457(f) Plans

While deferred compensation plans such as the 457(f) offer many benefits, these benefits do come at a cost. In exchange for offering the company's executives the opportunity to defer the payment of income taxes, there are a series of rules involving:

• Eligibility Requirements

• Asset Ownership

• Rollovers

• Distributions

• Risk of Forfeiture

Interestingly, there are no contribution rules for 457(f) plans. In fact, an employer can contribute any amount; essentially deferring as much compensation as the executive likes, and the employer is willing to pay. But where certain rules do apply, we're going to talk about each in more depth in the following subsections.

Eligibility Requirements

Participation in a 457(f) plan is limited or restricted to a select group of highly-compensated individuals and / or a select group of management employees. The exact eligibility thresholds for each company will vary, but they are pre-determined and therefore the plan's administrator or documentation will provide guidance on eligibility.

Asset Ownership

The money contributed to a 457(f) plan can be invested in fixed or variable annuities, mutual funds, and even life insurance. These assets, however, remain owned by the employer until paid to the employee. It is because of this rule that 457(f) plans create a tax shelter for the executive. By not taking ownership of the assets, income taxes can be deferred. Unfortunately, this also means the asset is available to creditors in the case of employer default on a loan or bankruptcy.

Because the asset belongs to the employer, the employee cannot use the money in their account as collateral. It's also protected from claims against the employee until distributed.

Rollovers and Transfers

The rollover rules for 457(f) plans are very straightforward. The money is not eligible for rollover or transfer into a 457(b) or any other qualified retirement plan such as an IRA. Remember, the money is not an asset of the employee until distributed.

Plan Distributions

There are normally three ways that a distribution from a 457(f) plan takes place: a disability, the passing away of the employee, or the employee retiring from the company. On occasion, the employee and employer may agree upon a date on which a distribution takes place. At this point in time, a substantial risk of forfeiture no longer exists.

Distributions are usually made on a lump-sum basis. When paid, the entire account's value is subject to FICA, federal, and state income taxes.

The final rule we're going to talk about involves the concept of "substantial risk of forfeiture." As just mentioned, when distributions take place this risk no longer exists. At that time, all of this deferred compensation is immediately taxable.

Until money is distributed from the account, it is an asset of the employer. This is why taxes can be deferred; the money is not yet owned by the employee until a distribution takes place. To ensure the asset is not owned by the employee (and merely being held by the employer); Internal Revenue Service demands there must be a substantial risk of forfeiture. In other words, they require a mechanism by which the employee risks losing all of the money in the account.

The most obvious example of substantial risk of forfeiture would be the executive leaving the company before reaching normal retirement age. When that happens, the executive would lose (forfeit) their rights to this money. Anyone planning to participate in a 457(f) plan should consult with the plan's administrator. They should be able to explain all of the forfeiture provisions outlined in the organization's deferred compensation agreement.