iRecruiting and retaining top executives can be challenging for non-governmental tax-exempt organizations such as Code §501(c)(3) organizations, private universities, and certain healthcare organizations (Nonprofits). Not only are Nonprofits competing for the same top talent against for-profit entities with bigger budgets, but to protect their tax-exempt status, they must comply with IRS rules requiring that compensation paid to their employees be “reasonable” and not “excessive.”
To make their compensation packages more attractive to potential employees, Nonprofits may therefore offer executives deferred compensation options. This article describes certain rules applicable to Nonprofit-sponsored Code §457(b) plans.[1]
Complying with these rules is important because operational errors related to Nonprofit Code §457(b) plans generally can’t be corrected within the requirements of the IRS’s Employee Plans Compliance Resolution System (EPCRS). Rather, the IRS only will consider requests for the correction of §457(b) plan operational errors on a provisional basis outside the EPCRS, and will not consider requests related to document issues.
Nonprofits that fail to administer their Code §457(b) plans correctly from day one risk losing their plans’ tax-favored status. Following these five rules may help Nonprofits avoid that headache.[2]
Keep it Small(ish)
To avoid ERISA’s funding, disclosure, and reporting (Form 5500[3]) requirements, a Code §457(b) plan sponsored by a Nonprofit must be categorized as a “top-hat” plan. A “top-hat” plan is:
- an unfunded arrangement – i.e., plan assets are not held in trust for employees, but remain the property of the employer and available to its general creditors,
- that is limited to a “select group of management or highly compensated employees.”
When determining whether a “select” group of management or highly compensated employees exists, courts and the Department of Labor may consider:
- The number of employees eligible to participate in the plan vs. the Nonprofit’s total number of employees;
- The average salaries of members of the eligible group vs. those of other employees or other management/highly compensated employees; and
- The ability of members of the eligible group to negotiate their own salary or compensation packages.
While ERISA does not specify how big a “select group of management or highly compensated employees” may be, courts reviewing this issue have typically found that a top-hat group will include no more than 12-15% of all employees. That’s the top range for a top-hat group, though – smaller would be better.
Know Your Limits
Annual contributions to a Code §457(b) plan sponsored by a Nonprofit can’t exceed the lesser of:
- 100% of the participant’s compensation; or
- The Code §457(b) limit for the year ($23,000 for 2024).
The limit applies on a combined basis to both employee deferrals and nonforfeitable (vested) employer contributions for the applicable year. It’s also personal to the employee, meaning the annual limit will apply no matter how many Nonprofit Code §457(b) plans an employee may participate in. The amounts contributed to an employee’s Code §457(b) plan account will not, however, affect the amounts an employee may contribute to a Nonprofit’s Code §401(k) or 403(b) plan.
Participants in Nonprofit Code §457(b) plans are not eligible to make over age 50 catch-up contributions. They may, however, be eligible to make “special” catch-up contributions for the three years before they reach normal retirement age.
Contributions exceeding the annual limits made to a participant’s Nonprofit Code §457(b) plan account must be distributed to the participant, along with any allocable earnings on the excess, by April 15 of the taxable year following the year in which the excess contributions were made.[4] Failure to correct excess contributions within this time frame could cause a Code §457(b) plan to lose its tax-favored status.
The excess deferrals will be treated as taxable income to the participant in the year they were deferred (and reported on an IRS Form W-2 or Form W-2c for that year), while any earnings will be treated as taxable income (and reported on Form W-2) in the year the participant receives them.
Don’t Forget the FICA
Employee deferrals to a Nonprofit Code §457(b) plan are subject to Social Security and Medicare (FICA) tax withholding when contributed to the plan. In addition, any nonforfeitable (vested) employer contributions will also be subject to FICA when made.[5]
If a Nonprofit fails to properly withhold FICA tax from contributions to a participant’s Code §457(b) plan account when those contributions are made, it will need to correct the failure by filing any required IRS Forms 941-X, and paying over any required FICA taxes (both the employer and employee portions of those taxes). The Nonprofit may seek reimbursement from the participant for his or her portion of the FICA tax.
No to Loans; But Yes to Unforeseeable Emergencies
Unlike Code §401(k) and 403(b) plans, Nonprofit Code §457(b) plans cannot offer loans to participants. Allowing a Nonprofit Code §457(b) plan participant to take a loan would constitute an impermissible distribution, and could adversely affect the tax-favored status of the plan.
Nonprofit Code §457(b) plans can, however, allow participants to take distributions arising from an “unforeseeable emergency.” An unforeseeable emergency is a severe financial hardship of a participant or beneficiary resulting from:
- An accident or illness of the participant or beneficiary, or of the participant’s or beneficiary’s spouse or dependents;
- A property loss suffered by the participant or beneficiary due to casualty (such as uninsured damage from a natural disaster); or
- Other similar extraordinary and unforeseeable circumstances resulting from events beyond the participant’s or beneficiary’s control.
In addition, the IRS has determined that a Nonprofit Code §457(b) plan may allow unforeseeable emergency distributions for funeral expenses of a participant’s spouse, dependent, or non-dependent child as emergencies arising from events beyond the participant’s control. Other unforeseeable emergencies may include imminent foreclosure or eviction from the participant’s primary residence, or a need to pay for medical expenses or prescription drugs.
The Devil is in the Distribution Rules
Distributions may cause Nonprofit sponsors of Code §457(b) plans some consternation. That’s because amounts deferred under a Code §457(b) plan are included in a participant’s taxable income when paid or “made available” to the participant.
Nonprofit Code §457(b) plans typically provide that amounts are considered to be made available on the earliest date following a participant’s severance from service (i.e., termination) that the plan permits distributions to begin (but not later than the date required minimum distributions (RMDs) must begin[6]).
For example, a plan may provide that, unless the participant elects to defer amounts held in his or her Nonprofit Code §457(b) plan account within 60 days following the participant’s termination, the entire account will be paid to the participant on the 90th day after termination. So, if the participant takes no action to further defer distribution of his or her Code §457(b) plan account, payment should occur on the 90th day post-termination. That may not always happen, however.
Failure to distribute a participant’s account as required by the Code §457(b) plan is an operational error that may result in significant adverse tax consequences to the participant.[7] Accordingly, Nonprofits sponsoring Code §457(b) plans should understand how the distribution provisions of their plans work, and ensure that any payments are made when required.
Even when payment is made when required, a Nonprofit may not properly report it. Distributions from Nonprofit Code §457(b) plans are reportable on Form W-2 and subject to federal income tax withholding (but not FICA withholding, assuming FICA was withheld when the amounts were contributed to the plan). Failure to properly report and withhold from Code §457(b) plan distributions may require correction.
Finally, amounts distributed from a Nonprofit Code §457(b) plan are not eligible for rollover. It may be possible, however, in some cases for a participant to transfer their distribution to the Code §457(b) plan of a subsequent Nonprofit employer.
What to Do Now?
Nonprofits sponsoring Code §457(b) plans should review their plan documents and administrative practices to ensure that they comply with all legal requirements and have been administered according to their terms. If corrections are needed, the sooner they can be made, the better.
[1] Federal, state, and local government entities may sponsor Code §457(b) plans, but are subject to different rules than those applicable to Nonprofits. Entities associated with churches aren’t eligible to maintain §457(b) plans unless they’ve made an election to be subject to ERISA.
[2] The “headache” caused by a Code §457(b) plan error could easily become a migraine for the Nonprofit sponsoring the plan. If a plan intended to be a Code §457(b) plan fails to satisfy those requirements, then it will be treated as a Code §457(f) plan. The plan’s terms will likely violate the even more complicated requirements of Code §457(f) – and, even worse, possibly the requirements of Code §409A – leading to significant adverse tax penalties for affected participants.
[3] While a Nonprofit sponsoring a “top hat” Code §457(b) plan is not required to file annual Forms 5500 with respect to the plan, it must notify the DOL of the plan’s existence by electronically filing a top hat plan statement.
[4] See https://www.irs.gov/retirement-plans/issue-snapshot-457b-plans-correction-of-excess-deferrals.
[5] Typically, Nonprofit employer contributions to a Code §457(b) plan are nonforfeitable when made. While a Nonprofit Code §457(b) plan can subject employer contributions to a vesting schedule, doing so will complicate the administration of the plan.
[6] Yep. Nonprofit Code §457(b) plans are subject to the same RMD rules as Code §401(k) and 403(b) plans.
[7] See footnote 2, above. In this situation, however, the error typically won’t affect all of the Nonprofit Code §457(b) plan participants – just the participant for whom payment was impermissibly delayed.
