of the employer’s creditors. The amounts used to pay participants must come from the tax-exempt entity’s general assets. The assets can’t be segregated into a separate trust established for the exclusive benefit of participants and their beneficiaries, even if a portion represents employee salary reduction deferrals. However, the tax-exempt entity may place the assets in a rabbi trust. A rabbi trust’s assets are available to satisfy the claims of the tax-exempt entity’s creditors.
Contributions to a funded plan are immediately taxable to the participants.
The plan must be limited to provide benefits for a select group of management or highly compensated employees. Otherwise, the plan is subject to the Employee Retirement Income Security Act (ERISA) Title I funding requirements.
Plan can’t make loans to participants.
The amount of any participant loan is treated as a plan distribution to the participant. The loan may also violate the limitation on the events under which a plan can make a distribution.
In general, distributions to participants can be made following any of these events:
- Attainment of age 70 ½
- Severance from employment
- Unforeseeable emergency
- Plan termination
- Distribution of small amounts
So, a loan could cause the plan to fail to meet the requirements of an eligible 457(b) plan.
Plan can’t permit age-50 catch-up contributions.
However, the plan may permit participants to make the special catch-up in the last three eligible plan years before their normal retirement age.
Excess deferrals (and any allocable income) must be returned to the participant by April 15 after the end of the taxable year in which they were made.
Otherwise, the plan fails to be an eligible 457(b) plan.
Taxation when amount is paid or made available.
Even if plan assets haven’t been distributed, they’re includible in a participant’s income in the taxable year they’re made available to the participant.
Participants in a tax-exempt employer’s deferred compensation plan that doesn’t satisfy the requirements of Internal Revenue Code section 457(b) are subject to the taxation requirements of IRC section IRC 457(f).
It’s critical for tax-exempt employers to understand the rules that apply to an eligible 457(b) plan before deciding on this plan for its employees. If a tax-exempt employer wants to sponsor a plan that covers a broad cross section of employees, it may consider adopting other types of plans, such as a 401(k) plan or 403(b) plan. (403(b) plans are limited to an organization that is tax-exempt under IRC 501(c)(3)).
The unique characteristics identified above are also the source of mistakes tax-exempt employers that have 457(b) plans make. This may be because the tax-exempt sponsor is unaware of these key differences or because they mistakenly adopt and operate a governmental 457(b) plan. In many cases, they may not correct their 457(b) plans on a provisional basis outside of Employee Plans Compliance Resolution System (EPCRS) for failures related to an unfunded plan benefiting selected management and highly compensated employees. However, the IRS may consider closing agreements proposals to mitigate the impact on non-highly compensated employees or other circumstances (for example, the tax-exempt employer erroneously included non-highly compensated employees in their 457(b) plan).