This is the third of a series of articles that describe non-qualified deferred compensation plans (NQDC) that are available to non-profit employers. For an organization that is a 501(c) non-governmental tax-exempt organization, there are two types of non-qualified deferred compensation plans available to the organization’s key employees. Those types are under Non-Profit Section 457(b) and Section 457(f) plans. NQDC plans are generally limited to a select group of management or highly compensated employees. The plan sponsor can select the key employees that can participate in the plans.
Funding
Non-governmental 457(b) plans must remain unfunded in order to avoid taxation of amounts credited under the plan. Plan assets are not held in trust for employees but remain the property of the employer (available to its general creditors in the event of litigation or bankruptcy). Assets cannot be set aside for the exclusive benefit of participants. Since 457(b) plans must remain “unfunded,” the employer’s liability can be met by earmarking a specific corporate asset (corporate owned life insurance, mutual funds, annuities, or investments) to meet future obligations or benefits can be paid from future cash flow.
There are two general ways in which the employer can pay benefits. The plan sponsor can use its normal cash flow to pay benefits as they occur or. Alternatively, the plan sponsor may use employer-owned investments such as mutual funds and/or individual securities that are on the organization’s balance sheet to pay for the benefits. The employer may also purchase an employer-owned investment contract or variable annuity. No specific plan assets are set aside to meet the benefit payments.
Risk of Insolvency
The deferred compensation in the 457(b) plan, despite being invested at the participants’ discretion, still belongs to the employer because the participants have deferred being paid. If the employer were to have financial difficulties and become insolvent, the participants would be in line with the rest of the organization’s creditors to access the deferred compensation.
Rabbi Trust
Employee deferrals in non-governmental plans are frequently placed in “rabbi trusts”. A rabbi trust creates security for employees because the assets within the trust are typically outside the control of the employers and are irrevocable. The rabbi trust is funded, but the trust assets remain available to creditors. Employees are lower in priority than general creditors in the event of legal claims against the employer.
Distribution Rules for 457(b) Plan
Identified in the plan document, events that permit distribution typically include severance from employment, retirement, disability or death. Plan sponsors may offer participants the ability to take an in-service withdrawal should they have an “unforeseeable emergency.”
Hardship distributions are permitted if the distribution is to finance an unforeseeable emergency. -These conditions include financial hardship due to illness, accident, or loss of home due to a natural disaster. Other extraordinary circumstances beyond the control of the participant or beneficiary such as funeral costs are also eligible reasons.
The participant must have exhausted all other resources, and the amount distributed is necessary to meet the emergency.
The deferred compensation plan does not apply a penalty for early withdrawal, but all distributions are taxed as ordinary income. In contrast, the defined contribution plan applies a 10% penalty if a distribution is made before age 59½,
Benefits can be paid as a lump sum or through installments. Although installment payments are only subject to tax when received, any unpaid installment payment remains the property of the employer and is subject to general creditor status. Each 457(b) plan has a default date or specified time period by which a participant must make an election to defer payment and postpone taxation by electing a future distribution date. If no timely election is made by the end of the specified time-period (default date), payments will begin to be made.
Generally, a participant must choose within 30, 60, or 90 days after their severance date. Participants are typically allowed to make a one-time change, but the date can never be accelerated. Once finalized, the distribution conditions are irrevocable and cannot be changed.
Distribution rules should be clearly explained and communicated to the participants in the plan. Often participants incorrectly assume that their defined contribution plan and the 457(b) accounts have the same distribution rules. Distributions are made through payroll and reported on a W-2, (not an IRS 1099) unless the participant has died, and a beneficiary is requesting the distribution.
If the plan sponsor withheld Social Security taxes (FICA) when the participant made the deferral, the tax will not be charged again at the time of distribution.
Required minimum distribution (RMD) rules that are subject to the most current SECURE 2.0 Act also apply to 457(b) plans. However, if the plan document allows it, a participant that has attained the RMD age, the participant can defer their RMDs until they retire.
Events that may trigger a distribution is the participant’s severance from employment, plan termination, a qualified domestic relations order, or a small account distribution.
Distribution Rules for 457(f) Plan
Benefits under 457(f) plans receive less tax-favorable treatment than those under 457(b) plans. When a participant becomes vested and the benefit is no longer subject to a substantial risk of forfeiture, the full amount of the vested benefit is taxed as ordinary income, even if the participant does not actually receive it. It is common for plan benefits to be vested periodically in increments, although actual distributions may be delayed until retirement.
As is the case with 457(b) plans, there are no tax penalties for distributions prior to age 59 ½. There are no required minimum distribution rules for 457(f) plans. The sponsor is required to withhold Social Security tax (FICA) at the time of the distribution.
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