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Nimbly Shifting Between 403(b) and 457(b) Plans

By Linda Segal Blinn

Jack was nimble enough to jump over the candlestick without getting burned. If you work with both 403(b) and 457(b) plans, take a page from Jack’s book — learn the key differences between 403(b) and 457(b) plans.

Why Timing Is Everything

By definition, employee deferrals into a 403(b) plan are made pursuant to a cash or deferred arrangement, giving an eligible employee the ability to make either pre-tax deferrals or (if the plan permits) Roth 403(b) contributions to his employer’s 403(b) plan up to the IRS annual deferral limit (in 2015 and 2016, $18,000 before available catch-ups and subject to annual cost of living adjustments). As a result, a 403(b) salary reduction agreement only extends to amounts that an employee chooses to contribute to the 403(b) plan instead of receiving as cash compensation. To be a valid 403(b) salary reduction agreement, that agreement can only apply to compensation that is not yet paid or currently available to that employee as of the effective date of the salary reduction agreement.

Unlike a 403(b) plan, a 457(b) plan is a deferred compensation arrangement. As a result, amounts deferred into the plan may include pre-tax deferrals, Roth 457(b) contributions (if the sponsor is a governmental employer and the plan so permits), and/or employer nonelective contributions. Thus, the IRS’ 457 annual contribution limit (in 2015 and 2016, $18,000 before an available catch-up and subject to annual cost of living adjustments) takes into account both employee and (to the extent vested) employer contributions. For these purposes, employer contributions are considered vested when no longer subject to a substantial risk of forfeiture. If employer contributions are subject to a vesting schedule, the vested employer contributions must also take into account any gains or losses for the annual contribution limit in which those amounts are no longer subject to a substantial risk of forfeiture.

Since a 457(b) plan does not operate under the IRS’ cash or deferred arrangement provisions, the rules governing 457 deferral agreements differ from 403(b) salary reduction agreement requirements. In general, an employee making deferrals into his employer’s 457(b) plan must have entered into his 457 deferral agreement before the first day of the calendar month in which the deferred compensation would be paid or made available. (If the 457(b) plan also permits nonelective employer contributions, those contributions are treated as if made under a deferral agreement entered into before the first day of the calendar month).

The IRS’ 457 regulations provide an exception to this general rule for the effective date for deferral agreements. If the 457(b) plan permits, a newly hired employee may make deferrals into the 457(b) in the calendar month of hire, provided that the deferral agreement is in place no later than the first day that the newly hired employee performs services for the employer.

The first day of the month after the month in which the employee entered into the agreement (or the special rule for newly hired employees) is the earliest effective date permitted under the IRS regulations for 457 deferral agreements. An employer’s payroll department may require time to process an employee’s deferral election. Some 457 plans may take this practical limitation into account by providing that deferrals from a valid 457 deferral agreement will be effective as early as administratively practicable, but not earlier than the first day of the following calendar month in which compensation is paid or made available to the employee.

In the Event of an Emergency

A hardship withdrawal is permitted under a 403(b) plan if a participant has an immediate and heavy financial need and the distribution is necessary to satisfy that need. To assist a 403(b) plan sponsor in determining whether a participant is entitled to a hardship withdrawal, the IRS provides safe harbor reasons for what would constitute an immediate and heavy financial need, as well as for the amount necessary to satisfy that financial need.

An unforeseeable emergency withdrawal from a 457(b) plan must satisfy a stricter standard. An unforeseeable emergency is a participant’s severe hardship resulting from extraordinary and unforeseeable circumstances arising out of events beyond the participant’s control. The IRS provides examples of what might be considered an unforeseeable emergency:

  • illness or accident of the participant, spouse or dependent;

  • participant’s property loss caused by casualty; or

  • funeral expenses of the participant’s spouse, dependent, or non-dependent child.

Because an unforeseeable emergency withdrawal depends on whether the particular facts and circumstances were both unforeseeable and beyond the control of the participant, the IRS does not provide any safe harbors for an unforeseeable emergency withdrawal. Instead, a 457(b) plan sponsor would need to determine on a case-by-case basis whether a participant has an unforeseeable emergency based on all relevant facts and circumstances. For example, in Revenue Ruling 2010-27, the IRS noted that the need to repair a participant’s principal residence because of significant water damage that is not covered by insurance would be an extraordinary and unforeseeable circumstance arising as a result of events beyond the control of the participant.

The IRS has identified improper unforeseeable emergency withdrawals as one of the top-10 issues encountered on audit. The IRS stresses that a 457(b) plan should maintain strong internal controls when determining whether a participant is entitled to an unforeseeable emergency withdrawal, including maintaining supporting documentation for both the unforeseeable emergency and the amount needed to satisfy that unforeseeable emergency.

Why the 457 Catch-up Is Special

Unique to 457(b) plans, whether sponsored by a nonprofit organization or a governmental employer, is the “Normal Retirement Age” Catch-up (also known as the “Special 457 Catch-up”). The Special 457 catch-up permits a participant to make a one-time election to defer up to twice that year’s IRS 457 annual contribution limit, if that participant is within the three-year time period before the year in which he will reach his elected “normal retirement age.” Normal retirement age is used only for purposes of calculating the Special 457 Catch-up — the participant is not entitled to a withdrawal from the 457(b) plan once he reaches normal retirement age nor is he obligated to terminate employment once he reaches normal retirement age.

While the 457 plan defines normal retirement age, the IRS provides parameters. Normal retirement age must be no earlier than whichever is first — age 65, or the earliest age at which the participant has a right to retire and receive unreduced benefits under his employer’s defined benefit pension plan (or money purchase plan, if there is no DB plan). The latest normal retirement age permitted is age 70½.

Once a participant has elected his normal retirement age, there must be a calculation to figure out the actual amount available under the Special 457 Catch-up. For each of the three years before the year of the participant reaching normal retirement age, the amount available that year under the Special 457 Catch-up compares the amount the participant contributed to the 457 plan in prior years to each prior year’s IRS 457(b) annual contribution limit, starting with the year the individual was first eligible to participate in the plan through the prior tax year. The total difference between actual participant contributions to the 457(b) plan and the applicable IRS 457(b) annual contribution limit will determine the cumulative amount available under the Special 457 catch-up, capped at twice the current year’s IRS 457(b) annual contribution limit .

As a best practice, the employer should maintain documentation of the participant’s election of normal retirement age, prior contribution history, and calculation of the Special 457(b) Catch-up. And if a participant in a governmental 457(b) plan is eligible for both the Age 50+ Catch-up and the Special 457(b) Catch-up in the same tax year, he cannot use both of those catch-ups in the same year. Rather, in keeping with IRS requirements, such a participant can use the catch-up in that year that allows him to contribute the greatest amount.

Linda Segal Blinn, J.D.* is Vice President, Technical Services for Tax-Exempt Markets for Voya Financial®. Note that the author is not a practicing attorney for Voya Financial.

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