The IRS has issued proposed regulations for Code §457 plans. The new regulations reflect tax law changes made to 457 plans by EGTRRA and other tax laws dating back to TRA 86.
Nonqualified deferred compensation. Code §457 is the statutory provision governing nonqualified deferred compensation plans for government and tax-exempt organizations. Since governments generally are not permitted to have 401(k) plans, the 457 plan often serves as a 401(k) substitute for governmental plans. Although tax-exempt organizations also can maintain 457 plans, the tax-exempt organization must limit participation to the highly compensated and management employees to avoid a conflict with Title I requirements (e.g., eligibility, vesting, hold assets in trust). If the tax-exempt organization does not limit participation it could not comply both with the Code §457 requirement to retain the deferrals as part of the employer’s assets and the Title I requirement that requires the employer to set aside the deferrals in a trust that is exempt from the employer’s creditors. Although the typical 457 plan is an elective deferral plan, the 457 rules also apply to any employer contributions made under the plan. However, the 457 rules do not apply to severance pay plans.
Documentation. An employer that establishes a 457 plan must incorporate the material terms of the plan in a written document. If the 457 plan is a governmental 457 plan, the employer also must establish a trust, custodial account or annuity contract that is for the exclusive benefit of the participants and beneficiaries. The trust requirement does not apply to a tax-exempt organization.
Contribution limits. Except for the first month of an employee’s employment, an employee does not need to make a salary reduction election before his/her compensation is earned. However, the employee must make the deferral election before the first day of the month in which the compensation is paid or made available. Elective deferrals and any employer contributions may not exceed the lesser of 100% of an employee’s compensation or the Code §457(b) dollar limit ($11,000 for 2002). For taxable years commencing after 2001, compensation will include any elective deferrals. 457 plans also may permit catch-up contributions in excess of the dollar limit under two separate provisions. A 457 plan may use the EGTRRA age-50 catch-up provision ($1,000 for 2002) or the special larger 457 catch-up rule that permits an employee to increase his/her deferrals for the three years prior to normal retirement age. The special 457 catch-up provision allows an employee to defer two times the basic annual limit, but only to the extent the employee has underutilized the 457 limit in prior years. A 457 plan participant may not use both catch-up limits for a particular year. If an employee defers in excess of the 457 limit for a taxable year, the regulations permit the plan to self-correct the excess by paying out the excess as soon as administratively practicable after the plans discovers the excess deferral.
Loans. An eligible governmental 457 plan may permit participant loans. A tax-exempt organization’s 457 plan may not permit participant loans. Participant loans are subject to the same taxation rules under Code 72 that are applicable to qualified plans. Although loans from governmental plans are not subject to the prohibited transaction rules, the loans are subject to the pre-ERISA loan requirements which reflect many of the prohibited transaction requirements (e.g., availability, reasonable rate of interest, fixed payment schedule, bona-fide loan, exclusive purpose of the participants).
Distributions. Distributions from an eligible governmental plan are taxable when the employee receives the distribution. In addition, the distributions generally are eligible rollover distributions. Therefore, the plan must provide the direct rollover notice and subject distributions not directly rolled over to 20% income tax withholding. Rollovers from a qualified plan, 403(b) plan or IRA to an eligible government 457 plan must be separately accounted for in the 457 plan because those types of contributions are subject to the 10% premature distribution tax. However, the 457 plan otherwise does not have to distinguish between the different types of rollovers to the 457 plan. Distributions from a tax-exempt organization’s 457 plan continue to be taxable when the funds are available. Therefore, a participant in a tax-exempt 457 plan would need to make a distribution election before the funds are available. Furthermore, distributions from a tax-exempt 457 plan are not eligible for rollover and such plans may not accept rollovers.
Plan terminations/transfers. A 457 plan may incorporate a provision that permits distribution upon plan termination. This new provision will allow employers to eliminate 457 plans and employees to roll over the distributions from terminated governmental 457 plans. A 457 plan also may permit transfers between like-type of 457 plans (i.e., eligible governmental plan to eligible governmental plan; or tax-exempt 457 plan to a tax-exempt 457 plan.
Correction. The IRS intends to expand the EPCRS correction program to permit an employer to correct 457 plan failures under that program.
Effective date. The proposed regulations are effective for taxable years beginning after December 31, 2001. However, an employer may rely on the proposed regulations in taxable years commencing after August 20, 1996. The IRS will not require plan amendments reflecting EGTRRA and the new regulations until the later of the date on which the IRS issues guidance on plan amendments or the date final regulations are issued.
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