Bryant - Course 5. Retirement Planning & Employee Benefits. 4. Government 457 Plans Flashcards
Our dream retirement might remain a dream if planning for it is delayed too long. All of us look forward to our retirement years. We dream of doing all the things we could never find the time to do while working.
Both employers and employees share the same desires for tomorrow. The secret to pursuing retirement dreams is careful financial planning that will provide us with additional sources of income for a comfortable retirement. Most employees rely on their employer’s retirement savings plan to provide most of that additional income.
The Internal Revenue Code (IRC) sets the regulations for such retirement savings plans. Most of them are tax deductible and tax deferred to the employee. These types of plans are attractive to the employer for recruiting, rewarding, retaining, and retiring—known as the Four R’s. One such plan is based on Section 457 of the IRC.
The Government Plans (457) module, which should take approximately three hours to complete, will explain the code of law regulating the Section 457 plan.
Upon completion of this module, you should be able to:
* Detail the design features of a Section 457 plan,
* State the tax implications of a Section 457 plan,
* Explain how to install a Section 457 plan, and
* Specify alternative plans.
Module Overview
All nonqualified deferred compensation plans of governmental and non-church controlled tax-exempt organizations follow the regulations detailed in Internal Revenue Code Section 457. Under this code, the employer makes an agreement with each employee to reduce his or her pay by a specified amount. The deferrals are placed in one or more investment outlets that may include insurance products. The deferred amounts and their investment earnings will be distributed to the employee upon retirement, death, termination of employment, or if elected, the calendar year in which the participant attains age 73.
To ensure that you have a solid understanding of Government Plans (457), the following lessons will be covered in this module:
* Section 457 Plan
Section 1 - Section 457 Plan
Section 457 provides rules governing all nonqualified deferred compensation plans of governmental units and governmental agencies and also non-church controlled tax-exempt organizations. A plan designed to comply with these rules is referred to as a Section 457 plan. The regulations that determine the structure of Section 457 plans are less stringent than those for qualified plans, which must comply with many complex rules.
It is essential for a financial planner to learn the code of law regulating the Section 457 plan, its tax and other legal implications, and how to install the plan. He or she must also be aware of alternative plans and how they compare with the Section 457 plan.
To ensure that you have a solid understanding of the Section 457 plan, the following topics will be covered in this lesson:
* When Is It Used?
* Design Features
* Tax Implications
* ERISA Requirements
* Alternatives
* How to Install a Plan
Upon completion of this lesson, you should be able to:
* List the employers who can use the Section 457 plan,
* Define eligible plans,
* Explain the rules that apply to catch-up contributions,
* State the distribution requirements for a Section 457 plan,
* Describe the coverage and eligibility requirements,
* Enumerate the funding regulations for a Section 457 plan,
* Specify the tax policies for a Section 457 plan,
* List the available alternatives to a Section 457 plan, and
* Outline the steps in installing a Section 457 plan.
When are Section 457 Plans Used?
Section 457 is used when structuring a nonqualified deferred compensation plan for certain entities. Any such plan adopted by an employer that is an affected organization generally must comply with the rules discussed in this lesson.
What are the design features of a Section 457 plan?
The following discussion of the design features of a Section 457 plan includes:
* Eligible employers,
* Limit on amount deferred,
* Timing of salary reduction elections,
* Distribution requirements,
* Coverage and eligibility, and
* Funding.
What Employers Are Covered for Section 457 Plans?
Section 457 applies to nonqualified deferred compensation plans of:
* The following state and local government employers:
* A state,
* A political subdivision of a state, such as a city or township, or
* Any agency or instrumentality of a state or political subdivision of a state, for instance, a school district or a sewage authority.
* Tax-exempt employers include:
* Any organization exempt from federal income tax, except for a church or synagogue or an organization controlled by a church or synagogue.
Which of the following employers would NOT be subject to Code Section 457’s rules for nonqualified deferred compensation plans?
* A school district
* A privately owned company
* A city sewage authority
* A charitable organization
A privately owned company
- Section 457 applies to nonqualified compensation plans of state and local government employers and tax-exempt employers/organizations.
What is the Limit on Amount Deferred Under Section 457 plans?
Under Section 457, plans that include limits on the amounts deferred are subject to favorable tax treatment; these are generally referred to as eligible Section 457 plans.
Plans providing greater deferral, generally designed for executives, are referred to as ineligible.
Specific limits on the maximum amount deferred each year for eligible Section 457 plans are defined in Section 457.
Special catch-up contribution rules may also apply whereby an employee may qualify to contribute more than these limits.
Since eligible 457 plans are a form of nonqualified deferred compensation, these is no statutory limit on the amount of income that participants may defer. State True or False.
* False
* True
False
- Under Section 457 of the IRC, plans that include limits on the amounts deferred are subject to favorable tax treatment.
- These plans are generally referred to as eligible Section 457 plans.
What is the Limit on Amount Deferred in Eligible Section 457 plans?
For an eligible plan, the amount deferred annually by an employee cannot exceed the lesser of 100% of the employee’s compensation or $22,500 in 2023.
The applicable dollar amount is adjusted for cost-of-living increases, in increments of $500. Salary reductions under a Section 457 plan do not have to be coordinated with elective deferrals to other plans such as Section 401(k) plans (qualified profit-sharing or stock bonus plans under which participants have the option to put money in the plan or receive the same amount as taxable cash compensation) and Section 403(b) plans (a tax-deferred employee retirement plan that can be adopted only by certain tax-exempt organizations and certain public school systems.
* This means that any elective deferral under a 457 plan will not decrease the amount that an employee can defer under other tax-advantaged plans.
* A participant with sufficient compensation at two employers, one that sponsors a Section 457 plan, can contribute the maximum to each employer’s plan.
Suppose Michael Orentlich, whose annual salary is $150,000, participates in his employer 457 plan. Michael has another job that has a 401(K) plan. Even though Michael contributes the maximum to his 457 plan, he would still be able to contribute and deduct up to an additional $22,500 into his 401(k) plan in 2023.
Practitioner Advice:
* Participants in a plan of a governmental employer or a non-church-controlled tax-exempt organization who are age 50 and over are eligible for an additional salary reduction catch-up contribution of $7,500 (2023).
The $7,500 catch-up limit will be indexed for inflation in future years.
What is an Ineligible Section 457 Plan?
Ineligible
Under Section 457, plans providing greater deferral, generally designed for executives, are referred to as ineligible. Ineligible plans are also referred to as forfeitable plans.
Under this Section, if an employee defers more than the annual dollar limit, the additional deferred amount is not necessarily taxed immediately; it is taxed in the first taxable year in which there is no substantial risk of forfeiture. Thus, if a deferred compensation plan has forfeiture provisions, amounts greater than the annual dollar limit can be deferred until the year in which the forfeiture provision lapses.
For example, an employer subject to Section 457 might provide supplemental deferred compensation to selected executives, in amounts greater than the annual dollar limit, with a provision that the amount deferred would not be payable unless the executive served a full term under a multi-year contract. Taxation on the amount deferred would not occur until the year in which each executive served the full term and the deferred amounts became nonforfeitable.
A major problem in designing such plans is to develop forfeiture provisions that are substantial enough to defer taxes, but are nevertheless acceptable to the executive.
* Another major design problem occurs at retirement.
* In general, it is very difficult to design a bona fide, substantial forfeiture provision that extends past the executive’s retirement.
* Consequently, Section 457(f) amounts are generally taxable in full no later than the year of the executive’s retirement.
* If deferral past retirement is essential, other techniques might be investigated.
Describe Catch-up Contributions in 457 Plans
The old catch-up provision, which still applies to each of the last three years before normal retirement age, enables participants to make up for contributions not deferred in previous years. They may “catch up” for any year(s) since January 1, 1979, if they were eligible to contribute to a deferred compensation plan but did not contribute the maximum amount allowed under the Internal Revenue Code.
Catch-up contributions can be defined as elective contributions which:
* Exceed the applicable limitation as determined at year-end,
* Are treated by the eligible plan as catch-up contributions, and
* Do not exceed the annual catch-up contribution limit.
Special rules apply to the new catch-up contributions under a Section 457 plan:
* The additional over-50 elective deferral amounts are not available in any year in which the participant makes additional deferrals under the old three-year catch-up provision described below.
* Notwithstanding the amount in the table, the additional deferral cannot exceed the excess, if any, of the participant’s compensation overall regular elective deferrals.
* For example, consider a participant over age 50 who has compensation of $23,000 in 2023 and regular salary deferrals of $22,500. In such a case, only an additional $500 can be deferred under this 50-or-over provision (ignoring that FICA contributions may need to be made from the compensation).
* The Section 415 limitation (limitation applied to qualified deferral plans that place a cap on the amount of money that plan participants and employers can contribute to a plan on a tax-deferred basis) does not prevent the use of this 50-or-over provision, even if the total deferred thereby exceeds the Section 415 limitation.
* For example, suppose a participant over age 50 has annual compensation of $100,000. He or she has regular annual additions of $66,000(2023) to the employer’s defined contribution plans for the year, which is the full Section 415 limitation. In this case, the 50-or-over excess deferrals would still be available.
* All eligible participants must have the same right to make this election.
The dollar limit is applied per individual, not a per-plan, basis. For example, consider the case of Lydia, who is employed by two different governmental employers. Her total annual deferral from both employers cannot exceed the $22,500 limit in 2023. The 100% of compensation limit applies on a per-plan basis. Thus, Lydia may not defer more than 100% of her includable compensation under any one plan.
The new catch-up rule does not apply during a participant’s last three years before retirement. During those years, the old catch-up rule of Section 457(b)(3) applies. The contribution ceiling can be increased in each of the last three years before the normal retirement age to the lesser of:
* Twice the dollar limit for the year, or
* The regular limit of the lesser of the dollar limit for the year or 100% of taxable compensation, plus the total amount of deferral not used in prior years.
Exam Tip:
* Remember that all elective deferrals must be aggregated in applying the applicable limit EXCEPT deferrals into a Section 457 plan.
Describe the Timing of Salary Reduction Elections in 457 Plans
Employee elections to defer compensation monthly under Section 457 must generally be made under an agreement entered into before the beginning of the month.
What are the Distribution Requirements in 457 Plans?
Plan distributions cannot be made before:
* The calendar year in which the participant attains age 73,
* Severance from employment,
* An “unforeseeable emergency,” as defined in the regulations, or
* Upon the death or disability of the plan participant.
* A participant can elect to receive an involuntary cashout of up to $5,000 from his account under a tax-exempt non-governmental organization’s plan.
This is possible if:
* No amount has been deferred by the participant for two years, and
* There has been no prior distribution.
A cashout distribution in excess of $1,000, and by definition, less than or equal to $5,000, must be automatically transferred to an individual retirement plan. This is unless the participant affirmatively elects to have the distribution transferred to another eligible retirement plan or to take the distribution in cash. However, the automatic rollover rule does not apply to any distribution until final safe harbor regulations are issued by the Department of Labor.
- A participant may make a one-time election after amounts are available and before the commencement of distributions, to defer the commencement of distributions.
- Minimum distributions must be made under the rules of Section 401(a)(9) (distributions from IRAs must generally begin as of age 73), which apply to other tax-advantaged plans as well.
- The qualified plan rules of Section 414(p) regarding Qualified Domestic Relations Orders (QDROs) apply to Section 457 plans. A QDRO is a decree, order, or property settlement under state law relating to child support, alimony, or marital property rights, which assigns part or all of a participant’s plan benefits to a spouse, former spouse, child, or other dependents of the participant.
- They apply for years beginning after December 31, 2001, so that a Section 457 plan will not violate the restrictions on distributions under Section 457(d) by making a QDRO distribution.
- Under prior law, such distributions were not permitted.
Section 457 plans are subject to the minimum distributions requirements under Section 401(a)(9). State True or False.
* False
* True
True
* Minimum distributions must be made under the rules of Section 401(a)(9) (distributions from IRAs must generally begin as of age 73, which apply to other tax-advantaged plans as well.
What happens after Severance from Employment for a 457 Plan?
After December 31, 2001, distributions may be made upon severance from employment. Under prior law, it was upon “separation from service.”
An employee is not considered to have separated from service when he continues on the same job for a different employer as a result of a liquidation, merger, consolidation or similar event involving his former employer.
A severance from employment occurs when a participant ceases to be employed by the employer sponsoring the plan.
* An employee may experience a severance of employment without experiencing a separation from service.
How does Section 457 define unforeseeable emergency?
An unforeseeable emergency is one of the reasons that would permit distributions from a Section 457 plan. The current regulations under Section 457 define unforeseeable emergency as severe financial hardship to the participant resulting from:
* A sudden and unexpected illness or accident of the participant or a dependent
* A loss of property due to casualty, or
* Other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant.
The regulations specifically mention that the purchase of a residence or college education of children is not considered an unforeseeable emergency. Any amount distributed from the plan as the result of an emergency cannot exceed the amount reasonably needed to satisfy the emergency.
Which unexpected circumstances resulting in financial hardship are considered an unforeseeable emergency? (Select all that apply)
* Loan defaults
* Sudden illness
* Property loss due to casualty
* College education
Sudden illness
Property loss due to casualty
* Sudden and unexpected illness or accident or property loss due to casualty are considered unforeseeable emergencies.
What are the Coverage & Eligilbility requirements for Section 457 plans?
There are no specific coverage requirements for Section 457 plans. For a governmental organization, the plan can be offered to all employees or to any group of employees or even to a single employee.
* However, most private nongovernmental tax-exempt organizations are subject to the Employee Retirement Income Security Act of 1974 (ERISA). Therefore, the ERISA eligibility rules may apply to the Section 457 plan of the tax-exempt organization. The eligibility requirements would be the same as those applicable to a nonqualified deferred compensation plan for a taxable employer.
* Such plans can avoid the ERISA rules if they are structured to take advantage of specific ERISA exemptions.
* An example of one such exemption is for unfunded plans covering only a select group of management or highly compensated employees, the top-hat group.
What are the rules regarding funding of a Section 457 plan?
The rules regarding funding of a Section 457 plan for nongovernmental tax-exempt organizations are different from those for governmental organizations.
While formal funding is not permitted for the former, the latter must be funded.
Governmental organizations must be funded.
Describe funding for Non-governmental Tax-exempt Organizations
A Section 457 plan for such organizations may not be funded. However, financing, or informally funding, the plan with insurance or annuity contracts is allowed and is almost always appropriate.
A Section 457 plan for any nongovernmental tax-exempt organization cannot be funded in the same sense as a qualified plan, that is, with an irrevocable trust fund for the exclusive benefit of employees.
* However, the employer can, and in most cases should, finance its obligations under the plan by setting aside assets in advance of the time when payments will be made.
* Life insurance or annuity contracts are often used for this purpose.
If the employer purchases life insurance contracts to finance the plan, there is no current life insurance cost to employees. This is under the condition that the employer:
* Retains all incidents of ownership in the policies,
* Is the sole beneficiary under the policies, and
* Is under no obligation to transfer the policies or pass through the proceeds of the policies.
This favorable result applies even if the contracts are purchased at the option of participants. However, as with all deferred compensation plans, benefits to participants and their beneficiaries, including death benefits, are not excludable as life insurance proceeds, even if life insurance is used to finance the plan.
For the plan of a tax-exempt organization that is subject to ERISA, the no funding requirement of Section 457 may conflict directly with certain ERISA requirements, such as the funding and exclusive purpose requirements. Though this issue has not yet been resolved, the Internal Revenue Service (IRS) has recognized the possibility that a plan subject to ERISA will not be able to satisfy the Code’s requirement that the plan be unfunded.
Section 457 plans for nongovernmental tax-exempt organizations are generally subject to Title I of ERISA unless they are structured to take advantage of specific exemptions from ERISA coverage.
The most significant exemptions are for:
* Top-hat plans, that is, unfunded plans maintained primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees, and
* Unfunded excess benefit plans, that is, unfunded plans maintained solely for the purpose of providing benefits for certain employees in excess of the limitations imposed by Code Section 415.
Unless a Section 457 plan for a nongovernmental tax-exempt organization is structured to take advantage of an ERISA exemption, it will be subject to ERISA and will probably be unable to satisfy the Code’s requirement that the plan be unfunded.
* One way to eliminate the conflict is to limit participation in the plan to a select group of management or highly compensated employees, the top-hat group.
