457(f) - On vesting, taxes paid but money stays in the Plan?

[ERISA-Bubs]

A company wants to set up a 457(f) Plan.  They are aware of the taxation upon vesting rule, but they don't want to make a full distribution upon vesting.  Instead, they want to distribute a percentage to cover taxation, but leave the rest in the plan until a specified payment date.

I don't see this as a problem, but what issues am I missing?

• The company is a nonprofit, so how are 990 tax returns handled for contributions/distributions.
• The money in the Plan will continue to accrue earnings after it is vested but before it is distributed -- is there a tax issue here, or are the investment earnings not realized until final distribution?
• Does the tax distribution (the amount distributed at vesting to cover taxes) have to be a set amount (specified in the plan ahead of time) or can it just be the amount necessary to cover taxes, which is calculated at the time of distribution?

Thank you in advance!

[Carol V. Calhoun]

The major issue is that they then have a plan subject to 409A, and need to make sure it complies. 

The investment earnings are not taxed until distribution. 

[EBECatty]

I have been involved with a few of these for clients - all put in place prior to my involvement - and every one of them has regretted it. 

I understand the logic behind the plan design, but from a taxation, withholding, 990, payroll reporting, recordkeeping, etc. standpoint it's a real pain. 

[ERISA-Bubs]

14 minutes ago, EBECatty said:

I have been involved with a few of these for clients - all put in place prior to my involvement - and every one of them has regretted it. 

I understand the logic behind the plan design, but from a taxation, withholding, 990, payroll reporting, recordkeeping, etc. standpoint it's a real pain. 

Do you have some examples I can convey to help them determine whether they really want to do this?

[ERISA-Bubs]

23 minutes ago, Carol V. Calhoun said:

The major issue is that they then have a plan subject to 409A, and need to make sure it complies. 

The investment earnings are not taxed until distribution. 

Thank you.  I am comfortable with designing something 409A-compliant.

[EBECatty]

My experience may not be universal, but among other things:

• The 990 reporting, usually done by someone not administering the plan, is complicated with amounts credited, vested, taxed, distributed, or reported in prior years potentially all happening in one year.
• The participants do not see the value in receiving distributions to pay taxes, only to wait several years (or more) to actually receive a benefit, particularly where they leave employment before payment is made and they have been taxed on money that remains available to their former employer's creditors.
• Depending on the plan type, to calculate the taxable amount in a given year they may need to do present value calculations with unknown variables.
• As Carol notes, with other plan types, tax is imposed on vesting, then again on later earnings upon distribution. While not double-taxed, it's another set of calculations/recordkeeping.
• If any of this is done incorrectly or overlooked for a year because no one thought to look for amounts vesting (but not due) in a given year, tax returns must be amended, etc. 
• 409A. Inevitably one of the employees will ask to accelerate payment after several years of paying taxes with no benefit.
• If you don't calculate the participant's estimated tax rate, or if you simply use the supplemental rate, and the participants are highly paid, they will owe more in tax when they file their return than was distributed to them on vesting/taxation. They will be unhappy. Usually a separate bonus will be paid to make them whole.
• Payroll software, or the people using it who may not be used to working with the above issues, can make it difficult to accurately reflect all of the above.

Again, not all of these are always problems, but together they can make what would otherwise be a very simple plan design (contribution, earnings, vest, pay, withhold, tax, report) far more complicated. Just my two cents. 

[ERISA-Bubs]

That is very helpful!  Thank you!

[Luke Bailey]

On 9/8/2023 at 9:28 AM, ERISA-Bubs said:

Does the tax distribution (the amount distributed at vesting to cover taxes) have to be a set amount (specified in the plan ahead of time) or can it just be the amount necessary to cover taxes, which is calculated at the time of distribution?

It can be the amount necessary to cover taxes, but can't exceed the amount of Federal, State, local, and foreign taxes required to be withheld in connection with vesting. Treas. Reg. 1.409A-3(j)(4)(iv).

EBECatty raises some very good points, but the design does make it look a lot more like a retirement plan, e.g. if the plan provides for a 10- or 15-year payout, in approximately level amounts, following separation from service. Income tax on all the earnings is deferred, no more FICA is owed, and most of the payments (e.g., over the 10- or 15-year period) are tax-free recovery of basis. For a senior executive and board who want a real retirement benefit, it's a good design. The biggest issue is the creditworthiness of the 501(c)(3), so makes the most sense for a well-established employer.

And finally, explaining how it works makes for an interesting PowerPoint presentation, if you're into that.