Remember Tax and Other Rules When Running a 457

Think you’ve taken care of everything with your 457 plan? Maybe you have—but maybe you haven’t. 

In the second of a two-part series in the Trucker Huss “The Benefit of Benefits” blog, Scott E. Galbreath discusses more common mistakes he has encountered in 457 plans that exempt organizations (EOs) sponsor. Coverage of Part I is here. 

Amending Plans 

Like any employee benefit plan, it sometimes is necessary to amend a 457 plan. Not doing so can result in missing opportunities to enhance what is offered to employees and plan participants. For instance, the SECURE Act, as well as SECURE 2.0, changed the rules for required minimum distributions (RMDs) by raising the age at which participants must begin taking RMDs. For a plan to comply with this and for it to be applied to participants, an amendment to the plan document must be made. 

In addition, failing to amend a plan when there have been changes to the laws and regulations governing it can result in running afoul of those laws and regulations, which could result in penalties to the plan or even plan disqualification. 

Tax Rules

There are a number of tax rules relevant to 457 plans that EOs should consider. 

Income tax. EOs that maintain a 457(f) plan for their executives should remember that a participant in such a plan is subject to income tax on the benefits when they become vested, Galbreath reminds. The employer needs to remember to report and collect the income taxes when vesting occurs—and that when vesting occurs itself can vary, depending on plan provisions. 

FICA. For purposes of FICA—Social Security, Medicare, and unemployment taxes—457(b) and 457(f) plans are treated as nonqualified deferred compensation plans. More precisely, such compensation is subject to FICA taxes on the later of (1) when the services giving rise to the compensation are performed and (2) the date the employee is vested. Further, Galbreath points out, if deferred compensation is taken into account correctly when vesting occurs, that deferred compensation as well as earnings on it will not be subject to additional FICA taxes when paid. 

Excise taxes. Galbreath reminds that Internal Revenue Code Section 4960 imposes a 21% excise tax on an applicable EO that pays compensation of more than $1 million to an individual in any given year.  And the compensation for purposes of Section 4960 in a given year is the present value of any deferred compensation when it vests—and the vested portion of a 457(b) or 457(f) plan counts against the $1,000,000 threshold.

Internal Revenue Code Section 409A

Galbreath notes that qualified plans and 457(b) plans are exempt from Code Section 409A, but 457(f) plans are not—and adds that mistakes that violate Code Section 457(f) often also violate Section 409A. And, he warns, a participant can be taxed on his or her entire vested benefit, and be subject to an additional 20% in federal taxes as well as interest at a full percentage point more than the going rate, if Section 409A is not followed.