defined benefit 457(b) plan

[Felicia]

Please advise what a defined benefit 457(b) plan is and where I can find additional information on it.

Thanks.

[Lori Friedman]

Felicia,

It might be helpful for you to have some background information about I.R.C. Sec. 457. I'll limit my answer to the law as it applies to non-governmental tax-exempt organizations.

When a for-profit employer creates a nonqualified deferred compensation arrangement (NDCA), simple economics will keep its actions in check. There's a fundamental tension between an employee's wish to defer compensation and the business's need to minimize its own tax liability. Under a NDCA, the company can't claim any tax deductions until the deferred compensation is actually paid out and taxable to the employee. Also, the company, and not the employee, must pay income tax on any earnings from amounts set aside in the NDCA. This inherent conflict will usually inhibit the amount of compensation that a taxable employer will allow an employee to defer.

In general, however, exempt organizations don't have the same incentives to seek deductions and minimize tax liability. Because there's a lack of intrinsic restraint on the amounts that a tax-exempt organization will allow its employees to defer, the Internal Revenue Code steps in and imposes some rules. Sec. 457 is a bundle of very strident requirements for the NDCAs of exempt organizations. Sec. 457 is restrictive, not permissive. Rather than thinking of Sec. 457 as something "special" that can be offered only by exempt organizations, it's best to remember that Sec. 457 is a whole series of hurdles through which an exempt organization must jump.

Sec. 457(b) just is one portion of that law. A Sec. 457(b) arrangement, commonly called an "eligible deferred compensation plan", is subject to (1) maximum limits on annual deferrals, (2) a general prohibition on in-service distributions, and (3) minimum distributions after age 70-1/2. You can learn more about Sec. 457(b) at the following links: http://www.irs.gov/retirement/article/0,,id=96315,00.html and http://www.457bwise.com.

I have no idea why someone would use the terms "defined benefit" and "457(b)" concurrently. The two concepts don't work together at all. "Defined benefit" is technical language for certain plans that exist in the universe of I.R.C. Sec. 401(a) qualified plans. A 457(b) arrangement belongs in the more muddled and problematic world of NDCA. 457(b) deferrals are subject to strict annual contribution limits, not governed by a promised payout or return.

Other parts of I.R.C. Sec. 457 can be used to create arrangements that mimic a defined benefit plan (a promise to pay a certain level of compensation at some time in the future), but that's a whole other discussion. I think that I've already gone on long enough with this one!

[mbozek]

It would be possible to design a DB 457(b) plan using the annual deferral amount as the minimum funding amount to provide the benefits. The amount deferred for an employee under the 457 plan at retirement would be the present value for paying an annuity benefit to a participant. Because of its complexity I have never seen such a plan. A simplier alternative would be to pay the account balance to the participant under the mrd rules.

[Lori Friedman]

Mbozek,

I often deal with 457(f) arrangements that are "DBP-esque"...the employer promises to pay a certain periodic amount over a specified number of years or for the remainder of the executive's life. These types of arrangements become absolute nightmares when something goes wrong with the substantial risk of forfeiture.

It seems as if you frequently practice in the 457(f) arena. Have you, also, encountered this same sort of plan and had to deliver bad news about the tax consequences?

I had a real-life experience that was heartbreaking. An exempt organization's Executive Director became handicapped. The organization's Board of Directors, out of compassion, support, and respect for this individual, voted to pay her $XXXX each month for the rest of her life. Of course, there was no SROF -- the woman was no longer capable of self-care certainly couldn't perform services for the organization -- so the present value of the expected payments was immediately and fully taxable to the individual. She had to deplete her own resources and borrow money just to pay the income and FICA taxes. The organization performed an act of kindness and had no idea that it would push the woman into a 457 trap. Very sad...

[mbozek]

L: Are u saying that the payments were considered made under a 457f plan? I am not going to do research but why couldn't the board just continue to pay her salary each month and have it taxed as income as paid? I would never let an employee be taxed like that because the payments are not deferred comp under 457 but could be structered as salary continuation, disabilty or a transfer of property under IRC 83. By the way how was this determination to tax the benefits under 457 made?

[SoCalActuary]

Are you working in the area of plan sponsors who are eligible for 457 plans?

In the past, I have done NDCA's for businesses that were "Excess benefit defined benefit plans". In these plans, the employer agrees to supplement the regular pension for selected individuals, with the benefit a guaranteed payment based on compensation and service over a period of time after retirement. Thus it was a DB plan.

Can you give more detail on your client?