Eligible 457 Plans, a New Tax Deferral Opportunity
The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), which President Bush signed into law on June 7, 2001, has many provisions which affect the pension benefit programs of tax-exempt employers. This WTP Alert focuses on a provision of EGTRRA which creates a new tax deferral opportunity for executive employees of tax-exempt organizations: the Eligible 457 Plan.
Many of the tax deferral vehicles available to executives of tax-exempt organizations prior to the enactment of EGTRRA, such as severance pay plans, equity split dollar life insurance, synthetic option programs and supplemental executive retirement programs (“SERPs”), involve significant risk of unfavorable tax treatment. The Eligible 457 Plan accomplishes a significant level of tax deferral without undue risk of adverse tax treatment. Therefore, we believe that tax-exempt employers should evaluate whether an Eligible 457 Plan will meet the organization’s objectives.
1. Requirements of an Eligible 457 Plan. An Eligible 457 Plan is a deferred compensation plan maintained by either a State or local government or a tax-exempt organization (other than a church or church controlled organization) and which meets the statutory requirements listed in Section 457(b), (c) and (d) of the Internal Revenue Code (the “Code”). Current requirements of Section 457(b) which are applicable to a tax-exempt organization are as follows:
- The plan may cover only individuals who perform services for the employer.
- The plan must provide that deferrals will not exceed the amount set forth in Section 457(b) of the Code.
- The plan must require that compensation will be deferred for any calendar month only if the agreement providing for deferral has been entered into before the beginning of the calendar month.
- The plan must provide that all compensation deferred under the plan and all income attributable to the deferrals will remain the property of the employer subject only to claims of the employer’s general creditors.
2. Limitations on Usefulness of Eligible 457 Plans Prior to the Enactment of EGTRRA. Prior to the enactment of EGTRRA, the deferral limit for an Eligible 457 Plan was $8,500, an amount which was $2,000 less than the deferral limit under a 401(k) plan or tax deferred annuity program under Section 403 (b) of the Code (“TDA”). Moreover, the $8,500 amount was required to be reduced by amounts deferred under either a 401(k) plan or a TDA. Because deferrals by employees of tax-exempt employers are subject to the claims of the employer’s creditors, an Eligible 457 Plan was used only when the employer sponsored neither a Section 401(k) plan nor a TDA.
3.Key Changes to Eligible 457 Plans as a Result of EGTRRA. EGTRAA made a number of changes that will impact eligible deferred compensation plans under Section 457 of the Code. Those changes are as follows:
- The deferral limit for Eligible 457 Plans was increased from $8,500 to $11,000, effective January 1, 2002. The deferral limit will increase by $1,000 each year until it reaches $15,000 on January 1, 2006.
- The amount of the contributions which may be made in the participant’s last three taxable years ending before he or she attains normal retirement age under the plan (“make up” contributions) is increased from $15,000 to two times the deferral limit. Effective January 1, 2002, the make-up contribution is $22,000.
- Individuals who participate in a 401(k) plan or a TDA are no longer required to coordinate 401(k) and TDA deferrals with the deferrals under an Eligible 457 Plan for purposes of determining whether the deferral limits are met.
- The payment requirements under an Eligible 457 Plan have been amended so that they are more similar to the payment provisions for qualified plans and TDAs.
- Distributions under Eligible 457 Plans pursuant to a qualified domestic relations order would be taxed under the rules applicable to qualified plans.
4. Opportunities for Using Eligible 457 Plans.
- An Eligible 457 Plan will provide additional opportunities for the tax-exempt employer to provide benefits for executive employees. The benefits will be limited to the deferral amount ($11,000 in 2001 or any make up contributions (available during the last three years prior to normal retirement age). Thus, contributions for an employee who is within three years of normal retirement age can be as high as $22,000 in 2002.
- An Eligible 457 Plan is not limited to employee deferrals. The employer may make contributions under an Eligible 457 Plan. However, the combination of contributions and deferrals that become vested during the plan year cannot exceed the applicable limit.
5. Potential Pitfalls.
- Creditor Claims. Because the contributions made to a Section 457 plan are subject to the claims of the employer’s creditors, the employee is always at risk of losing contributions and deferrals.
- ERISA Coverage. Because an Eligible 457 Plan does not comply with the funding requirement of ERISA, participation in the plan must be limited to “a select group of management or highly compensated employees.” Making an Eligible 457 Plan over-inclusive can create ERISA compliance issues.
- Vesting Issues. Contributions are included toward the deferral limit only to the extent they become vested during the current year. Therefore, if an Eligible 457 Plan has a vesting schedule, the employer must determine the extent to which prior contributions become vested during the current year.
- Contribution Limit. Contributions under an Eligible 457 Plan are limited to the elective deferral amount ($11,000 for 2002), except in the years when make up contributions are permitted. To the extent the employer wishes to provide executive employees with benefits in excess of the limitations, another non-qualified vehicle will be required.
- Plan Failures. If the employer fails to follow the complex rules for Eligible 457 Plans, the arrangement will become ineligible.