Carol V. Calhoun, Counsel
Venable LLP
600 Massachusetts Avenue, NW
Washington, DC 20001
Phone: (202) 344-4715
Fax: (202) 344-8300
Mobile: (202) 441-5592
E-mail: Click here to send e-mail.
Venable LLP
600 Massachusetts Avenue, NW
Washington, DC 20001
Phone: (202) 344-4715
Fax: (202) 344-8300
Mobile: (202) 441-5592
E-mail: Click here to send e-mail.
- The proposed regulations for the first time specifically require a written plan document.
- This contrasts with a governmental
403(b) plan, or a non-ERISA salary-reduction-only403(b) arrangement of a nongovernmental employer, which is not required to have such a document.
- Except for the first month ofan employee’s employment, an employee does not need to make a salary reduction election before his or her compensation is earned.
- Deferrals of accumulated sick pay, vacation pay, or back pay are specifically permitted.
- However, this does not necessarily permit the deferral of other kinds of wage income. In particular, the IRS has historically taken the position that an individual cannot defer items such as severance, if received after the individual ceases to be an “employee.”
- IRS officials have informally stated that they may consider some sort of limited rule that would, for example, permit an individual who terminated employment December 31 to defer accumulated vacation or sick pay received in January of the following year.
- The employee must make the deferral election before the first day of the month in which the compensation is paid or made available.
- The aggregate of elective deferrals and any employer contributions, in the absence of a catch-up election, may not exceed the lesser of
- 100% of an employee’s compensation, or
- a dollar limit ($11,000 for2002).
Unlike the
401(k) and403(b) limits, the457(b) limit applies to employer contributions as well as elective deferrals. However, a governmental employer may avoid this limit by making nonelective or matching457(b) contributions through contributions to a401(a) or403(b) plan, rather than through contributions tothe457(b) plan itself. - The definition of compensation has been amended to include elective deferrals.
- This effectively raises the compensation limit on elective deferrals under
457(b) plans from 50% or less of compensation to 100% of compensation, if the only deferrals are elective deferrals. - However, elective deferrals do not include picked up employee contributions under governmental plans pursuant to Code section
414(h)(2), which must still be deducted from compensation before applying the limit.
- This effectively raises the compensation limit on elective deferrals under
- Catch-ups.
- Amount of catch-ups. A participant in a
- Special
457(b) catch-up rule that permits an employee to increase his/her deferrals for the three years prior to normal retirement age, or - Age 50 catch-up provision($1,000 for 2002, in addition to the $11,000 otherwise permissible); applies only to governmental plans.
- A participant may use these catch-up provisions more than once if he or she participates in the plans of more than one employer.
- Definition of normal retirement age:
- Allows flexible definition of “normal retirement age,” and allows a plan to permit the election of a normal retirement age by the participant within certain limits.
- Thus, a participant who wanted to allow for maximum tax-deferred accumulation of earnings could put the
457(b) catch-up contributions into the plan as early as the earlier of- age 59½ (or 40 in the case of qualified police and firefighters), or
- the normal retirement age under the employer’s defined benefit plan, if any.
- A participant who did not have the resources to make the contributions early could, if permitted by theplan, select a normal retirement age as late as age 70½.
457(b) plan can use either (but not both) of the following catch-ups in a particular year:
- An eligible governmental
457(b) plan (but not a nongovernmental457(b) plan) may permit participant loans. - Participant loans are subject to the same taxation rules under Code 72 that are applicable to qualified plans.
- Loans are subject to prohibited transaction requirements under Code sections
401(a) and 503(b), as well as pre-ERISA rules governing bona fide loans.
- Regulations provide examples of unforeseeable emergencies that can give rise to in-service distributions:
- the imminent foreclosure of or eviction from the participant’s or beneficiary’s primary residence;
- payment for medical expenses,including non-refundable deductibles and the cost of prescription drug medication, to the extent the participant cannot otherwise pay such expenses;and
- the need to pay for the funeral expenses of a family member. (It is unclear what the definition of a “family member” is for this purpose; this may be clarified in final regulations.)
- “Unforeseeable emergency “nevertheless remains a narrower term than “hardship” for purposes of distributions from
401(k) or403(b) plans.
- Time of taxability.
- Distributions from aneligible governmental plan are taxable when the employee receives the distribution.
- Distributions from a tax-exempt organization’s
457(b) plan continue to be taxable when the funds are available. Therefore, a participant in a tax-exempt457(b) plan would need to make a distribution election before the funds are available.
- Rollovers.
- Distributions from a governmental
457(b) plan generally are eligible rollover distributions.Therefore, the plan must provide the direct rollover notice and subject distributions not directly rolled over to 20% income tax withholding. - Distributions from a tax-exempt
457(b) plan are not eligible for rollover and such plans may not accept rollovers. However, transfers among457(b) plans are still permitted under section 457(e)(10).
- Distributions from a governmental
- Rollovers from a qualified plan,
403(b) plan or IRA to an eligible government457(b) plan must be separately accounted for in the457(b) plan because those types of contributions are subject to the 10% early distribution tax. However, the457(b) plan otherwise does not have to distinguish between the different types of rollovers to the457(b) plan.
- A
457(b) plan may now incorporate a provision that permits distribution upon plan termination. - This provision will allow employers to eliminate
457(b) plans, in instances in which they do not face contractual, or state or local law, barriers to doing so. - Employees may roll over distributions from terminated governmental
457(b) plans, but not nongovernmental plans, to a qualified retirement plan or other acceptable rollover recipient. This means that a termination of a nongovernmental457(b) plan, even though permissible, will result in tax consequences to the participant.
- In the past, there has been no formal procedure for correcting excess deferrals, and there has been a concern that any excess deferrals will result in loss of
457(b) status without opportunity for correction. - The regulations do not provide any method for a tax-exempt employer to make a correction to avoid loss of
457(b) status, although a correction procedure may be provided in the expanded EPCRS program as discussed below. - Regulations provide for correcting “excess deferrals” in a governmental plan by distributing them “as soon as administratively possible” after the plan determines the amount is an excess.
- Uncorrected excess deferrals.
- Uncorrected excess deferrals in the plan(s) of one employer can result in the plan’s losing its
457(b) status. This contrasts with the approach used by some employers in the past, of merely characterizing the excess as a 457(f) deferral. - Uncorrected combined deferrals due to a participant’s participation in the plans of more than one employer result only in unfavorable tax consequences for the participant.
- Uncorrected excess deferrals in the plan(s) of one employer can result in the plan’s losing its
- The IRS intends to expand the EPCRS correction program to permit an employer to correct
457(b) plan failures under that program. - It is unclear how the new correction rules will interact with the rule providing that a governmental
457(b) plan will not lose its457(b) status unless it refuses to correct after being notified by the IRS of deficiencies.
- The proposed regulations are effective for taxable years beginning after December 31, 2001.
- However, an employer may rely on the proposed regulations in taxable years commencing after August 20, 1996.
- The IRS will not require plan amendments reflecting EGTRRA and the new regulations until the later of the date on which the IRS issues guidance on plan amendments or the date final regulations are issued. However, state constitutional guarantees may in some instances require earlier amendments.
- Excise tax on early distributions.
- An amount distributed from a
457(b) plan is not subject to an excise tax on early distributions, except to the extent that it consists of amounts previously rolled over to the457(b) plan from a qualified plan, a403(b) plan or an IRA. - Some had suggested that the converse should also
apply — a distribution from a qualified plan, for example,should be exempt from the excise tax on early distributions to the extent it consisted of amounts previously rolled into the qualified plan from a457(b) plan. However, Notice 2002-3 states that, “any amount rolled over from the [governmental457(b)] Plan to another type of eligible employer plan or to a traditional IRA will be subject to the additional 10% tax if it is distributed to you before you reach age 59½, unless an exception applies.” - Thus, an individual who is considering rolling money from a governmental
457(b) plan to another type of plan will need to balance the potential for tax deferral against the adverse consequences that may ensue if he finds he needs to take a distribution of the money from the receiving plan before attaining age 59½ or meeting one of the exceptions. - Tax on certain unrealized appreciation
- Tax on certain net unrealized appreciation on employer securities distributed from a qualified plan of a private employer can be deferred until the distributee sells the securities.For example, if a qualified plan held employer securities purchased for $1,500,and distributed to an individual when their value was $2,000, the individual could pay tax only on the $1,500, and defer tax on the other $500 until s/he sold the securities.
- The Notice states that,”Generally, you will no longer be able to use the special rule for net unrealized appreciation if you roll the stock over to a traditional IRA or another eligible employer plan.” Thus,an individual considering rollover from a qualified plan of a private employer to a 457 plan must balance the immediate tax advantages with the loss of the special rule for net unrealized appreciation.
- Ten-year averaging or capital gains treatment.
- Tax provisions allowing for ten-year averaging or capital gains treatment on lump sum distributions to certain individuals will be lost if the amounts are rolled over to an IRA, a governmental 457 plan, or a
403(b) plan. - Indeed, if some distributions from a plan are rolled over to another plan, such treatment may be lost even as to future distributions from the distributing plan.
- This means that it may still be worthwhile to roll money from a
401(a) plan to a separate conduit IRA (which would hold only such amounts), rather than to a regular IRA,403(b), or457(b) plan in some instances. If the IRA does not hold money from any other source, the favorable tax treatment may be preserved.
- Tax provisions allowing for ten-year averaging or capital gains treatment on lump sum distributions to certain individuals will be lost if the amounts are rolled over to an IRA, a governmental 457 plan, or a
- Only a traditional IRA, not a Roth IRA, can accept rollovers.
- Plan provision limiting rollovers.
- A plan that elects to accept rollovers can limit the types of rollovers it accepts, for example by not accepting rollovers of after-tax employee contributions.
- However, if a plan accepts rollovers of after-tax employee contributions, the Notice says that it must account for them separately so that the taxation of ultimate distributions from the transferee plan can be determined.
- Conformity Issues
- Maximum deferrals in a
457(b) plan.- If state law limits deferrals under a
457(b) plan, some portion of the deferral may be taxable at the state level, even if it is not taxable at the federal level. - If state law defines a
457(b) plan to include only one that permits deferrals of less than a certain amount,excess deferrals may cause the entire deferral, not just the excess, to be taxable.
- If state law limits deferrals under a
- Rollovers to or from a
457(b) plan.- If a state law provides for deferral of taxation on rollovers from a
401(a) plan, for example, only if theyare transferred to another401(a) plan or an IRA, a rollover from a401(a) planto a457(b) plan may be taxable for state purposes. - If a state law has not been amended to reflect the ability to roll over amounts from a
457(b) plan, a distribution from a457(b) plan that is rolled over to another plan may stillgive rise to state taxes.
- If a state law provides for deferral of taxation on rollovers from a
- Although a number of states have amended their plans to conform to federal legislation, a few are still considering amendments or are not amending their statutes.
- Notices to employees.
- A notice to employees regarding their rollover rights should point out that state taxation may differ from federal taxation.
- IRS provided a sample of language for this purpose in Notice 2002-3, supra.