Non-Governmental 457(b) - Distributions and Accounts

I've got two questions relative to non-governmental 457(b) Plans.  As a TPA firm, we have historically only assisted with plan documents for a few top hat plans, but I find myself needing to get more involved in reviewing assets and generally have more oversight on what is actually transpiring within one or two of the plans.

1)  Two clients have all of the 457(b) assets in brokerage accounts that in the name of plan and FBO the participant.  There are 4 or 5 participants.  This seems to completely negate the requirement that these plans be "unfunded".  There is a rabbi trust, but that does not change the fact that these should not be SDBAs in the participant name, correct?  

2) A participant took a distribution earlier this year after terminating employment.  The timing was in accordance with the document.  The employer understands that they need to have the distribution reported on the 2023 W-2.  That participant took the entire account balance as a cash distribution and had no taxes withheld.  Since payroll taxes apply, I take it this is wrong, but how can we fix?  Do we have the client run the distribution of deferred compensation through payroll to determine how much in taxes is due and ask for the money back from the participant?

It seems like it would be cleaner to never have a distribution paid directly from an account to a participant and have the account balance instead paid to the employer (since it company assets until paid anyway) and then have them run through payroll and issue the distribution in the same manner as a paycheck (aside from applying FICA if already withheld). Is that what you all are doing?  

Thank you!!!

7 hours ago, 401(k)athryn said:

1)  Two clients have all of the 457(b) assets in brokerage accounts that in the name of plan and FBO the participant.  There are 4 or 5 participants.  This seems to completely negate the requirement that these plans be "unfunded".  There is a rabbi trust, but that does not change the fact that these should not be SDBAs in the participant name, correct? 

401(k)thryn, I think this presents a fact issue. If the terms of the account were that while the participant had the right to communicate directly with the broker-dealer to change assets, but could not direct a distribution, this could be OK, i.e., may not cause the assets to come within the participant's dominion and control. It is fairly common. If the participant was able to take a distribution without the employer's direct involvement and approval, the IRS at least would probably argue that the participant had dominion and control of the funds and should have been taxed on deposit. Just my guess as to what they would say.

7 hours ago, 401(k)athryn said:

2) A participant took a distribution earlier this year after terminating employment.  The timing was in accordance with the document.  The employer understands that they need to have the distribution reported on the 2023 W-2.  That participant took the entire account balance as a cash distribution and had no taxes withheld.  Since payroll taxes apply, I take it this is wrong, but how can we fix?  Do we have the client run the distribution of deferred compensation through payroll to determine how much in taxes is due and ask for the money back from the participant?

There's a procedure whereby the employee can certify that they included the amount in income and that may get the employer off the hook, although the employer may still be subject to penalties. The procedure is complicated. Otherwise the employer is on the hook for all the tax they should have withheld.

The other problem I see is how this distribution was transacted. Was the employee able to directly request and receive payment after being reported as terminated, without the employer having to authorize payment? Something like this, and maybe the issue with the titling and ownership of the account creates constructive receipt blows up the tax deferral? Also, if indeed a rabbi trust, there should be a trustee who should ensure proper reporting. If the trustee doesn't facilitate W2 reporting then the best practice, in my opinion, is for the trustee to transfer funds to the employer's payroll function for proper reporting.

Silly rabbi trusts are not for kids!