A Section 457(b) plan is a type of nonqualified deferred compensation plan that certain governmental and tax-exempt organizations can establish for their employees. Like other deferred compensation plans, the purpose of a Section 457(b) plan is to encourage employees to set aside funds for their retirement. Although it is a nonqualified plan, a Section 457(b) plan somewhat mimics a qualified plan in that it offers similar tax benefits for employees. These tax benefits generally include pretax salary-reduction contributions and tax-deferred growth of investment earnings.
Only certain governmental and tax-exempt organizations can establish and maintain a Section 457(b) plan. Governmental organizations that qualify include: (1) a state (including the District of Columbia), (2) a political subdivision of a state (e.g., a city or township), and (3) any agency or instrumentality of a state or of a political subdivision of a state (e.g., a school district or sewage authority). Tax-exempt organizations that qualify, generally, include any organization that is exempt from federal income tax, except for: (1) a church or synagogue, or (2) any organization controlled by a church or synagogue.
There are no specific coverage requirements for Section 457(b) plans. For a governmental employer, the plan can be offered to all employees or to any group of employees–even a single employee. Individuals who perform services for the employer are eligible to participate. This includes employees, as well as independent contractors.
An employee may defer the lesser of $16,500 (in 2010 and 2011) or 100% of his or her gross compensation to a Section 457(b) plan. The dollar limit is indexed for inflation each year. An employer may also make nonelective contributions to a 457(b) plan on an employee’s behalf. The total employer nonelective contributions and employee deferrals cannot exceed the limits described above.
What is unique about Section 457(b) plan deferrals is they do not reduce the amount an employee can contribute to a 401(k) or 403(b) plan maintained by your employer or another employer. For example, if you work for a school district that also maintains a 403(b) plan, you can defer $16,500 to each plan in 2011, plus any applicable catch-up contributions.
An eligible 457(b) plan (both governmental and nongovernmental) can allow increased contributions during one or more of a participant’s last three taxable years, preceding attainment of normal retirement age (the “special” Section 457 catch-up rule). The amount of increased contributions the plan can allow may be based on previously underutilized contribution limits. In other words, participants can “make up” for the fact that they did not fully contribute in years past; however, a participant’s maximum deferral may not exceed twice the allowed contribution amount for the year ($33,000 in 2011).
Eligible governmental 457(b) plans can also include a separate catch-up provision that allows employees age 50 and older to contribute an additional $5,500 in 2011. Employees who are also eligible for the special catch-up rule described above can use either the special rule or the “age 50” catch-up rule, whichever provides the higher catch-up amount in any year. The “age 50” catch-up rule is not available for nongovernmental 457(b) plans.
An employee is eligible for only one catch-up limit under Section 457(b) per year, regardless of whether he or she participates in multiple 457(b) plans of one employer or in separate 457(b) plans of more than one employer. However, an employee may be able to double up on catch-up contributions, if he or she participates in a 457(b) plan and also a non-457(b) employer sponsored plan.
As with many other types of retirement plans, employees who participate in a Section 457(b) plan can enjoy significant tax benefits, including:
Employees’ salary deferrals to a Section 457(b) plan are made on a pretax basis. The contribution is taken directly from the employee’s salary and invested in the plan before any taxes are withheld. This means that the amount each employee defers to the plan is not included in his or her gross income in the year of deferral. The employee pays less income tax, because his or her taxable income is lower than it would otherwise be.
Funds held in a Section 457(b) plan grow tax deferred. Any earnings on plan investments are not taxable as long as they remain in the plan. However, when an employee begins to receive distributions from the plan, he or she will pay income tax on the earnings.
Possible Tax Credit:
Some employees who participate in a governmental 457(b) plan may qualify for a partial income tax credit (“Saver’s Credit”) for amounts deferred to the plan. The amount of the tax credit (if any) is based on the employee’s annual gross income and federal income tax filing status.
In general, Section 457(b) plan distributions may not be taken before:
The calendar year in which the participant attains age 70½
- The date the participant has a severance from employment (special rules apply to independent contractors), or
- The date the participant is faced with an “unforeseeable emergency.”
There are some strict rules regarding distributions for an unforeseeable emergency, so be sure to consult a tax adviser and your plan administrator.
Distributions may also be made from a 457(b) plan:
- Upon the participant’s death;
- Upon plan termination, or
- If the plan contains a “small benefit” rule allowing distribution of account balances less than $5,000 (excluding rollover amounts) where the employee has not contributed to the plan for at least two years. The plan may provide for automatic cash out of these amounts, or may allow the distribution at the request of the participant.
Rollovers of eligible rollover distributions are permitted between employer-sponsored qualified retirement plans, Section 403(b) annuities, governmental Section 457(b) plans, and IRAs; however, 457(b) plans are not required to allow incoming rollovers. These rollover rules do not apply to Section 457(b) plans maintained by nongovernmental tax-exempt organizations. When considering a rollover into or out of a 457(b) plan, consult a tax adviser and your plan administrator, as this may affect your ability for early withdrawal.
At Henssler Financial we believe you should Live Ready, which includes understanding the laws that govern your retirement plan so that you can reduce your taxable income and save for retirement. If you have questions regarding your retirement plan options the experts at Henssler Financial will be glad to help. You may call our experts at 770-429-9166 or e-mail at firstname.lastname@example.org.