Tag Archives: 457(b)

An executive survival guide for tax-exempt employers sentenced to Section 457

Pizzano-DominickThis blog is part of a 12-part series entitled “The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.” To read the introduction to the series, click here.

By the time executives of the corporate world-at-large experienced the first full-fledged legislative lockdown of their nonqualified deferred compensations, when the American Jobs Creation Act of 2004 instituted Internal Revenue Code (IRC) Section 409A, most of their counterparts in the tax-exempt sector had already been long used to having such benefits confined. Many years earlier, the Tax Reform Act of 1986 (TRA 86) sentenced these benefits to the custody of IRC Section 457, generally effective for taxable years beginning after December 31, 1986. The problem is that even as we approach the 30th anniversary of this sentence, Section 457 applicability and compliance still remain sources of confusion and frustration for many not-for-profit employers as they seek to provide significant executive compensation programs.

Tax-exempt employers, not employees
When not-for-profit organizations hire key decision-makers from the “for-profit” world, these organizations frequently find individuals desiring deferred compensation benefits similar to those offered by their former employers. Unfortunately, too often the tax-exempt organization complies and implements a plan that, while perfectly in compliance with the tax laws governing similar plans sponsored by corporations in the for-profit sector, does not comply with the more restrictive limitations applicable to most not-for-profit entities. If the Internal Revenue Service (IRS) discovers such a plan during an audit of the individual or the organization, the employer’s good intentions could result in extremely adverse tax consequences for the executive.

The deliberations that led to the 457 sentence
Why are tax-exempt employers subject to stricter limits than their for-profit counterparts? Because the IRS gives these organizations a pass come tax time, they cannot afford to offer the same charity to their employees. The IRS does not mind if executives of taxable entities defer as much as 100% of their compensation because, while the opportunity to tax this pay is generally deferred until the funds are distributed, the plan sponsor’s ability to take a tax deduction on such amounts is similarly delayed, thereby creating a vital trade-off that enables the U.S. Department of the Treasury to view these arrangements as tax-neutral. In contrast, tax-exempt employers have no tax deductions that can be deferred and thus no trade-off to offset the Treasury’s loss of current tax revenue incurred by their employees’ deferrals of compensation. Because tax-exempt entities as non-taxpayers are not concerned with deductibility of compensation, unless it involves unrelated trade or business income, there would be no incentive for them to limit their employees’ deferrals on their own if Section 457 did not exist.

Applicability of Section 457: Not all tax-exempts are treated equally

Free from Section 457: No separation of Church and the Feds: Originally sentenced to Section 457 by TRA 86 with the other tax-exempts, NDCPs maintained by churches and qualified church-controlled organizations (QCCOs) were paroled in 1988, when the Technical and Miscellaneous Revenue Act exempted this congregation of plans from the application of Section 457 (however, a nursing home or hospital that is associated with a church, but which is not itself a church or a QCCO, would be covered by Section 457 if it is a tax-exempt entity). The only other NDCPs granted Section 457 immunity are those established by the federal government or any agency or instrumentality thereof; although this should not be too surprising given that the creation of these rules as well as determining who must comply with them is, after all, a federal function.

Those sentenced to Section 457: The states, cities, towns, and the rest of the tax-exempts: If an employer is an entity that is a state or local government or a tax-exempt entity other than those described in the preceding paragraph, any NDCP it establishes must comply with Section 457. Plans of states and local governments have been subject to Section 457 from its creation in 1978; however, because the rules governing these arrangements are more similar to those covering qualified plans (e.g., all employees—not just executives—participate, and plan assets must be held in a separate trust for the exclusive benefit of participants), the remainder of this blog will focus on the rules applicable to the nongovernmental tax-exempts sentenced to 457.

What are the terms of a Section 457 sentence?
While a 457 sentence is mandatory, in the sense that it is levied based on the employer’s status, tax-exempt employers do have considerable discretion over the manner in which they choose to serve this sentence: a 457(b) plan (aka an eligible 457 plan), a 457(f) plan (aka an ineligible plan), or concurrently using both. The following chart reveals their major differences:

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Guidance issued on in-plan Roth rollovers to designated Roth accounts

The Internal Revenue Service (IRS) has issued Notice 2013-74, providing guidance on the expanded types of amounts eligible for in-plan Roth rollovers within 401(k), 403(b), or 457(b) governmental retirement plans. These amounts, which became eligible for in-plan Roth rollover treatment in 2013 under the 2012 American Taxpayer Relief Act, include sums that are otherwise not distributable to participants under the terms of the plan, such as elective deferrals, matching contributions and nonelective contributions, and annual deferrals made to 457(b) governmental plans.

The IRS’s new guidance also includes deadlines for adopting plan amendments to provide for these in-plan Roth rollovers of such otherwise nondistributable amounts, as well as rules applicable to all in-plan Roth rollovers.

For more perspective on this new guidance, read this Client Action Bulletin.

Will your retirement savings be capped?

As part of the proposed federal fiscal year 2014 budget, President Obama included a cap on the amount of retirement savings an individual could accumulate in tax-deferred retirement plans. The total accumulation amount for an individual includes all qualified tax-deferred savings plans such as traditional defined benefit (DB), cash balance, money purchase, profit sharing, 401(k), and 403(b) plans, as well as funded governmental 457(b) arrangements and Individual Retirement Accounts (IRAs), both traditional and Roth.

The proposal is most likely a result of the presidential campaign last year, during which it was reported that Governor Mitt Romney had qualified accounts in excess of $100 million. However, the administration’s budget proposal would not tax accumulated accounts in excess of the cap. If the accumulated accounts exceed the cap, the individual would not be allowed to make future deferrals or receive any future employer contributions under any retirement plan.

The proposal would essentially cap tax-advantaged retirement plans to an amount necessary to provide the maximum annuity permitted under a defined benefit plan. The current limit is $205,000 payable annually at age 62. The annual annuity amount would be increased by a cost of living adjustment.

After converting the annuity to a present value using current interest rates, the total accumulation amount is approximately $3.0 million to $3.4 million. Because of the current low interest rate environment, that total accumulation amount is inflated. If interest rates return to a historical level, the maximum accumulated amount could be as low as $2.2 million to $2.4 million for an individual age 62.

No real details are available on how account values would be reported or how the cap would be calculated. There is a concern small business owners could eliminate their retirement plans if they were at the accumulated cap, because they would not receive the benefit of tax-deferred treatment. As a result, retirement savings vehicles for many rank and file employees could be eliminated. As an alternative, consideration could be taken to limit only employee deferrals under the proposal or a portion of employer-provided contributions, allowing small business owners some incentive to keep their retirement plans.

Under the proposal, it is estimated that the accumulation cap would result in approximately $9 billion in additional federal tax revenue over the next 10 years beginning October 1, 2013. On the flip side, it has not been determined how much tax revenue would be lost in future years as a result of smaller account balances for these taxpayers. All distributions from qualified retirement plans (other than Roth accounts) are taxed at distribution.

It will be interesting to see if this proposal will gain traction with lawmakers.

American Taxpayer Relief Act of 2012, fiscal cliff legislation, and in-plan Roth conversions

Effective January 1, 2013, the recently negotiated and signed American Taxpayer Relief Act of 2012 includes provisions for in-plan Roth conversions. The new provision is akin to the in-plan Roth rollover, with the difference being that the provision is applicable for amounts that are not currently eligible for distribution. The legislation benefits plan sponsors and participants but it also provides a revenue stream for the federal government.

Roth contributions to a qualified 401(k) or 403(b) plan or to a governmental 457(b) plan are made on an after-tax basis. This means participants pay taxes on contributions now, not later. Before the new rules, if a plan permitted an in-plan Roth “rollover,” then a participant could move money from a non-Roth plan account (pretax salary deferrals, employer match, employer nonelective contributions) to the Roth account within the same plan. Participants were only allowed to do this if they had distributable events (i.e., distribution at age 59½, severance from employment) and the amount was eligible for rollover. Under the new law, if a plan permits an in-plan Roth “conversion,” then a participant may move money from a non-Roth plan account to the Roth account within the same plan, without having a distributable event.

If participants decide to take advantage of an in-plan Roth conversion, they will pay income taxes at their current tax rates. The conversion is not subject to mandatory or optional withholding, nor to the early 10% penalty tax, although a recapture rule may apply a 10% penalty if in-plan Roth amounts are distributed within a five-year period. This means the participant needs to think about the following: Is my tax bracket at retirement going to be higher than it is now and do I have the money outside of my plan assets to cover the taxes?

If participants expect to remain in the same tax bracket for the remainder of their working careers, there is no advantage to paying the tax now. However, for participants who believe they will be in higher brackets as they go through their working careers and in retirement, and have other money available to cover the income tax, then conversion of a non-Roth account may be beneficial. The converted amount would be considered tax-free, as are the future earnings on it, if certain requirements are met, including a five-year holding period. If the participant will cross multiple tax brackets, it may be beneficial to spread the Roth conversions over multiple years. This helps the participant accumulate resources to pay the taxes and makes the conversion more affordable.

There are additional questions and considerations the participant needs to address, such as when to retire, whether to work after retirement, how much money will be needed in retirement, whether estate taxes must be paid, and how much Social Security provides. These are not easy questions to answer, but taxes and taxable income may impact the answers. Most participants want to maintain a standard of living in retirement that is not less than what they currently have. Considering after-tax investment vehicles, such as a Roth account, may help participants achieve their financial retirement goals.