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.