Aging Sec. 457 Plan Regs. Rejuvenated

The IRS issued proposed regulations on Sec. 457 deferred compensation plans, under which state and local governments and tax-exempt entities must meet certain eligibility standards and limits not applicable to plans of taxable entities. For a deferred compensation plan established by a tax-exempt or government employer, which does not conform to Sec. 457 standards, an employee will be taxed currently on any amounts deferred, unless the right to plan benefits are subjected to a substantial forfeiture risk. For such an ineligible plan, compensation is included in a participant's or beneficiary's gross income for the first tax year in which there is no substantial risk of forfeiture of the right to such benefit (Sec. 83).The proposed regulations reflect 1986–2002 law changes and address and clarify other issues. They generally apply to tax years beginning in 2002.

General Provisions

Sec. 457 applies to tax-exempt employers and to state and local governments; it does not apply to a church, a qualified church-controlled organization or the Federal government.

It pertains to both elective and other types of contributions (e.g., mandatory, nonelective employer and employer-matching contributions).

An eligible plan must be in writing, include all of the material terms for plan benefits and operate in compliance with the regulations.

All amounts deferred under an eligible governmental plan must be set aside in a trust, custodial account or annuity contract, for the exclusive benefit of participants and their beneficiaries. For a tax-exempt employer, they must be unfunded.

Deferrals, Limits and Agreements

Annual deferrals. Under the proposed regulations, an agreement to defer compensation will be valid if made before the first day of the month in which compensation is paid or made available. An agreement does not have to be entered into before services are performed. However, compensation payable in the first month of employment could be deferred if an agreement is entered into before a participant performs services.

Deferral limits. The proposed regulations explain the annual limits permitted under current law. Generally, the basic annual limit cannot exceed the lesser of (1) a specified dollar amount or (2) 100% of a participant's "includible compensation." The dollar amount is $11,000 for 2002; $12,000 for 2003; $13,000 for 2004; $14,000 for 2005 and $15,000 for 2006. After 2006, the $15,000 amount is adjusted for cost-of-living.

The plan may permit catch-up contributions starting three years before the participant's normal retirement age. Generally, the maximum catch-up amount is two times the basic annual limit, but only to the extent a participant has not previously deferred the maximum amount under an eligible plan or similar tax-deferred retirement plan. Special age-50 catch-up rules are also provided.

Sick and Vacation Pay Deferrals

Under the proposed regulations, an eligible plan can allow a participant to elect to defer accumulated sick, vacation and back pay.

Distribution Requirements

Minimum distributions. The proposed regulations generally incorporate by reference the requirements of Sec. 401(a)(9) and the regulations thereunder.

Post-2001 rollovers. The direct rollover rules applicable to qualified plans and Sec. 403(b) contracts apply to eligible government plans.

Plan-to-plan transfers. Transfers may be permitted under certain circumstances. An eligible government plan may transfer its assets to another acceptable government plan; a tax-exempt plan may transfer its amounts deferred to another plan. However, amounts cannot be transferred from a tax-exempt plan to a government plan and vice versa.

Loans

The proposed regulations do not permit a tax-exempt organization's eligible plan to make a loan. However, loans from an eligible government plan are respected, subject to a facts-and-circumstances general standard. Loans must have a fixed repayment schedule and bear a reasonable interest rate. The IRS will probably extend its current no-letter-ruling position to eligible plans with loan provisions.

The proposed regulations will replace existing regulations (adopted in 1982) and incorporate law changes through 2002 and clarify various issues. Overall, the regulations will probably prove helpful to governmental agencies and tax-exempt organizations planning current and future employee compensation strategies.

From M. Howard Pell, CPA, PKF, New York, NY