Mind Your B's and F's: A Primer on Deferred Compensation Plans for Tax Exempts

Date: September 2, 2015

This article appeared in Association TRENDS, June 2015, and is reprinted with permission of the publisher.

Retirement programs for employees of tax exempt associations are similar in many ways to retirement programs sponsored by a for-profit business enterprise.  Both types of organizations may offer generally all of their employees qualified retirement plans (401(k) plans for both, 403(b) plans only for tax exempts) and deferred compensation plans for a “select group of management or other highly compensated employees.”  However, the tax treatment of deferred compensation arrangements is where the similarities between tax exempt and for-profit organizations end.  

Tax exempt associations may sponsor both “eligible” and “ineligible” deferred compensation plans.  These arrangements are also referred to as “457(b)” and “457(f)” plans, respectively, referencing the governing sections of the Internal Revenue Code.  457(b) plans offer the employee the opportunity to defer pay in addition to contributions made under a traditional qualified retirement plan such as a 401(k) plan.  Contributions to an eligible 457(b) arrangement are limited in 2015 to $18,000.  However, by layering a 457(b) plan with a traditional 401(k) plan, an employee could choose to defer up to $36,000 of pay ($42,000 if age 50 or older).  Deferrals under a 457(b) plan are not taxed until paid to the participant.  Contributions may also be made to a 457(b) plan by the association rather than as an employee elective deferral or as a combination of employer and employee contributions.  

Many associations also wish to further incentivize an executive-level employee to commit to a tenure of employment by offering a deferred compensation program providing for contributions in excess of the contributions that may be made to a qualified retirement plan and an eligible 457(b) program.  Such an arrangement is referred to as an “ineligible” 457(f) plan.  The associations typically will provide for vesting in the account if the executive remains employed with the association for a specified period of years.  

In the private sector, deferred compensation accounts are generally not includible in the executive's gross income until the amounts are received by the executive.  However, ineligible 457(f) plan accounts are includible in the executive's gross income when the accounts are no longer subject to a “substantial risk of forfeiture.” For these purposes, if the executive could voluntarily terminate employment and collect his or her account, there is no substantial risk of forfeiture.  The fact that the 457(f) accounts remain subject to the claims of the association's creditors also does not put the account at a substantial risk of forfeiture.

For this reason, ineligible 457(f) plans are rarely, if ever, funded with the employee's own contributions.  Accordingly, care needs to be taken when negotiating an employment contract with an executive, particularly one who is transitioning from the for-profit sector, who desires to have the ability to defer income in excess of deferrals that may be made under qualified plans and a 457(b) plan.