T—457 Plans

Section 457 plans are nonqualified deferred compensation plans available to employees of state and local governments and tax-exempt organizations. By deferring income, employees are able to reduce current income taxes while saving more for retirement than they would with the typical after-tax savings plan. “State and local governments” include a state, a political subdivision of a state, or any agency or instrumentality of either of them (e.g., a school district or sewage authority). Tax-exempt organizations include those types of nongovernmental organizations exempt from tax under Code Section 501 (i.e., most nonprofit organizations that serve their members or some public or charitable purpose, but not a church or synagogue). Under “eligible” plans, only individuals may participate, not partnerships or corporations. Partnerships and corporations may participate in “ineligible” plans. Section 457 plans can also be made available to independent contractors, but under somewhat different rules.

ELIGIBLE PLANS. Under “eligible” plans, in 2025, deferrals are limited to the lesser of $23,500, or 100 percent of includable compensation. Benefits usually are not subject to forfeiture. Eligible plans are most often used for the “rank and file” employees of state and local governments, who desire to defer limited amounts of compensation on an attractive tax deferred basis. The term “eligible plans” is used to describe the deferred compensation plans of state and local governments and tax-exempt organizations that comply with the provisions of Section 457. When a plan provides for deferrals in excess of the lesser of $23,500 or 100 percent of compensation, Section 457(f) states, “compensation shall be included in the gross income of the participant or beneficiary for the 1st taxable year in which there is no substantial risk of forfeiture.” Plans falling under Section 457(f) are variously referred to as “ineligible” plans and “Section 457(f)” plans.

Employees of state and local governments are not taxed until benefits are actually paid. In contrast, employees of tax-exempt organizations are not taxed until the benefits are actually paid or otherwise made available to them. Tax-exempt organizations can only make eligible plans available to a select group of management or highly compensated employees. (These higher paid employees of tax-exempt organizations often prefer “ineligible plans” providing
for greater deferrals.)

Unlike plans of state and local governments, plans of tax-exempt organizations can be subject to the participation, vesting, and funding requirements of ERISA. These ERISA requirements are in conflict with the “no funding” requirements of Section 457 for taxexempt organizations. This prevents most tax-exempt organizations from having a Section 457 plan unless the plan fits within the ERISA “top hat” exemption (i.e., an unfunded plan for a select group of management or highly compensated employees). This also means that “rank and file” employees of tax-exempt organizations cannot participate in Section 457 plans.

The earliest plan distributions can be made is at severance of employment, death, an “unforeseeable emergency,” or in the calendar year in which the participant reaches age 70½ (72 after 2020). Plan distributions must generally begin by April 1 of the year. following the year in which the employee retires or attains age 70½ (72 after 2020), whichever is later. Distributions from Section 457 plans are subject to ordinary income taxes. Rollovers are permitted to and from an eligible Section 457 plan of a state or local government, a qualified plan, a Section 403(b) tax sheltered annuity, or an IRA.

INELIGIBLE PLANS. Under “ineligible” plans, employees may make unlimited deferrals of compensation, provided the benefits are subject to a “substantial risk of forfeiture.” A “substantial risk of forfeiture” is said to exist if a participant’s right to the compensation is conditioned upon the future performance of substantial services. The risk of forfeiture must be both real and substantial. These plans are most often used by tax-exempt organizations to provide substantial deferrals for a select group of management or highly compensated employees (the “top hat” group). Use of ineligible plans by state and local governments is generally limited to highly paid employees who can accept a risk of forfeiture, since such a risk is often unacceptable to the “rank and file” employee. Because employees are taxed when there is no longer a substantial risk of forfeiture, vesting provisions must be carefully drafted.

For example, payment of compensation might be conditioned upon the continued employment of the participant for a specified period, measured by a pre-established service completion date. At the end of the service completion date, when there are no longer any future service requirements, and therefore no risk of forfeiture, the deferred amount (including earnings accumulated prior to the lapse of the risk) is included in the participant’s taxable income. However, the earnings credited to the participant’s account after the substantial risk of forfeiture ends generally will not be taxable as compensation until actually paid or otherwise made available. It may be desirable to release compensation over a specific period of years in order to reduce the tax burden as the contract conditions are met.

Ineligible plans are not required to comply with any specific distribution requirements. Non-qualified or ineligible plans for tax-exempt organizations differ primarily from those used in for-profit businesses because of the fact that deferral of taxation cannot be pushed beyond retirement. Both eligible and ineligible plans may not be formally funded, except for eligible governmental plans. However, it is customary and desirable for employers to “informally” fund their obligations through the purchase of life insurance, annuities, or investment products.

If life insurance is purchased with amounts deferred, the premiums are not taxed to the participant as long as the employer remains the owner and beneficiary of the contract. However, upon the employee’s death, payment of the proceeds to the employee’s beneficiary would be taxed under the normal annuity rules and would not be treated as tax-free death proceeds. Any deferrals, and assets purchased with the deferrals, must remain the property of the employer and are subject to the employer’s general creditors.