Excess deferrals when an employee contributes to both a 403(b) and 457

[Guest SandiY]

We are a State government. Employees in our department of education may choose to participate in the 403(B) plan or the 457 deferred compensation plan, or both. If an employee particpates in both, we know that the employee is subject to the lower 457 plan contribution limitation (which is currently $8,000). However, if the employee contributes more than $8,000 during the plan year(usually happens by mistake), is there an IRS rule or regulation that states which plan must refund the excess contribution?

Example: Employee contributes $8,000 to his eligible 457 plan and $2,000 to his 403(B) plan, during 1999. Since the limit is $8,000, the employee has an excess deferred of $2,000.

Question: Can someone cite an IRS rule/regulation/etc. that indicates whether the 457 or 403(B) plan must refund the excess $2,000?

[Michael Devault]

Sandi, I'm not sure that there is a specific citation that addresses your question. However, I believe that it can be derived logically.

Section 1.457-1(a)(3) establishes that it is the 457 deferral limit that is reduced by the contribution to the 403(B) plan. Therefore, in your example, the 457 limit of $8,000 is reduced to zero by the $8,000 contribution to the 403(B). Since the $2,000 contribution to the 457 plan exceeds the 457 limit of zero, it would seem logical that the excess contribution was made to the 457, so that plan must refund the excess.

I'm curious to know if any other members have any experience in this matter or if they know of any specific ruling on the matter.

Hope this is of some benefit to you.

[Guest mike webb]

Section V.A.1(1)(h) of the recently updated IRS Audit Guidelines for 403(B) Plans concur with your logic, Michael. The section specifically uses an identical example to the the one provided by SandiY. The guidelines indicate that any combined 403(B)/457 deferral amounts "are treated as excesses in the eligible 457 plan and are taxable currently under 457".

The guidelines go on to say that "an individual who, although eligible, does not defer any compensation under the 457 plan in any given year is not subject to the $8,000 annual limit of 457©(2). Such an individual can defer the full $10,000 under the 403(B) plan...".

Thus, in SandiY's example, there would not have been an excess if the employee in question declined to defer compensation into the 457 arrangement and simply deferred $10,000 into the 403(b)program (assuming that the employee was not otherwise limited by the 415 limitation or the 403(B)(2) exclusion allowance).

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Mike W.

[Guest SandiY]

Thanks Mike D. and Mike W. for the info. If we look to the 457 plan as the "excess deferral", do you know whether the employee is given the excess deferral/money back (like an in-service distribution), or whether the employee just has to claim the "excess" as income on his/her tax return? In giving your answer, if you can cite some type of IRS ruling, that would help. Also, if your answer is that the employee should not receive the money, but instead, just claim the excess as income, how would the employee keep from being taxed twice on that money since he/she would pay taxes on the money when he/she retires and takes a distribution?

[Michael Devault]

Sandi, the Income Tax regulations are pretty clear that the excess deferrals are considered "made available" to the employee in the year in which the amounts were deferred. As such, they will be included in taxable income that year. Look at section 1.457-1(B)(2)(B)(iii), examples 5 and 6.

To my knowledge, there is nothing in the Code or Regulations that specifially address how excess deferrals are to be handled. They are not "in service" distributions, as such, since those types of distributions are limited to those who haven't participated in two years and have small account balances. However, it could be argued that they should be refunded (similar to excess deferrals under 402(g)).

Code section 457(d) says that a 457 plan's distribution requirements can't make amounts available to participants before the earlier of (a) separation from service (B) age 70-1/2 or © in an unforeseeable emergency. Initially, this would seem to infer that the money can't be distributed. However, the operation of the regulations have already made the amounts available because they are excessive deferrals. Thus, it would seem that the plan could make available amounts that have already been made available.

Does the language of the plan document address this situation? If so, you can be guided by that language. Otherwise, a call to the IRS might be in order. I wouldn't think that they would object to distributions of excessive deferrals, but it doesn't help to check.

Hope this is of benefit. Good luck!

[Ellie Lowder]

Try Sheryl Press or John Tolleris in the IRS 457 division - 202-622-6030. In previous conversations, the "remedy" was to refund the excess from the 457 plan.