Tax-exempt organizations at times must be creative when structuring attractive compensation plans for their executive team. A section 457 deferred compensation plan may be one of the ways to sweeten the pot for a candidate. Used by tax-exempt organizations, these “top hat” nonqualified retirement plans allow key employees or a select group of employees to defer receipt of compensation to a later date, perhaps when their tax rate is lower.
Section 457 plans come with stringent rules and limitations that all parties should be aware of before signing on the dotted line. Prospective employees and the organizations sponsoring the plan can save a lot of headache and conflict if their 457 plan is carefully planned and structured in the way that suits the needs of the organization and its executive employee.
Unlike retirement plans such as 403(b) plans, assets under a 457 plan are “unfunded.” The assets belong to the organization until the individuals covered are eligible for a distribution. Individuals may be permitted to select the investment options but the assets do not belong to the individuals until they vest. If an individual does not vest under the plan then amounts deferred revert to the employer sponsoring the plan.
Choosing a Type of 457 Plan
There are two types of 457 plans. Employers and employees who understand the options they have may be able to work out a section 457 plan arrangement that meets their needs.
A 457(b) plan is available to highly compensated and management-level employees of tax-exempt organizations. The amount that may be deferred in 2017 is $18,000 (subject to cost of living adjustments). This limit includes both employer and employee salary reduction contributions.
It is important to note that the age 50 catch-up contribution is not permitted in a nongovernmental 457(b) plan. This prohibition is often times misunderstood resulting in excess contributions made to the 457(b) plan. Excess contributions must be returned by April 15 of the year following the contribution. Failure to do so will result in taxation of the entire 457(b) accumulation.
Amounts accumulated under a 457(b) plan are typically available for distribution upon the occurrence of a distributable event, as provided for under the plan. Distributable events may include separation from service or attainment of a retirement age specified in the plan. Unlike other retirement plans such as a 403(b) plan, accumulations in the 457(b) plan are subject to income tax in the year the distributable event occurs even if no distribution is actually taken from the plan. This is referred to as constructive receipt and often catches individuals by surprise. It should be noted that most 457(b) plans permit individuals to delay distribution until age 70 ½ provided the individual signs an election to defer receipt upon the occurrence of the distributable event.
Organizations and individuals covered by 457(b) plans should be certain to understand the provisions of the plan. It is too easy to be caught by surprise resulting in unanticipated tax consequences that could be avoided by understanding the plan.
A 457(f) plan is implemented when there is a desire to defer more than $18,000 a year. A 457(f) plan not only provides for greater deferrals but comes with greater challenges to meet in order to avoid unintended tax consequences.
A 457(f) plan must contain a “substantial risk of forfeiture.” The rights to amounts deferred must be conditioned upon the future performance of substantial services such as remaining employed through an agreed upon age or year. Once the individual has met the agreed upon future performance the substantial risk of forfeiture no longer exists. The total amount accumulated is vested and subject to income tax even if the individual does not take a distribution.
If the individual does not remain employed until the agreed upon age or year then the entire accumulation is forfeited and remains an asset of the organization.
The 457(f) plan is subject to the deferred compensation rules under Section 409A of the Internal Revenue Code. As such, the payment of the deferred compensation must follow the terms of the 457(f) plan as initially written. The payments may not be accelerated or deferred to a later date, with limited exceptions.
457 Plans and Employment Agreements
Deferred compensation provided by a 457 plan is typically a major component of the compensation package offered to key employees. It is crucial to fully understand the provisions of the plan in order to provide the intended benefit. As a major component of compensation, it is advisable to coordinate the 457 plan with the employment contract if one is in place for the individual. The contract should identify the type of 457 plan in place, amounts deferred by the employer and the agreed upon risk of forfeiture and availability of distributions. The fine print may be missed in the employment agreement, and the results could leave the employee without his or her deferred compensation.
Renegotiated Employment Agreements and the Rolling Risk of Forfeiture
In June 2016, the IRS issued proposed regulations relaxing the substantial risk of forfeiture rules. In general, the risk of forfeiture may be extended provided an agreement is made in writing at least 90 days before the date on which the existing risk of forfeiture would have vested. Thus it is important in renegotiating employment agreements to review the 457(f) plan if the desire is to delay distributions until actual termination of employment instead of the conclusion of the initial employment agreement.
Know Your Plan and Review Periodically - Avoid Surprises
Section 457 plans, if used correctly, can offer key employees an attractive benefit as part of their overall compensation package. Careful planning is required to structure these plans appropriately. The employer and employee should have a thorough understanding of the provisions of the plan and should review it periodically to be certain that that the plan continues to meet its intended goals in light of any changing circumstances or change in the employment agreement. All parties need to be proactive in regards to these plans rather than reactive in order to avoid unwanted tax consequences. Employees and employers who understand the ins and outs of their nonqualified plan will be able to use them to their advantage. For more information about section 457 plans, please contact us.
Bernie Kaplan is the Managing Director of the Retirement and Benefit Plan Services Group in the Boston office. He can be reached at 617.761.0541 or Bkaplan@cbiztofias.com. Bernie consults on a wide variety of employee benefit topics including 403(b) plans, qualified retirement plans, executive compensation, nonqualified deferred compensation, section 409A and health care reform.