Many people think that governmental section 457(b) plans and private sector 401(k) plans are the same because they both allow pre-tax deferrals of similar amounts of income—but they’re not.
Due to their differing origins, their rules and requirements are different, and it’s important not to assume that what works for a 401(k) plan will also work for a governmental 457(b) plan. Take, for example, the timing of deferral elections.
Similarities Between 401(k) and Governmental 457(b) Elections
The basic function of either a 401(k) plan or a governmental 457(b) is to permit eligible participants to “defer” compensation they would normally receive from their employer and be taxed on. In order to avoid taxation as a result of having the choice between current cash compensation and deferred compensation, the rules under Section 401(k) or 457(b) need to be followed because these provide limited exceptions to the doctrine of constructive receipt.
One basic rule common to both 401(k)s and 457(b)s is that you can’t defer amounts of income earned or received before the plan has been adopted or implemented. While it is not uncommon to see 401(k) plans with certain “effective dates” going back to the beginning of a plan year, if the plan is being adopted/signed mid-year, that plan cannot accept deferrals that pre-date the date of adoption/execution of the plan. Similarly, a 457(b) plan cannot accept pre-tax deferrals of amounts of compensation earned prior to the date of adoption of the plan.
Differences Between 401(k) and Governmental 457(b) Elections
- Timing of 401(k) elections is more flexible. Once a 401(k) plan has been properly established, the timing of deferral elections and changes to those elections is generally quite flexible. Although plan sponsors and plan administrators may establish particular plan rules regarding the timing of deferral elections (and related changes), the 401(k) rules potentially allow elections and changes to be made at any time before the income is “currently available”—generally the pay date.
- Timing of 457(b) elections is less flexible and requires more planning. By comparison, the deferral rules for governmental 457(b) plans generally require an election to defer (or a change in an existing election) to be made during the calendar month prior to the calendar month in which the subject income would be paid. Although there is an exception for a newly hired employee who is becoming eligible for the plan for the first time—which allows an election to be made in the first month of employment when the employee is being paid—that initial election must be made on or before the employee’s first day of work. There also is a special timing rule that may apply when a governmental employer is implementing a new 457(b) plan. However, this exception probably would not apply to instances where an existing 457(b) plan is moving from one recordkeeper to a new recordkeeper.
Conclusion
We are mentioning the “month prior” and the “first day of employment” rules for governmental 457(b) plans because we know that a fair number of public agencies do not necessarily follow these rules to the “T.” Workers and human resource staff are now moving regularly between the private sector and the public sector. As a result, both new participants and HR staff may be assuming that the looser deferral rules for 401(k)s automatically apply to their 457(b). Unfortunately, if the more strict 457(b) rules are not followed, there could be unwelcome tax consequences.
Jeff Chang is a partner at Best Best & Krieger LLP.
Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA or its members.
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