With the release of two new issue snapshots, IRS continues to focus on nonqualified deferred compensation plans under Internal Revenue Code Section 457. One snapshot explains the rules for correcting deferrals in excess of the annual limits for 457(b) plans, while the other explores some of the tax consequences to nongovernmental tax-exempt employers and their employees when a 457(b) plan becomes an ineligible 457(f) plan. Although snapshots typically don’t provide new guidance, they often include tips that could prove useful in the event of an IRS audit.
Correcting excess deferrals
When a 457(b) plan fails to limit deferrals to the annual maximum, the plan must timely distribute the excess deferrals and any earnings to avoid becoming an ineligible 457(f) plan. The timing requirements for corrective distributions differ for 457(b) plans maintained by governmental and tax-exempt employers:
- Plans maintained by tax-exempt entities must distribute excess deferrals by April 15 of the year following the year in which the error occurred.
- Governmental plans must distribute excess deferrals as soon as administratively practicable after the error is discovered.
The first snapshot notes that auditors will review Forms W-2 to determine whether excess deferrals occurred, and if so, whether the employer distributed and properly reported the excess as distributions. Auditors will request documentation verifying the timely distribution of excess deferrals, so employers should retain proof of corrections.
If a participant is responsible for the excess deferrals (e.g., by contributing to multiple plans of unrelated employers), the plan can — but isn’t required to — provide for the distribution of excess deferrals and any earnings.
Consequences of noncompliance for plans of tax-exempt employers
The second snapshot highlights some of the tax consequences when an eligible 457(b) plan maintained by a tax-exempt entity becomes an ineligible 457(f) plan. This can happen if the plan fails to timely correct excess deferrals caused by plan error or fails to satisfy any other requirements of Section 457(b). A tax-exempt entity’s plan becomes ineligible on the first day of noncompliance.
The switch to an ineligible plan results in a significant change to the tax treatment of participants’ benefits. Under a 457(b) plan maintained by a tax-exempt employer, deferrals and earnings are not included in a participant’s gross income until they are paid or made available to the participant. Under a 457(f) plan, deferrals and related earnings are includible in income when they are no longer subject to a substantial risk of forfeiture, with later earnings taxable at the time of payment.
When a 457(b) plan becomes ineligible, the 457(f) tax treatment applies not just to future deferrals and earnings, but also to all vested deferrals and earnings from open tax years — which means participants may have to amend their tax returns for those open tax years. These changes also complicate plan administration for the employer. The snapshot focuses mainly on the different income tax timing and withholding rules for eligible and ineligible plans and notes that auditors may examine a plan’s vesting provisions and Forms W-2.
The snapshot is noticeably silent on a bigger issue: When an eligible 457(b) plan becomes an ineligible 457(f) plan, the plan may also become subject to Section 409A. The interplay of the 457(f) and 409A rules — and the potential consequences of noncompliance — are complex, which may be why IRS left this issue out of the snapshot.
- Tax-exempt and government entities issue snapshots (IRS, Sept. 28, 2020)
- Issue snapshot: 457(b) plans — correction of excess deferrals (IRS, Sept. 24, 2020)
- Issue snapshot: 457(b) plan of tax-exempt entity — tax consequences of noncompliance (IRS, Sept. 25, 2020)
Mercer Law & Policy resource
- IRS focuses on 457(b), 403(b) plan catch-up contributions (June 16, 2020)