Improper distribution from 457 Plan

[Guest tws]

Participants in a 457 Plan maintained by a school district used deferrals to pay premiums on life insurance policies. Policies were owned by the school district. Just discovered that in 2000 three participants who were unhappy with the investment performance of their policies decided to move them to another company. The school district transferred ownership of the policies to the participants who then assigned them to the new company in a tax free exchange for the new policies. The new policies are owned by the participants. Apparently no one involved in this transaction knew that the policies could not be distributed to the participants absent a qualifying event.

What, if anything, can be done now to correct this situation? Can the participants pay back the cash value of the policies distributed on the basis that the distribution of the policies was a mistake? Unfortunately one of the participants has died and his beneficiaries have collected on his new policy.

What reporting should be made to the IRS? Will treating the distribution as a taxable event and having the participants include it in their income for 2000 affect the eligibility of the Plan because it made an improper distribution?

I would greatly appreciate any comments.

Thanks

tws

[mbozek]

TWS: The SD needs to consult a tax advisor or attorney regarding the tax and reporting implications in this mess. Q1- what was reported in 2000 regarding the transfer of the policies? The three individuals should have included the cash value of the LI policies as income in 2000 becuase the policies were transferred to them. Therefore the proceeds of the LI on the deceased should have been paid tax free to his bene. Paying back cash values in a following year does not change the tax consequences that occurred in 2000. Q2 - what will the SD do about reporting the distribution? Under the applicable regs the employer should issue a revised w-2 form for 2000 indicating the amount of the cv in the policies as wages less any after tax amounts previously taxed. The decision to report the income is up to the employer on the advice of counsel.

[Guest Tom Geer]

First, breathe a sigh of relief that it's a governmental plan. Under 457 , governmental plans have until the first day of the plan year starting at least 180 days from a notice of noncompliance from IRS. This means that the mistake won't blow up the plan.

The exact coreection methodology is unclear, in partricular because the distributed policy doesn't exist any more. I agree with mbozek that you need an attorney to work with on this. And, in particular, one who has dealt with 457 issues.