Large Open Office Woman reviews documents

Impending changes to IRC Section 457 empowers employers of tax-exempt and governmental entities to begin offering or improve existing deferred compensation plans.

Employer strategies

Proposed IRC 457 Deferred Compensation Plan Regulations Provide Flexibility

  • Kelly Davis
  • 9/27/2016

The IRS recently released the proposed regulations to Section 457 for deferred compensation plans. This section of the Internal Revenue Code (IRC) permits tax-exempt and governmental employers to offer a 457(b) plan, 457(f) plan, or both to employees.

In light of the proposed regulations, tax-exempt and government employers have the opportunity to evaluate existing deferred compensation arrangements, severance plans, sick pay, vacation leave, and employment contracts and consider plan changes that could enhance the organization’s offerings.

IRC defines deferred compensation

Deferred compensation may be any plan, contract, or arrangement that permits an employee — usually top-tier executives — to delay taxation on certain compensation or benefits that are earned in one tax year and payable in a future tax year. Generally, deferred compensation provided to employees of tax-exempt organizations and government entities is subject to taxation under Section 457(f) of the IRC, unless provided through a qualified plan under Section 457(b), 403(b), or 401(a).

457(b) plans offer age 50 catch-up

Let’s start with understanding the role of a 457(b) plan. This plan allows employees of sponsoring organizations to defer income taxation on retirement savings into future years. Contributions to 457(b) plans may include employee salary deferrals and employer contributions annually up to the IRS predetermined limit under IRC 402(g) ($18,000 in 2015 and 2016). Governmental 457(b) plans may allow participants over the age of 50 to contribute additional contributions ($6,000 in 2015 and 2016) at the end of the current tax year. Age 50 catch-up contributions are not allowed in non-governmental 457(b) plans, but special catch-up contributions for participants who are within three years of normal retirement age are available for both non-governmental and governmental 457(b) plans.

457(f) plans require substantial risk of forfeiture

A 457(f) plan allows a tax-exempt employer to supplement the retirement income of its select management group or highly compensated employees. The benefit is then paid to the executive upon retirement, death, or disability. Generally, there is no annual limit on the amount of contributions that may be deferred on behalf of qualifying executives.

This plan and associated deferrals is only possible if there is a substantial risk of forfeiture on the deferred contributions of which when the risk is removed, the participant’s deferral amounts become taxable. The deferred amounts and earnings are employer assets and subject to the claims of general creditors until the participant’s benefit is no longer subject to a substantial risk of forfeiture.

457(f) plans trigger different tax treatment compared to an eligible plan under 457(b), so the determination of whether compensation is considered part of a Section 457(f) plan, and when it vests, is critical to the timing of when a participant recognizes the compensation for income tax purposes.

Proposed regulations focus on enhancements for 457(f) plans

The proposed regulations mainly redefine IRC 457(f) plans and provide possible plan design enhancements, such as the opportunity to delay the immediate taxation on deferred benefits to a participant under Section 457(f) when the substantial risk of forfeiture to their benefit is removed. The proposal also clarifies rolling risk of forfeiture. Previous guidance did not allow an extension of the substantial risk of forfeiture past the date initially specified that the risk of forfeiture to a participant’s benefit would be removed. The new regulations provide an exception to this rule if certain criteria are met.

The proposed regulations provide other notable clarifications that align many 457(f) plan concepts with IRC 409A, which provides additional certainty to plan design, administration, and reporting. For example, a deferral of compensation under IRC 457(f) from one year only to a payment date on or before March 15 of the following year will no longer be considered a deferral for either IRC 457(f) or 409A under the new regulations.

New guidance defines leave and severance pay

Prior to the proposed regulations, authoritative guidance did not define a bona fide severance pay plan exempt from IRC 457. The proposed regulations provide that a bona fide sick or vacation leave plan must demonstrate that the primary purpose of the plan is to provide for paid time off from work because of sickness, vacation, or other personal reasons.

How we can help

While these changes could take years to finalize, tax-exempt organizations and government entities may rely on the proposed regulations moving forward. With the flexibility and clarification these regulations provide, there may be opportunities for organizations to benefit from these proposed updates. Once finalized, these changes will be implemented in the following calendar year and will apply to amounts deferred after the effective date and unvested amounts deferred prior to the finalized date.