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457(f) Plans

Last updated 25th Nov 2022

The 457(f) is a deferred compensation plan that allows eligible employers to contribute money on a pre-tax basis into investments that provide key executives with a retirement benefit. By doing so, these companies can help their executives defer payment of federal and state income tax on the money contributed into their accounts.

In this article, we're going to focus on the Section 457(f) plans, which provide a valuable benefit to the executives that companies frequently want to retain. We're going to explain the benefits these plans provide to both the employer and the employee. We'll also discuss some of the rules involving contributions, distributions, rollovers, and income taxes. Finally, we're going to talk about the single most important feature of these plans, risk of forfeiture, and why that provision exists.

Benefits of the 457(f)

As mentioned, the 457(f) deferred compensation plan offers both employer and employees many benefits including:

  • Allowing employers to attract and retain the executives they value the most.
  • Providing a retirement or deferred compensation plan that is easy to establish and easy to maintain.
  • Flexible investing options involving the contributions made by the employer.
  • Offering an added benefit to existing employee programs.
  • Deferring of both state and federal income taxes.
  • Permitting companies to provide benefits that do not affect the employee's ability to fund an IRA or 401(k) plan.

Overall, the 457(f) allows employers to offer top executives a deferred compensation arrangement that provides a future income stream to the executive. The rules of these plans help employers retain executives via some of the "golden handcuff" provisions it contains.

457(f) Rules

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

457f plans
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.

Substantial Risk of Forfeiture

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.

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Moneyzine Editor

Moneyzine Editor