This series of articles describe nonqualified deferred compensation plans (NQDC) that are available to non-profit employers. Qualified plans such as defined contribution plans have strict IRS requirements that severely limit the amount of retirement benefits available to highly compensated executives and other professionals in the organization. Consequently, employers offer non-qualified deferred compensation plans.
Offering a non-qualified deferred compensation (NQDC) plan is a flexible benefit solution to supplement and complement existing qualified plans. NQDC plans are not restricted on the amount or level of benefits allowed. A NQDC plan permits participants to defer more pretax compensation than is possible with a defined contribution plan in which they may be capped out in order to meet nondiscrimination tests.
Governmental vs. Non-Profit Plans
There are two types of Section 457(b) and 457(f) plans available based on the type of employer. Governmental employer Section 457(b) and 457(f) plans differ from non-profit employer plans although they have the same name. Governmental plans are funded and have no creditor or bankruptcy risk. These plans offer age 50+ catch-up deferral features and rollovers rather than require a distribution or payout schedule.
Non-profit employer’s Section 457(b) and 457(f) plans are used by hospitals and non-profit organizations. The plans are not subject to ERISA, do not require discrimination testing, have no minimum participation requirement and there is no Form 5500 filing. The 457(b) plan generally is used to accept employee deferrals. Although the plan can also accept employer contributions, there are specific limitations that make the employer portion more complicated to track. To simplify the plan administration, employers generally use 457(f) plan for employer contributions. The employer can offer both or either one as stand-alone plans.
NQDC Plans for Non-Profit Organizations
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.
To meet the exception under ERISA, the plan must also be unfunded. Therefore, deferrals must remain an asset of the employer until they are distributed or made available. Unlike qualified defined contribution plans, deferrals under 457(b) are subject to creditors of the organization in the event of financial stress, litigation or insolvency of the organization.
Section 457(b) Plan
Non-Profit Section 457(b) is an “eligible” non-qualified deferred compensation plan for healthcare and non-profit organizations under IRC 501(c).
This “Top Hat” plan must limit participation to groups of highly compensated employees or groups of executives, managers, directors, or officers. The plan may not cover rank-and-file employees.
Key employees in the 457(b) plans can defer a portion of their annual compensation or bonuses before taxes (pre-tax) into the plan. The participant can decide how much to defer into a 457(b) plan the year prior to earning the income and then can choose how and when benefits are paid. Section 457(b) Eligible Deferred Compensation plans accept contributions from both employers and plan participants.
The plan allows participants to defer compensation on pre-tax basis and have the contributions accumulate and grow on a tax-deferred growth basis. Ordinary income taxes become due upon distribution. Employee contributions are 100% vested. Distributions are taxable as regular income in the year the participant receives them. Distributions can be lump sum or in installments. Distributions are made through payroll and are reflected in the participant’s IRS Form W-2.
If a plan does not satisfy the requirements under 457(b), then the Section 457(f) rules on the taxation of deferred compensation apply.
Section 457(f) Plan
The plan sponsor can also offer a 457(f) plan to make discretionary contributions to participant accounts beyond the 457(b) plan limits. With a 457(f) plan, the employer promises to pay that money, plus any earnings or additional contributions made to the participants of the plan at a future date. The employer can fund the plan with taxable investments or the organization’s cash flow. This plan is unfunded and does not provide the same protection as a qualified, defined contribution plan.
If the organization does not comply with IRS rules, participants in a 457(f) plan could be subject to taxes and penalties.
Plan Design
The investment line-up for participants can mirror or be totally different from the defined contribution plan.
The plan sponsor can decide how payouts can be received from the plan. Benefits from the 457(b) plans can be distributed as a lump sum or in annual installments based on a per-determined schedule. Benefits from the 457(f) plan are generally paid as a lump sum.
Plan features to include in the plan documents:
Withdrawals from the account are penalty-free before 59 ½ when leaving the job or retiring, there is no 10% tax penalty.
Unforeseeable emergency withdrawals that meet certain conditions may be permitted.
Contributions
Employee contributions in 457(b) plans are fully vested. Employer contributions may be established with a vesting schedule. All employer contributions are tax deductible to the employer.
Participants that have both a defined contribution and 457(b) plans can contribute the maximum amount to both plans. The IRS permits a participant to make a maximum pretax contribution of In 2024 the maximum annual contribution limit for 457(b) plans is $23,000 to their defined contribution plan and an additional pretax contribution of $23,000 to the 457(b) for a total of $46,000 in 2024.
Catch-up Contributions
The defined contribution plan permits additional catch-up contributions for participants who are 50 years or older. The non-governmental 457(b) plan does not permit this feature as distinguished from the governmental 457(b) plans that do permit this formula.
Participants who are within three years of normal retirement age and under-contributed in prior years in which they were eligible, may be able to increase their contribution limits up to 2 times their normal deferral limits.
There is a special non-governmental 457(b) catch-up contribution formula that can be designed to make high catch-up contributions for 3 years before the normal retirement age. The catch-up approach allows the participant to contribute either twice the annual limit, up to $46,000 in 2024, or the basic annual limit added to the basic annual limit not used in previous years.
Non-governmental catch-up contributions allow eligible employees to contribute up to another full employee deferral limit. The amount is limited to “unused” deferrals from previous years. An employee who already deferred the maximum in the 457(b) plan for all years of employment would not be able to use this type of catch-up. The three-year period must be continuous and must not include the year of retirement. This provision requires the compilation of prior year underused limits.
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