On November 1, 2023, the IRS announced the inflation adjusted benefit plan limitations effective in 2024 in Notice 2023-75. The good news is the amount that can be electively deferred into a 401(k) or 403(b) plan increases from the current $22,500 to $23,000. However, the age 50 catch-up contribution remains the same as in 2023 at $7,500. The annual limit for contributions to a 457(b) plan also increases to $23,000. However, keep in mind while deferrals to a 401(k) or 403(b) plan share the one limit under Internal Revenue Code (Code) section 402(g), 457(b) plans have a separate independent limit.

Other important increases included the total compensation that can be considered under a qualified plan increasing from $330,000 to $345,000. The amount of compensation to be considered a Highly Compensated Employee under Code section 414(q) goes up to $155,000 from $150,000. The Code section 415 limit on the annual benefit from a defined benefit plan increased from $265,000 to $275,000. And the maximum annual contribution to a defined contribution plan under Code section 415 increased from $66,000 to $69,000.

Last month, in Part 1 of this blog on 10 common mistakes in 457 plans sponsored by tax exempt organizations (EOs), I gave the first five common mistakes I’ve seen in my practice working with these sponsors. See “Ten Common Mistakes in 457 Plans of Tax Exempt Organizations–Part 1“. This Part 2 continues with the next 5 common mistakes I see in these plans, including the taxation of 457(f) plans.

6. Failing to Amend Plans. From time to time 457 Plans must be amended for changes in the law. Some sponsors have a tendency to “set it and forget it” and may miss an important amendment. Likewise, they may have a service provider that alerts them to necessary and permitted changes to their 401(k) or 403(b) plan but not the 457 Plan.

For example, 457(b) plans are subject to the Required Minimum Distribution (RMD) rules. The SECURE Act raised the age at which participants must begin taking RMDs from 70 1/2 to age 72. The SECURE 2.0 Act raised it again to age 73. Many sponsors aren’t aware of this. These changes must be reflected in the plan document which will necessitate an amendment. Additionally, 457(f) plans are subject to Code section 409A and ERISA’s claims procedures and should have been amended to comply with these laws.

7. Income Taxation of 457(f) Plans. Many EOs maintain both a 457(b) and 457(f) Plan for their executives with the 457(f) Plan providing benefits above the annual limit allowed under 457(b) ($22,500 in 2023). The key difference between a 457(f) Plan and 457(b) Plan is taxation in two respects. First, a participant is subject to income tax on the benefits under a 457(f) Plan when they become vested. This can cause mistakes in failing to report and collect the tax upon vesting. Also, it’s important to note that if a 457(f) Plan provides a participant will get a distribution upon separation from service, with nothing more, then the participant is vested immediately because he or she could voluntarily terminate employment at any time and get his or her distribution. Therefore, such a plan would not defer tax. Providing that the participant will receive a distribution upon separation from service after age 65 if he or she was continuously employed until then, would mean the participant becomes vested at age 65, even if still employed. This would mean the entire account balance would be subject to income tax in the year the participant reached age 65, even if he or she did not separate from service. Many sponsors have mistakenly believed if the benefit wasn’t distributed, it wasn’t taxable.

8. FICA Taxation of 457 Plans. Whether it is a 457(b) Plan or a 457(f) Plan sponsored by an EO, the plan is treated as a nonqualified deferred compensation plan for purposes of the FICA employment taxes. FICA taxes consist of Social Security and Medicare taxes which are imposed on the employee and employer.  The employee portion is withheld from the employee’s wages and the employer matches it. However, while there is a limit on the amount of wages subject to Social Security taxes known as the Social Security Taxable Wage Base ($160,200 in 2023), the Medicare portion is unlimited.

The Social Security withholding rate is 6.2% of wages up to the wage limit.  The Medicare tax rate is much lower at 1.45%, however there is no limit on the amount of wages taxed.  There is an additional .9% Medicare tax rate on earned income above a threshold based on filing status ($250,000 for married joint filers). This amount is not withheld but paid by the employee on his or her income tax return.

As mentioned, 457 Plans are considered nonqualified deferred compensation plans for FICA purposes. Nonqualified deferred compensation is subject to FICA taxes on the later of when the services giving rise to the compensation are performed and the date the employee’s right to the deferred compensation is no longer subject to a substantial risk of forfeiture, i.e., vested.  Thus, elective salary reduction contributions to an EO 457(b) Plan are subject to FICA withholding when made because they are fully vested.  That is, the elective deferrals are post-FICA taxes. Employer contributions will be subject to FICA when they vest as will any vested earnings. Therefore, a participant in an EO 457(f) plan will be subject to both income tax and FICA tax upon vesting. Often, employer contributions aren’t made until late in the year, and can escape Social Security taxes altogether because they are not made until after the Participant has already earned the $160,200 Social Security Taxable Wage Base limit for the year and had the maximum Social Security taxes withheld. However, the Medicare Tax still applies.

If the deferred compensation is properly taken into account at vesting, then neither it nor any earnings on it will be subject to FICA taxes again when paid. This can be a significant savings. However, if the EO makes the mistake of not accounting for the deferred compensation at vesting, the contribution and all earnings will be subject to FICA when paid. This can cause both the employer and employee to pay otherwise avoidable Social Security taxes. Additionally, if the plan document says that the employer will account for FICA taxes at vesting but the employer fails to do so, it may be contractually liable to the employee for the FICA taxes due on payment.

9. Code Section 409A. Code section 409A governs nonqualified deferred compensation plans and regulates how amounts can be electively deferred, the time and form of distributions, and generally prohibits acceleration of distributions. The consequences of failing to comply with Code section 409A are that the participant is taxed on his or her entire vested benefit, plus such amount is subject to an additional 20% federal tax (California has its own additional 5% tax), and any interest due is charged at a rate that is a full percentage point higher than the going rate for taxes.

Certain plans such as qualified plans and 457(b) plans are exempt from Code section 409A as not being considered deferred compensation. However, 457(f) Plans are subject to Code section 409A. This makes mistakes in a 457(f) Plan that much more problematic. Often, the same mistake that violates 457(f) will also violate Code section 409A. For example, often when participants are approaching the year of vesting they want to push vesting out further so that they won’t be taxed on their benefit yet. This is permissible under proposed 457(f) regulations, provided the present value of the deferred compensation at the subsequent vesting date is at least 125% of the present value of the benefit at the original vesting date and the subsequent vesting date is at least 2 years later than the original. However, Code section 409A only allows subsequent deferrals if the election to subsequently defer is made at least a year before the payment was scheduled to be made and the deferral is for at least 5 years.

For example, assume a plan provides the participant vests on her 65th birthday but a month before such birthday she approaches her employer explaining she is in a high tax bracket and asking that the plan be amended so that she wouldn’t vest until the January 1 of the year after she turned 65, so she could retire at age 65 and begin receiving benefits in the following year when she no longer has taxable salary. This change, if made, would violate both Code sections 457(f) and 409A. Additionally, as mentioned, if a deferred compensation plan of an EO does not meet the requirements of Code section 457(b), it becomes a 457(f) Plan and subject to Code section 409A, making the consequences of mistakes in 457(b) Plans that much more dire.

10. Excise Tax on Compensation Above $1,000,000. Code section 4960 imposes an excise tax of 21% on an applicable tax exempt organization that pays compensation to an individual in excess of $1 million in any given year.  The amount of deferred compensation included for purposes of Code section 4960 in a given year is the present value of any deferred compensation when it vests.  Thus, the vested portion of a 457(b) or 457(f) plan will count against the $1,000,000 threshold in the year of vesting. As explained above under “”FICA Taxation of 457 Plans”, often employer contributions to EO 457 Plans don’t vest for many years and vest late in the year to save Social Security taxes. However, adding the entire vested benefit to the participant’s other taxable compensation for the year could push them over the $1,000,000 annual threshold subjecting the EO to the excise tax.

Conclusion. This article has listed 10 common mistakes I’ve found in EO 457 Plans. There are others. Fortunately, if mistakes are caught soon enough, they can often be “corrected” to preserve the tax advantages of the plan. The best advice for EO sponsors is to really know and understand the terms and operation of the plans. Additionally, the operation of the plan should be reviewed at least annually so that any mistakes can be identified and addressed timely.

In May, I blogged how 457 plans are bipolar in two ways. First, Internal Revenue Code (Code) section 457 describes the tax consequences of unfunded deferred compensation plans for both tax exempt organizations and state and local governments and the rules for each are quite different. Second, it describes the income tax consequences of eligible plans that meet the requirements of Code section 457(b) (457(b) Plans), and also describes the consequences of those plans that fail to meet Code section 457(b) and are taxed under Code section 457(f)(457(f) Plans).

In the next two blog articles I will discuss 10 common mistakes I’ve seen in 457 plans sponsored by tax exempt organizations (EOs). It’s important to note that they will not be discussing 457 plans sponsored by state and local governments (S&L Plans). However, both 457(b) and 457(f) Plans will be discussed.

  1. Confusion with State & Local Government Plans. As mentioned, EO 457(b) Plans are quite different from S&L Plans. An S&L Plan is much closer to a 401(k) plan in that it can cover all employees, it’s assets must be held for the exclusive benefit of the employees, it can have age 50 catch-up contributions, participant loans, in-service distributions, Roth deferrals, and permit roll overs to and from other types of plans. EO 457(b) Plans cannot have any of these provisions. Inexperienced tax exempt sponsors can adopt a plan with provisions that are not permitted. I’ve seen EOs, with the help of inexperienced advisors, adopt plans designed for state & local governments. It’s important to have advisors who know the difference between EO 457(b) and S&L Plans.
  2. Confusion Between 457(b) and 457(f) Plans. Confusion also happens between a 457(b) Plan and a 457(f) Plan. A 457(b) Plan enjoys the tax advantage that contributions to the plan will not be taxable to the participant until paid or otherwise made available. On the other hand, contributions to a 457(f) Plan are taxable when no longer subject to a substantial risk of forfeiture (or vested) regardless of when paid. Also, there is generally an annual limit on the amount that can be contributed to a 457(b) Plan ($22,500 in 2023). There is no limit under a 457(f) Plan. Some EOs that want to contribute more than the annual limit simply adopt a 457(f) Plan alone. Due to the better tax advantages of a 457(b) Plan, it is highly recommended that an organization adopt a 457(b) Plan for the contributions up to the annual limit and only contribute the amount in excess of the limit to a 457(f) Plan.
  3. Top Hat Requirement. EO 457 plans must be top hat plans designed to benefit a select group of management or highly compensated employees. They cannot cover all employees of the organization. Often an EO will try to cover someone that does not qualify as a member of the top hat group. Also, a top hat plan escapes the requirement to file an annual Form 5500 return, provided it files a top hat statement with the Department of Labor once. EOs sometimes fail to make this filing.
  4. Monthly Elective Deferral Rule. Unlike a 401(k) plan, elective deferrals under an EO 457(b) Plan are only valid for a given month if the deferral election was made by the participant in writing prior to the beginning of the month. This means one cannot make an annual deferral election for the year in January before the first payroll. Such an election would not be valid until February. In order to make it valid for January, it would have to be executed in December of the prior year. SECURE 2.0 eliminated this requirement for S&L Plans but not those sponsored by EOs.
  5. Contributing Too Much to 457(b) Plan. As mentioned, there is an annual limit on how much can be contributed annually for a participant in a 457(b) Plan. That amount is $22,500 for 2023. This happens to be the same amount that can be electively deferred into a 401(k) or 403(b) plan. However, it is a separate limit. A participant can defer $22,500 into a 401(k) plan sponsored by his or her EO employer and still have another $22,500 contributed to a 457(b) Plan sponsored by that employer. Contributions can be employee elective deferrals or employer nonelective or matching contributions. However, the limit is a total limit for employer and employee contributions for the year. Thus, an employee cannot defer $22,500 from salary and receive matching contributions from the employer. It is also important to note that for a 457(b) Plan, unvested employer contributions do not count against the annual limit until they vest. This can cause excess contributions in the year of vesting, if the vested account balance exceeds the annual limit for that year. For example, if an employer contributed the maximum dollar amount annually for a participant but the contributions weren’t vested until year five, the entire vested account balance would be counted as the contribution in year 5. In such case, there would be 4 year’s worth of excess contributions and the excess amount would have to be distributed to the participant by the April 15 following the end of the year of vesting and would be taxable. If not corrected in this manner, the plan will fail to be a 457(b) Plan and be taxed as a 457(f) Plan.

Stay Tuned For Part 2. This Part 1 has addressed five of ten common mistakes seen in EO 457(b) Plans . Part 2 of this article will address 5 more common mistakes found in EO 457(b) Plans . It will address employment taxes, taxation of 457(f) Plans, Code section 409A, the excise tax on compensation over $1,000,00, and plan amendments.

I am pleased to announce I will be attending the Western Benefits Conference at the Westin Kierland in Scottsdale, AZ in October. After a few years without having a conference due to the pandemic, the Western Pension & Benefits Council is bringing back the WBC. With its excellent program and top notch speakers this in-person conference is an excellent educational and networking event. Won’t you join me? See more details and register on the WPBC website.

On May 8, 2023, I wrote how guidance was sorely needed on SECURE 2.0’s self-correction of eligible inadvertent failures. See Guidance Sorely Needed On SECURE 2.0 Self-Correction of Inadvertent Failures. On May 25, the IRS issued Notice 2023-43 (Notice) providing guidance in the form of questions and answers meant to provide taxpayers guidance in advance of an update to Rev. Proc. 2021-30 containing the current version of the Employee Plans Compliance Resolution System (EPCRS). However, while the Notice provides some answers, many questions remain, requiring more substantive guidance. The Notice provides answers to two of the questions I raised in my prior article regarding a specific commitment to implementing self-correction and what is a reasonable period to complete correction. The statute provides that self-correction of an eligible inadvertent failure is not available if such failure was identified by the Secretary of the Treasury prior to any actions which demonstrate a commitment to implement self-correction with respect to the failure or the self-correction is not completed within a reasonable period after discovery.

Specific Commitment. The Notice provides that prior to EPCRS being updated, a determination as to whether an employer’s actions demonstrate a specific commitment to implement the self-correction of an identified eligible inadvertent failure will be based on all the facts and circumstances. However, the actions must generally demonstrate that the employer is actively pursuing correction. The mere completion of an annual compliance audit or general statement of intent to correct failures when they are discovered are not actions demonstrating a specific commitment.

Under this guidance it appears the example given in my earlier article of the employer having identified that some employees were not automatically enrolled that is in the process of calculating the necessary correction amounts would be considered to have made a specific commitment.

Reasonable Period. The Notice provides that whether an eligible inadvertent failure is corrected within a reasonable period after being identified by the employer is also determined by considering all relevant facts and circumstances. It then provides a safe harbor by stating that a failure that is corrected within 18 months of being identified will be treated as having been completed within a reasonable period. For an employer eligibility failure where an employer adopts a plan that it is not eligible to adopt (e.g., a for-profit employer adopting a 403(b) plan) to be corrected within a reasonable period all contributions to the plan must cease as soon as reasonably practicable and in no event later than 6 months after the failure is identified.

Identification By The Secretary. Somewhat surprisingly the Notice provides that an eligible inadvertent failure is treated as having been identified by the Secretary when the plan or employer comes under examination. Thus, once the plan or employer comes under examination, the eligible inadvertent failure cannot be self-corrected unless prior to the examination, the employer has demonstrated a specific commitment to implement self-correction. The failure need not be specifically identified under the examination.

Eligible Inadvertent Failures That Can’t Be Self-Corrected. Interestingly, the Notice provides a list of eligible inadvertent failures that until EPCRS is updated may not be self-corrected. These include the failure to initially adopt a written plan document; failures in orphan plans; a significant failure in a terminated plan; certain demographic failures; excess contributions to a SEP or SIMPLE IRA permitting the contributions to stay in the Participant’s IRA; failures in SEPs or SIMPLE IRAs that do not use model or prototype forms; and a failure in an ESOP involving Code section 409.

EPCRS Provisions That Don’t Apply. The Notice also provides a list of provisions in the current version of EPCRS relating to self-correction that do not apply to self-correcting eligible inadvertent failures. These include: the requirement that a qualified plan or 403(b) plan have a favorable determination letter; the prohibition of self-correction of demographic failures and employer eligibility failures; the prohibition of self-correction for significant failures of SEPs or SIMPLE IRA plans; the prohibition of self-correction of certain loan failures; the provisions regarding self-correction of significant failures that have been substantially completed before the plan or employer are under examination; and the requirement that a significant failure must be completed or substantially completed by the end of the third plan year following the year in which it occurred.

Other Answers. The Notice clarifies that eligible inadvertent failures can be self-corrected before EPCRS is updated even if the failure occurred prior to enactment of SECURE 2.0. If the eligible failure involves an excise tax, self-correction does not automatically waive the excise tax. However, waiver of the tax can be sought through the EPCRS Voluntary Correction Program (VCP). Likewise, before EPCRS is updated, an employer may submit a VCP application to correct an eligible inadvertent failure. An eligible inadvertent failure of an IRA cannot be corrected under EPCRS before EPCRS is updated.

Conclusion. The Treasury Department and IRS are accepting comments on the Notice through August 23, 2023. While the Notice has provided some initial guidance, much more is needed. As previously raised, guidance on the parameters of the necessary practices and procedures that must be in place to even qualify the failure as an eligible inadvertent failure is critical. Additionally, the coordination between the existing Self Correction Program under EPCRS (SCP) and the self-correction of eligible inadvertent failures need to be explained. Generally, a significant operational failure may be self-corrected under the SCP by the end of the third year after its occurrence. However, the Notice says this requirement does not apply to eligible inadvertent failures before EPCRS is updated. This appears to mean that, at least for now, a significant eligible inadvertent failure can be self-corrected later than three years after it occurred. On the other hand, the Notice provides that generally to be self-corrected within a reasonable period after being identified, the eligible inadvertent failure should be corrected within 18 months of being identified. The SCP focuses on when the failure occurred while correcting eligible inadvertent failures focuses on when the failure was discovered or identified. It appears this means that if a significant eligible inadvertent failure first occurred 5 years ago but was not identified until July of 2023, if it were self-corrected by January 1, 2025, it would be timely corrected. At least, I think that is what the Notice says.

Anyone who has ever dealt with Internal Revenue Code section 457 and the deferred compensation plans authorized by it will understand the title to this article.   Code section 457 describes the tax consequences of two kinds of plans:  eligible deferred compensation plans (457(b) plans) and ineligible plans (457(f) plans). The two have very different tax consequences. Participants in an eligible plan generally do not recognize the benefits as income until they are received. Under an ineligible plan benefits are taxed when vested.

Additionally, Code section 457 addresses unfunded deferred compensation plans of both State and local governmental entities and tax exempt organizations. Section 457 plans have very different characteristics and personalities depending on whether they are sponsored by a governmental entity or a tax exempt organization.  Governmental 457(b) plans are much more like a qualified plan, including the requirement that the assets be held for the exclusive benefit of employees in a trust, custodial account, or annuity. On the other hand, a 457(b) plan sponsored by a tax exempt organization is much more similar to a nonqualifed deferred compensation plan. Further Code section 457 provides the polar opposite with respect to assets, providing that the plan assets must remain the employer’s subject to its creditors.

I will be discussing the different characteristics, similarities and differences between 457 plans in a webcast titled “The Bipolar 457 Plan” for the National Institute of Pension Administrators on June 14. I hope you will join me.

On May 4, the IRS issued Notice 2023-36 inviting the public to submit recommendations for its 2023-2024 Priority Guidance Plan. While the IRS has its hands full due to the over 90 changes to retirement plan law contained in the SECURE 2.0 legislation enacted last December, I believe one particular provision needs guidance as soon as possible, the new expansion of self-correction under the Employee Plans Compliance Resolution System (EPCRS) for eligible inadvertent failures.

Old Rules of Self-Correction.

EPCRS includes a Self-Correction Program (SCP) through which plan sponsors can self-correct certain types of errors without the need to make a submission to the IRS to obtain approval. It currently classifies operational failures as either insignificant or significant. An insignificant operational failure may be corrected at any time. A significant operational failure must be corrected by the end of the third plan year after the plan year in which the failure occurred.

Whether a failure is insignificant (or significant) is based on the relevant facts and circumstances. EPCRS identifies 7 factors to be applied in making the determination. These are: 1)  Whether other failures occurred during the plan year; 2) The percentage of plan assets and contributions involved in the failure; 3) The number of years the failure occurred; 4) The number of participants affected relative to the total number of participants; 5) The number of participants affected relative to the number of participants who could have been affected; 6) Whether the correction was made within a reasonable time after discovery of the failure; and 7) The reason for the failure (e.g., data transcription error or minor math error, etc.).

I have always been fairly critical of this regime for determining significance principally because the EPCRS Rev. Proc. doesn’t clearly show how one should apply the factors or how many factors a sponsor must meet to conclude the failure is insignificant. It does state the no single factor is determinative. The Rev. Proc. then only applies the factors through examples concluding whether the failure was significant or not. However, each example applies no more than 2 factors. Therefore, for close cases, the sponsor needs to decide whether to self-correct and risk the possibility that the IRS could disagree, that the failure qualified for self-correction. The alternative would be to file under the Voluntary Correction Program (VCP), pay a user fee to the IRS, and wait for a compliance statement from the IRS stating it would not disqualify the plan based on the identified failures, if corrected as proposed. Often, the more expensive VCP route would be chosen by the sponsor to get assurance.

SECURE 2.0 Expansion.

SECURE 2.0 generally states that unless otherwise provided in the Internal Revenue Code, regulations, or other Treasury guidance, any “eligible inadvertent failure” to comply with the rules for tax favored status by certain plans may be self-corrected under EPCRS as set forth in Rev. Proc. 2021–30, (or any successor guidance). Self-correction is not available if such failure was identified by the Secretary of the Treasury prior to any actions which demonstrate a specific commitment to implement a self-correction with respect to such failure; or the self-correction is not completed within a reasonable period after such failure is identified by the plan sponsor. Provided self-correction is available under the above criteria, an eligible inadvertent failure, may be corrected at any time. The plans whose inadvertent eligible failures may be so self-corrected are qualified retirement plans (401(k), profit sharing, pension), 403(b) plans, SEPs, SIMPLE IRA plans and IRAs.

What Is An “Eligible Inadvertent Failure?

An eligible inadvertent failure is defined as a failure that occurs despite the existence of practices and procedures which: 1) satisfy the standards set forth in EPCRS, or 2) satisfy similar standards in the case of an individual retirement plan. EPCRS requires that the plan have established practices and procedures (formal or informal) reasonably designed to promote and facilitate overall compliance in form and operation with applicable Code requirements and these established procedures must be in place and routinely followed. Additionally, the failure is not eligible if it is egregious, relates to the diversion or misuse of plan assets, or is directly or indirectly related to an abusive tax avoidance transaction.

Guidance Needed.

Just reading the above demonstrates that the language of the statute uses many terms that need to be better defined through guidance. What action is sufficient to show a specific commitment to implement self-correction? For example, if a sponsor discovers that a number of employees weren’t automatically enrolled when they should have been and is in the process of calculating the correction amounts when audited by the IRS, is that sufficient? How specific do practices and procedures need to be? Can a sponsor have practices and procedures in place to amend the plan for any required changes in the law so that a failure to timely amend can be self-corrected as an eligible inadvertent failure? What practices and procedures do IRAs need? What is a reasonable period to complete the correction? Currently, if an operational failure is insignificant, there is no time period, will that standard go away? If an operational failure is significant, is completing correction after 3 years unreasonable? Will the significant/insignificant dichotomy go away? What is an egregious inadvertent failure?

Conclusion.

The new self-correction provision of SECURE 2.0 is effective upon enactment. While Congress directed the IRS to revise the EPCRS Rev. Proc. within 2 years of enactment, guidance is needed well before then. Hopefully, such guidance will “fill in the blanks” that the statute created to give plan sponsors and practitioners clearer parameters of the new program. Additionally, hopefully it will have brighter lines than the 7 factors of significance under the current SCP.

You may have noticed that The Benefit of Benefits Blog looks different. That is because it has been re-designed to match the branding of my new law firm.  I am very pleased to have joined the ERISA and Employee Benefits Attorneys at Trucker Huss effective March 21, 2023. With more than 30 legal professionals, Trucker Huss is one of the largest employee benefits specialty law firms in the country with offices in San Francisco, Los Angeles and Portland. 

I will be leading the Equity and Executive Compensation practice as well as working on qualified retirement plans and correction work that I have always done.  While the firm is headquartered in San Francisco, I will remain in the Sacramento area working remotely and servicing my Sacramento clients as well as other firm clients. 

I feel so fortunate to join such a well-respected firm of employee benefit professionals. Trucker Huss now has eight attorneys that have been inducted as Fellows into the prestigious American College of Employee Benefits Counsel for their contribution to the employee benefits field. We also have attorneys who concentrate their practices in all aspects of employee benefits law. There is really no issue in the ERISA and employee benefits area that Trucker Huss cannot handle. 

Several studies continue to show the importance of nonqualified deferred compensation (NQDC) plans to attract and retain executive level talent for employers. See Study Shows The Need For Nonqualified Plans To Attract And Retain Talent. SECURE 2.0 also contains a provision that may encourage the use of NQDC plans. It provides that after 2023, catch-up contributions under 401(k), 403(b) or governmental 457(b) plans by employees (over the age of 50) whose wages exceed $145,000 must be made on an after-tax Roth basis. The earnings on such catch-up contributions are then tax-free when paid.

This “Rothification” of catch-up contributions was a revenue raiser to help balance other provisions within the budget bill containing SECURE 2.0. What this means is that older highly-paid executives who desire to save more for retirement would have to do so with after-tax contributions under the above plans. However, an NQDC plan can allow some or all of those executives to defer salary on a tax-deferred basis instead of through catch-up contributions under the 401(k), 403(b) or 457(b) plan. Additionally, the NQDC plan does not have to limit deferrals to the catch-up amount ($7,500 in 2023). Of course, the contributions and earnings on the NQDC plan contributions will be taxed as ordinary income upon distribution. Additionally, the employer does not get a tax deduction until the employee recognizes the income.

$145,000 May Not Be Enough.

Of course, an NQDC plan must be a top hat plan designed for a select group of management or highly compensated employees to avoid Title I of ERISA. The fact that an employee earns more than $145,000 annually will not necessarily make her or him a member of the top hat group. In this context “highly compensated employee” does not have the same meaning as under Code section 414(q) for qualified plans. A legal analysis comparing each proposed employee’s compensation to others in the organization as well as the duties of such employees should be undertaken to ensure they are considered to be in the top hat group.

Disadvantages.

A 401(k), 403(b), or governmental 457(b) plan has a definite advantage over an NQDC plan. The assets are set aside from the employer to be used for the exclusive benefit of the participants. On the other hand, assets in an NQDC plan must remain subject to the employer’s creditors to avoid the employees being subject to current income taxation. However, a “rabbi” trust could be used to hold the deferrals and earnings. Under such a trust the trustee can only use the assets to: pay benefits when due under the NQDC plan; or to pay the employer’s creditors when the employer is insolvent. Thus, as long as the employer is solvent, the employee-participants will be paid their benefits.

Another disadvantage would be that the NQDC plan is subject to Code section 409A and running afoul of its provisions would cause the executive to be subject to income tax to the extent vested (and elective deferrals are always 100% vested) and also subject to an additional 20% federal tax. California residents would also be subject to an additional 5% state tax. However, properly drafted and operated, an NQDC plan shouldn’t violated Code section 409A.

Conclusion.

With Congress mandating catch-up contributions for higher paid employees to be Roth contributions beginning next year, employers should consider whether such employees would use an NQDC plan as a reasonable substitute for pre-tax catch-up contributions. Of course, if the employer already has an NQDC plan allowing elective deferrals, the executive may just want to increase her or his deferrals under that plan.

Among the many changes in the SECURE 2.0 legislation are a number of provisions allowing participants to access their retirement funds without incurring a penalty excise tax. These provisions are discussed below.

Withdrawals for Terminal Illness or Domestic Abuse. Effective on the date of enactment (December 29, 2022), SECURE 2.0 authorizes a plan to permit a participant diagnosed with a terminal illness to withdraw money from his or her retirement account regardless of age. The distribution will not cause the Participant to incur the 10% excise tax for withdrawals prior to age 59 1/2. However, it is still income.

Likewise, beginning in 2024, a plan can permit a domestic abuse survivor to withdraw the lesser of $10,000 or 50% of the participant’s account. While taxable income, the distribution is not subject to the 10% early withdrawal penalty. The Participant can self-certify that he or she has experienced domestic abuse. The general idea is that the participant may need the money to escape an unsafe situation. However, no reason for needing the money needs to be stated.

Additionally, the participant can repay the withdrawn amounts over a 3-year period. The repayments may be made to a different plan or an IRA and are treated as roll over contributions which allows for a refund of the income taxes paid on the withdrawn amount once they are repaid.

Qualified Disaster Recovery Distributions. Similarly, effective for disasters occurring on or after January 26, 2021, plans can allow withdrawals of up to $22,000 for participants living in a federally declared disaster area that have sustained an economic loss due to the disaster. This is a permanent rule for any federally declared disaster as opposed to prior rules on a case by case basis. Unlike the terminal illness or domestic abuse withdrawals, these can be taken into income over a three-year period. They too escape the early withdrawal excise tax and can be repaid as rollovers to a plan or IRA over a three-year period. The distributions must be made within 179 days after the later of (i) the first day of the disaster incident period or (ii) the date of the disaster declaration. For federal disasters occurring on or after Jan. 26, 2021, and before enactment of SECURE 2.0 (Dec. 29, 2022), eligible individuals can take a qualified disaster recovery distribution until June 27, 2023, if that date is later.

Additionally, during the applicable period for taking a disaster distribution, plans can allow participant loans to affected employees of the lesser of $100,000 or the present value of the benefit. This is twice the amount of a normal participant loan.

Also, loan payments that fall due during the applicable period for a disaster distribution may be suspended for a year and remaining payments adjusted. Finally, a participant who took a hardship distribution from the plan to purchase or construct a home within 180 days of the disaster, that will not be so used due to the disaster, may recontribute that distribution back to the plan.

$1,000 Emergency Withdrawals. Also beginning in 2024, a plan can permit a penalty-free withdrawal of up to $1,000 by a Participant for certain emergency expenses. Only one such emergency withdrawal can be made each year. The emergency expenses must be unforeseeable or an immediate financial need relating to personal or family emergencies.

The Participant can repay the distribution within 3 years.

Emergency Savings Accounts. Effective on the date of enactment (December 29, 2022) employers maintaining individual account plans may provide for a separate emergency savings account under the plan for nonhighly compensated employees. Contributions to such accounts must be on an after-tax Roth basis and cannot exceed $2,500 annually. Once the annual limit is reached, the contributions must stop or be re-directed to the Participants other Roth account under the plan. The employer can auto-enroll its nonhighly compensated employees at no more than 3% of salary.

Such emergency account contributions are considered elective deferrals subject to matching if the plan provides for matching contributions. At separation from service the account balance may be rolled over to any Roth account in a defined contribution plan or Roth-IRA.

Conclusion. SECURE 2.0 authorizes many ways a plan can allow participants access to their retirement savings for other reasons. The repayment features are meant to avoid retirement savings leakage that could otherwise occur if the amounts could not be repaid to the plan. It remains to be seen if amounts that can be repaid are repaid in practice. Of course, these provisions are all optional, making the decision whether to include them in the discretion of the sponsoring employer as a matter of plan design.