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.
- 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.
- 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.
- 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.
- 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.
- 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.