Internal Revenue Code (IRC) Section 457 details tax consequences for deferred compensation retirement plans for tax-exempt organizations (EOs) and state and local government entities (S&L plans). Plans that meet certain eligibility requirements under Section 457(b) have deferred tax benefits, and those that fail to meet these requirements are subject to tax consequences under Section 457(f). Here are some common mistakes that occur concerning EO 457(b) plans.
First, EOs often confuse 457(b) plans with S&L plans, which are distinctly different. S&L plans are more like 401(k) plans in that all employees may participate in these plans, their assets are held for the exclusive benefit of the employees, and they may have other beneficial features for participants, including age 50 catch-up contributions, participant loans, rollovers to other types of plans, and more. In contrast, EO 457(b) plans may not have these features. Without proper guidance, one danger is that an EO will mistakenly and impermissibly adopt an S&L plan instead of a 457(b) plan.
Also, confusion still exists between 457(b) plans and 457(f) plans. While 457(b) plans offer a tax advantage, in that contributions are only taxable once they are paid out or otherwise made available to participants, 457(f) plans do not offer that same advantage. Contributions to 457(f) plans are taxable when they are vested or no longer at substantial risk of forfeiture, regardless of when they are paid out. Another distinction between the plans is that there is an annual limit on 457(b) plan contributions ($22,500 in 2023) but no annual limit on 457(f) contributions.
Furthermore, EO 457(b) plans are so-called “top hat” plans in that they may only benefit a specific group of management or highly compensated employees; they may not benefit all employees of an organization. As top hat plans, EO 457(b) plans need not file an annual Form 5500 return but must file a one-time top hat statement with the U.S. Department of Labor.
EO 457(b) plans also have special rules about elective deferrals by participants. Elective deferrals for a 457(b) plan are only valid if the participant makes the deferred election in writing before the beginning of the month in which they want to exercise the elective deferral. As a result, unlike a 401(k) plan, a participant cannot make an annual deferral election in January for that calendar year, even prior to the first pay period. Instead, to ensure that the elective deferral is valid beginning in January, the participants must make the deferred election in writing in December of the previous year. While SECURE 2.0 eliminated this requirement for S&L plans, it did not eliminate this requirement for 457(b) plans.
Finally, as previously mentioned, 457(b) plans have an annual contribution limit for 2023 of $22,500, which happens to be the same as the contribution limit for a 401(k) or 403(b) plan. However, these are independent and separate contribution limits. Therefore, a plan participant can defer $22,500 into an EO employer-sponsored 401(k) plan and another $22,500 into an EO 457(b) plan. However, the total contribution for the 457(b) plan must include any employer nonelective or matching contributions. In other words, the $22,500 annual contribution limit applies to the employee and employer contributions combined.
Importantly, one must note that in a 457(b) plan, employer contributions only count against the contribution limit once they vest. During the vesting year, contributions may easily exceed the annual contribution limit. In that case, the employer would have to correct the problem by distributing the amount above the annual contribution limit to the participant by April 15 of the year following the vesting. This distribution would be taxable to the plan participant. Otherwise, the plan no longer qualifies as a 457(b) plan and becomes taxable under 457(f).
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