Internal Revenue Code Section 457 provides tax-advantaged treatment for certain non-qualified deferred-compensation plans. A 457 plan sponsor must be either:

  • a governmental unit (a state or political subdivision of a state or an agency or instrumentality of one of these), or
  • an entity exempt from income tax under IRC Section 501(c) (a non-governmental sponsor).

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 non-governmental 457(b) plans as well as common plan errors are discussed below.

Key features of non-government 457(b) plan

Plan must remain unfunded

Non-governmental 457 plans must remain unfunded. Plan assets are not held in trust for employees but remain the property of the employer (available to its general creditors in the event of litigation or bankruptcy). Non-governmental 457(b) plans commonly use "rabbi trusts" to hold employee deferrals. The rabbi trust is funded, but the trust assets remain available to creditors. Employees are lower in priority than general creditors in the event of legal claims against the employer.

Select group of management or highly compensated employees

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.

While there is no formal legal definition of a "select group of management or highly compensated employees," it generally means a small percentage of the employee population who:

  • are key management employees, or
  • earn a salary substantially higher than that of other employees.

Over the years, the courts and the Department of Labor have looked at one or more factors:

  • total employees versus the number of employees covered under the plan
  • the average salaries of the select group versus the average salaries of other employees,
  • the average salaries of the select group versus the average salary of all management or highly compensated employees,
  • range of salaries of employees in the select group, and
  • the extent to which the select group can negotiate salary and compensation packages.

Taxation of regular contributions

Contributions to a funded plan are immediately taxable to the participants. Contributions to 457(b) plans may include employee salary deferrals and employer contributions. The contributions are reported on Form W-2.

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) 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).

Ineligible 457(f) plans distinguished

Non-governmental 457 plans can be established by tax-exempt organizations as:

  • "eligible" under IRC Section 457(b), or
  • "ineligible" under IRC Section 457(f).

Non-governmental, tax-exempt entities can establish 457(f) (ineligible) plans that are tax deferred and that allow contributions exceeding the annual deferral limit. These plans and the associated deferrals are possible only if there is a "substantial risk of forfeiture" – when the risk has been removed, the participant's deferral amounts become taxable.

Catch-up contributions

  1. Age 50 catch-up contributions for participants who are age 50 or older at the end of the current tax year:
    • are allowed in governmental 457(b) plans
    • are not allowed in non-governmental 457(b) plans.
       
  2. Catch-up contributions for participants who are within 3 years of normal retirement age:
    • Available for both governmental and non-governmental 457(b) plans.
    • Allows eligible employees to contribute up to another full employee deferral limit.
    • Amount limited to "unused" deferrals from previous years.
    • An employee who already deferred the maximum in the 457(b) plan for all years of employment would not be able to use this type of catch-up.
    • The three year period must be continuous and must not include the year of retirement.
    • This provision requires the compilation of prior year underused limits, and the potential for errors is high, due primarily to the lack or inaccuracy of historical records.

Filing and reporting requirements

IRC Section 457 plans aren't required to file Form 5500, because they aren't subject to Title I of ERISA. However, non-governmental 457(b) (Top Hat) plans must file a notification of the plan's existence with the Department of Labor.

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. See Correction of excess deferrals in 457(b) plans.

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.

Common errors in non-governmental 457(b) plans

Check your plan operations for these common errors.

  1. Failure to limit participation in a non-governmental 457(b) plan subjects the plan to ERISA Title I funding requirements.
     
  2. Non-governmental 457(b) plans that must comply with the ERISA funding requirements will fail to satisfy IRC 457(b)(6), which provides that the plan must be unfunded.
     
  3. Contributions to a funded non-governmental 457(b) plan are immediately taxable.
     
  4. The plan fails to follow the unforeseeable emergency 457(b) plan distribution rules.

    Improper administration of unforeseeable emergency distributions is a frequent source of errors for 457(b) plan sponsors. Hardship distributions from a 457(b) plan are only permitted when a participant is faced with an unforeseeable emergency and where the amount of these distributions doesn't exceed the amount reasonably necessary to satisfy the emergency need. Although determining whether a participant or beneficiary is faced with an unforeseeable emergency is based on the facts and circumstances of each situation, rules and examples defining "unforeseeable emergency" must be applied. Errors made in administering these distributions include mistaken determinations, inadequate documentation and distributions that exceed the amount needed for the unforeseeable emergency. See unforeseeable emergency distributions from 457(b) plans for additional information.
     
  5. The plan fails to comply with IRC Section 457(b) catch-up limitations

    Generally, 457(b) plans can allow for two types of catch-up provisions. The first is the age 50 catch-up contributions for governmental employers only. This is the same age 50 catch-up as used in 403(b) and other defined contribution plans and amounts to an additional $6,500 in 2021 and 2020

    The second (available to all eligible employers) is available to 457(b) plan participants who are within 3 years of normal retirement age. This catch-up feature can be equal to the annual employee deferral limit for the year ($19,500 in 2021 and 2020; $19,000 in 2019; and $18,500 in 2018) so it can effectively double this limit in a given year. However, the IRC Section 457(b)(3) catch-up increase is limited to unused deferral limits from previous years. Participants who previously deferred the maximum amount of money into a 457(b) plan every year they were eligible for that plan would not be able to use this extra 457(b)(3) catch-up. Participants in eligible 457(b) plans may only use it in the last 3 tax years prior to the tax year in which the participant reaches normal retirement age under the terms of the 457(b) plan. For a governmental 457(b) plan the IRC Section 457(b)(3) catch-up contributions can't be combined with age 50 catch-up contributions in any year, so eligible participants are limited to contributing the higher of their age 50 catch-up increase or their IRC Section 457(b)(3) catch up increase.

    See the contribution limits for 457(b) plans. Model amendments for this catch-up provision can be found in Sections 3.3 and 3.4 of Revenue Procedure 2004-56.
     
  6. The plan fails to comply with IRC Section 457(b) permissive service credit transfer rules

    An eligible governmental 457(b) plan may permit participants and beneficiaries to transfer deferred amounts to defined benefit governmental plans for the purpose of purchasing permissive past service credit under the receiving defined benefit governmental plan. Permissive past service credit is credit for a period of past service recognized by a governmental defined benefit plan. Both the transferee and receiving plans must permit the transfers and the receiving plan must also prevent the amount transferred from exceeding the amount necessary to fund the benefit resulting from the past service credit on an actuarial basis. The participant and beneficiary must voluntarily contribute the transferred amount to the defined benefit governmental plan in addition to any regular employee contribution required under the plan. These transfers are not treated as distributions for purposes of the IRC Section 457(b) distribution restrictions, so the transfers may be made before the severance from employment of the participant or beneficiary.

    Model amendments for this catch-up provision can be found in Section 6.04 of Revenue Procedure 2004-56 and Final Regulations Regarding Purchase of Permissive Service Credit by Plan– to–Plan Transfer