Repeal of Sec. 457 Coordination Requirements

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) contains numerous pension reform provisions. Perhaps the most highly touted provisions are the increased contribution limits for various retirement plans. For example, under the EGTRRA, the maximum annual amount an employer may contribute to a defined contribution plan increases from the lesser of $35,000 or 25% of compensation in 2001, to the lesser of $40,000 or 100% of compensation in 2002. The limits on contributions to IRAs (deductible and Roth) increase from $2,000 in 2001 to $5,000 in 2008. Secs. 401(k) and 403(b) contribution limits increase from $10,500 in 2001 to $15,000 in 2006, and Sec. 457 plan contribution limits increase from the lesser of $8,500 or one-third of compensation in 2001 to the lesser of $15,000 or 100% of compensation in 2006.

Financial advisers and tax practitioners should not overlook one subtle section of the EGTRRA, which relates to contribution limits of Sec. 457 and 403(b) plans. Section 615 of the EGTRRA provides:

Subsection (c) of section 457...is amended to read as follows: "LIMITATION.--The maximum amount of the compensation of any one individual which may be deferred under subsection (a) during any taxable year shall not exceed the amount in effect under subsection (b)(2)(A) (as modified by any adjustment provided under subsection (b)(3))."

Section 615 is effective for tax years beginning in 2002.

Although it is not obvious at first glance, Section 615 is very good news for employees eligible to participate in both Sec. 403(b) and 457 plans. Section 615 allows employees eligible to participate in both plans to contribute (and defer from gross income) a maximum of $11,000 to each plan in 2002. Thus, an employee eligible to participate in both a Sec. 403(b) and a Sec. 457 plan could contribute (and defer from gross income) a total of $22,000 in 2002. In 2006, the maximum contribution to each plan will increase to $15,000, for a combined maximum annual deferral of $30,000.

The EGTRRA

Prior to the EGTRRA, old Sec. 457(c)(2) required that any contribution to a Sec. 403(b) plan also counted toward the Sec. 457 contribution limit. Because all contributions to a Sec. 403(b) plan were counted as Sec. 457 plan contributions, old Sec. 457(c)(2) limited total contributions to both plans to the $8,500 Sec. 457 limit rather than the $10,500 Sec. 403(b) limit. As a result, an employee participating in both a Sec. 403(b) plan and a Sec. 457 plan was effectively limited to a combined maximum contribution to both plans of $8,500 in 2001.

Section 615 of the EGTRRA replaced Sec. 457(c) in its entirety. Under revised Sec. 457(c), the new contribution limit for Sec. 457 plans is the lesser of $11,000 in 2002 (increasing to $15,000 in 2006) or 100% of compensation. In addition, revised Sec. 457(c) also contains a catch-up provision, which allows participants in the final three years before they reach retirement age to contribute twice the normal limit to their Sec. 457 plan.

The EGTRRA repealed in its entirety the Sec. 457 coordination requirements with Sec. 403(b) (and other sections such as Sec. 402(e)(3) (relating to Sec. 401(k) contributions), Sec. 402(h)(1)(B) (relating to simplified employee pensions) and Sec. 402(k) (relating to simplified retirement accounts)). Moreover, Section 611 of the EGTRRA, which established new limits for both Sec. 403(b) and 457 plans, does not contain coordination requirements for Sec. 403(b) and 457 plan contributions. The Conference Report states simply that the bill "repeals the rules coordinating the Section 457 dollar limit with contributions under other types of plans." Thus, it is clear that in repealing the Sec. 457 coordination requirements, Congress intended to allow participants in both a Sec. 403(b) and 457 plan to contribute the maximum amount to each plan.

Participation in Both a Sec. 403(b) and a Sec. 457 Plan

Participation in a Sec. 403(b) plan is generally available to employees of public schools, state colleges and universities, and tax-exempt Sec. 501(c)(3) organizations, provided the employer has established such a plan. Participation in a Sec. 457 plan is generally available to individuals providing services to a state, its political subdivision, its agency or instrumentality, its political subdivision and tax-exempt organizations, provided the employer has established such a plan. Employees of public schools, colleges and universities, and tax-exempt Sec. 501(c)(3) organizations (such as hospitals) may be eligible to participate in both a Sec. 403(b) and a Sec. 457 plan, if their employer establishes both types of plans. Types of individual clients who may be interested in participating in both plans to maximize their contribution and deferral opportunities include physicians, college professors and administrators, and public school teachers and administrators.

Benefit of Maximizing Contributions and Deferrals Using Sec. 403(b) and 457 Plans

The ability to defer an additional $11,000 in 2002 (and higher amounts in following years) has significant financial benefits to employees eligible to participate in both Sec. 403(b) and 457 plans. The future benefit of current tax deferral depends on the taxpayer's current marginal tax rate, the number of years until distributions begin, the expected marginal tax and capital gain tax rates at that time, and the expected return on investment.

Example: S is eligible to participate in both a Sec. 403(b) and a Sec. 457 plan. In 2002, she has a choice of (1) deferring $11,000 from gross income by contributing to a Sec. 403(b) plan and investing an additional $8,030 of after-tax earnings ($11,000 less her current marginal tax rate of 27%) in stock that appreciates, but pays no current dividends; or (2) deferring a second $11,000 by making an additional contribution to a Sec. 457 plan. Her marginal tax rate is expected to be 28% and her capital gain tax rate is expected to be 18% when she takes a distribution 25 years later from the plan or sells the appreciated stock. S expects an annual pre-tax investment return of 10%.

Under option 1, S's pre-tax earnings of $11,000 will generate an after-tax investment of $8,030, which will grow to $87,003. On liquidation of the stock 25 years later, S's gain of $78,973 will be taxed at the capital gain tax rate of 18%. The after-tax cashflow from option 1 is $72,788. Under option 2, the additional $11,000 pre-tax Sec. 457 contribution will grow to $119,182, which will be taxed at 28% on distribution. The after-tax cashflow from option 2 is $85,811. The repeal of the Sec. 457 coordination requirements allows S to contribute an additional $11,000 to the Sec. 457 plan. As a result, S will generate an additional $13,023 ($85,811 – $72,788) of after-tax cashflow. It should be noted that if S's pre-tax investment yield was 14% annually (closer to the historic returns from holding equity), she would generate an additional $33,892 of after-tax cashflow from option 2.

Exhibit 1 presents the increase in after-tax cashflow to a single taxpayer, arising from an additional $11,000 pre-tax contribution to either a Sec. 403(b) or a Sec. 457 plan in 2002. Exhibit 1 assumes a 10% annual pre-tax investment return over 25 years, at which time a distribution from the plan is made. It does not take into account taxpayers currently at the 10% and 15% marginal tax rate, who would most likely face liquidity constraints in making $22,000 of pre-tax Sec. 403(b) and 457 contributions. The example and Exhibit 1 show the financial benefit for a single taxpayer who makes an additional one-time contribution of $11,000 in 2002. The aggregate amounts that can be contributed to a Sec. 403(b) and a Sec. 457 plan increase from $22,000 in 2002 to $30,000 in 2006.

The repeal of the Sec. 457 coordination requirements by the EGTRRA creates significant tax and financial planning opportunities for taxpayers eligible to participate in Sec. 403(b) and 457 plans. Tax practitioners should discuss this provision with clients who could benefit by the repeal of the Sec. 457 coordination requirements.

From Manoj Athavale, Ph.D., and Mary Bader, CPA, J.D., LL.M., Minnesota State University-Moorhead, Moorhead, MN (Not associated with AFAi)