The Different Flavors of 457(b): Tax-Exempt and Governmental Employers

by Michael Webb

For those of you who are familiar with 457(b) plans, they come in two separate and distinct “flavors” if you will. One “flavor” is the one for governments (including public K-14 and public higher ed), while the other “flavor” is for private 501(c) tax-exempts (including private elementary/secondary schools, private higher ed, healthcare, arts, social welfare organizations, associations and any other entity exempt from tax under Section 501(c) of the Code, EXCEPT for 3121(w) “steeple” churches/QCCO’s). And, though these 457(b) plan types have some similarities, in most ways they are as different as, say, vanilla and pistachio. This article will examine the similarities and oft-misunderstood differences between these two types of plans.

Similarities

Though the differences between governmental and private tax-exempt 457(b) plans are significant, there are a number of similarities, as follows:

• Both must have a written plan document.

• Both permit a deferral limit that is separate from the 402(g) limit for 403(b)/401(k) plans, thus permitting significant deferral opportunities when a 457(b) is offered alongside a 403(b)/401(k) plan.

• Neither is subject to ERISA (in theory, most private tax-exempt plans ARE subject to ERISA, but, as a practical matter, cannot operate as ERISA plans) and are thus not subject to ERISA’s reporting and disclosure requirements, such as 5500s, SARs and SPDs (but see special one-time filing requirement for private tax-exempt plans, below).

• Both permit employee elective deferrals as well as employer contributions; for both plans; a single combined contribution limit for both contribution types applies, however.

• Contributions to both, whether elective deferrals or employer contributions are subject to FICA and FICA Medicare (which can be tricky with respect to employer contributions, which might not otherwise be subject to payroll withholding).

• Both permit Special “catch-up” contributions for participants who are within three years of normal retirement age (as specified in the plan).

• Contributions to both are not required to pass any nondiscrimination testing.

• Both, in theory, can implement vesting schedules for employer contributions, and the minimum vesting standards under the Code and ERISA do not apply. However, due to practical matters associated with vesting in 457(b) plans, vesting schedules are a rarity.

• Both may permit independent contractors to participate (but see “select management or highly compensated” requirement for private tax-exempt plans, below).

• For both, a salary deferral agreement must be in place during the month before the calendar month for which deferrals are to commence (with a limited exception for new hires). Note that the qualified plan exception that applies to the deferral of separation pay that the employee would have otherwise received had he/she continued working (e.g. accumulated sick/vacation), also applies to 457(b) plans.

• For both, there is no 10% premature distribution penalty. Withdrawals at any age can be taken with only ordinary income taxes due (note: the 10% penalty DOES apply to subsequent distribution of funds that are rolled into a governmental plan from 401(a)/401(k)/403(b) plans and IRAs).

• Both restrict in-service distributions to age 70½ and unforeseeable emergency.

• Both permit cashouts of small ($5,000 or less) account balances if there have been no contributions to the participant’s account for their previous two years and the participant has not previously taken a distribution.

• Both must commence distributions no later than April 1 following the later of the year in which the participant turns age 70 ½ or severs service with the plan sponsor.

• Both must pay benefits in a single sum or in annual installments that do not substantially increase over time (contrast to 403(b) plans, where participants can generally make partial withdrawals as they see fit).

• Both permit transfers between 457(b) plans of different plan sponsors (though only between plans of the same type; e.g. private tax-exempt to private tax-exempt. In addition, transfers can only be made between governmental plans in the same state). Governmental 457(b) plans may also transfer assets to purchase service credits from a state-sponsored defined benefit program.

• Both are subject to the QDRO rules, and both can permit QDRO-based early distributions.

• The provisions of USERRA, which relate to qualified military leave, apply to both types of plans (however, the HEART act, which updated some provisions of USERRA, does not apply to private-tax exempt 457(b) plans).

• Both permit plan participants to direct investments (if the plan permits).

• Both permit virtually any type of investment, without restrictions, but 501(c)(7) social clubs may need to pay taxes on annuity contracts.

• In both plan types, the plan sponsor generally does not have responsibility, fiduciary or otherwise, for plan investment performance (with the exception of governmental plans in a few states, where state law may provide for such responsibility).

• Both plan’s generally protect assets from the creditors of a participant in the event of a participant’s bankruptcy (however, protection from creditors in general (non-bankruptcy) situations is less clear for governmental 457(b) plans).

• Neither plan is required to be submitted to the IRS for formal approval (though state or local laws may require that a 457(b) plan be so submitted).

• Both may invest in life insurance, though there are practical issues with the administration of life insurance contracts in both plan types.

• Both plan types may be terminated.

Differences

The critical differences between governmental and private tax-exempt 457(b) plans can often be confusing to those unfamiliar with 457(b) plan, and even the seasoned practitioner can confuse the distinctions on occasion. These differences are, as follows:

• All employees can be included in a governmental 457(b) plan (though the plan sponsor can choose to limit eligibility at its discretion). Private tax-exempt 457(b) plans must limit participation to select management or highly compensated employees (there is ONE exception to this rule; 414(e) religious organizations may include all employees). The “select management or highly compensated employee” group is not defined by regulation (a recent court case, however, clarified that it likely could not be more than 15% of the total workforce), but is generally understood to include employees who exercise sufficient influence over their compensation arrangements that they do not require the protections of ERISA, such as C-suite employees.

• Governmental 457(b) plans must be invested in a trust which is not subject to creditors of the plan sponsor (Note: certain annuity contracts/custodial accounts are deemed to satisfy the trust requirements). Private tax-exempt 457(b) plans may not be held in a trust (although they can be placed in a Rabbi Trust as long as the employer is the owner of the trust assets); they must be held in the plan sponsor’s name and are subject to the plan sponsor’s creditors in the event of insolvency.

• The age-50 catch-up election is permitted in governmental 457(b) plans; it is not permitted in private tax-exempt 457(b) plans.

• Roth contributions and conversions in a governmental plan are permitted; such contributions are not allowed in private tax-exempt 457(b) plans.

• Loans are permitted in governmental 457(b) plan; they are not permitted in private tax-exempt 457(b) plans.

• Rollovers to and from governmental 457(b) plans are permitted; they are >not permitted to/from private tax-exempt 457(b) plans. The eligible rollover distribution rules also apply to governmental 457(b) plan distributions, which means that mandatory 20% withholding will apply to such distributions if not directly rolled over.

• Account balances in private tax-exempt 457(b) plans are generally taxable (for federal purposes) upon severance of employment (whether or not actually paid to the participant at that time) EXCEPT if the participant makes a one-time election to defer distribution to a later date (no later than the latest date that distributions must commence under the plan). Governmental 457(b) plans are not subject to such a requirement.

• Distributions from governmental 457(b) plans are reported on Form 1099-R; distributions from private tax-exempt plans are reported on Form W-2.

• Private tax-exempt 457(b) plans (EXCEPT plans of 414(e) religious organizations) must file a one-time “top-hat” disclosure to the Department of Labor. Governmental 457(b) plans are not subject to this filing requirement.

• Automatic enrollment is permitted in governmental 457(b) plans; it is not permitted in private tax-exempt 457(b) plans.

• Plan defects generally cause a private tax-exempt 457(b) plan to become ineligible immediately. For governmental 457(b) plans, there is a grace period.

Conclusion

As you can see, the myriad of similarities and contracts between governmental and private tax-exempt practitioners can be a quite a minefield! We hope that this article will assist practitioners in navigating the nuances of such plans.

Practice Pointer: Since it is difficult to master both types of 457(b) plans, some practitioners choose to master one plan type (say, governmental 457(b) plans) before turning their attention to the other type.

Michael Webb, TGPC, CEBS, is the NTSA Communication Committee Co-Chair and a Vice President at Cammack Retirement.

Please note that this article is for general informational purposes only, is not intended to be taken as legal advice or a recommended course of action in any given situation. Readers should consult their own legal advisor before taking any actions suggested in this article.

Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA, or its members.