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457 Plans Section 457 of the Internal Revenue Code and its regulations detail the requirements relating to the payment of nonqualified deferred compensation to employees of state and local governments and tax-exempt employers. While tax-exempt employers can now offer their employees 401(k) plans, state and local governments are prohibited from using 401(k) plans. Section 457 was enacted to provide a plan that would fill the same basis role as a 401(k) plan for employees of tax-exempt and governmental employers. There are two types of Section 457 plans; those referred to as “eligible plans” governed by Section 457(b) and (d) and those referred to as “ineligible plans”, governed by Section 457(f). Eligible 457 Plans. Most eligible 457 plans are sponsored by governmental employers.They are similar to 401(k) plans and typically allow participants to elect to defer a portion of their compensation into the plan on a regular basis through payroll withholding.They are a defined contribution type of plan and the funding of the plan will create an “account” for the benefit of the participant. The amounts in the account are not taxable to the participant until distributions are made from the plan to the participant. Eligible 457 plans sponsored by governmental entities require that the funds be held in a trust or custodian arrangement.This requirement was enacted by Congress in response to the bankruptcy of Orange County in California. Tax exempt employers normally cannot sponsor eligible 457 plans for their employees because such plans would have to meet the requirements of ERISA which include funding the plan. Section 457(b) requires by its terms that the plan be “unfunded”. As a result, the only type of eligible 457 plan that can be sponsored by a tax-exempt employer is a Top-Hat Plan. Ineligible 457 Plans. Ineligible 457 Plans are deferred compensation arrangements, typically used for the benefit of executives.The deferred compensation under an ineligible plan is taxable when there is no longer a substantial risk that the participant will forfeit the funds. Under the applicable code section, Section 457(f), a substantial risk of forfeiture exists if a person's rights to the compensation are conditioned upon the future performance of substantial services. Such deferred compensation under an Ineligible Plan is also subject to the provisions of Internal Revenue Code Section 409A, which governs the taxation of nonqualifed deferred compensation. Since the enactment of Section 409A in 2004 there has been confusion regarding the treatment of Ineligible Plans under the requirements of Section 409A and further guidance from the IRS is expected. |
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