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Tax Act Leaves Little To Differentiate 457s From Other Retirement Plans

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Life insurance agents and others in the pension benefits market are finding that 457 deferred compensation plans are looking more and more like 401(k) plans.

Now that President Bush has signed the Economic Growth and Tax Relief Reconciliation Act of 2001, the differences between the 457 planthe plan for employees of state governments, municipal governments and nonprofit agenciesand the 401(k) plan are even smaller.

The changes come at a time when state and municipal governments are discovering that, in some cases, as many as 50% of their mid-level managers are already eligible to retire.

“State and local government are scrambling to find ways that they can encourage people to stay in the work force,” says Martha Priddy Patterson, national director of employee benefits policy in the Washington office of Deloitte & Touche.

The 457 plan changes in EGTRRA may give officials new tools to keep the managers they need to keep, Patterson says.

The legislation that created Section 457 of the Internal Revenue Code and the 457 plan system took effect Jan. 1, 1979, two decades after 403(b) plans emerged and two years before 401(k) plans reached the market.

Beginning in January, EGTRRA will give sponsors of some 457 plans the option of implementing a series of major changes.

The biggest change will be the addition of a mechanism that public employees can use to get money from 457 plans into individual retirement accounts.

Before EGTRRA created a mechanism for moving the 457 money, “participants either had to transfer to a new employers 457 plan or leave it in their ex-employers plan and take distributions directly from the plan,” says Dawn Robins, a retirement plan specialist at The Legend Group, Palm Beach Gardens, Fla.

Distribution options were limited, Robins adds.

Now, “theres more control, more portability,” Robins says. “Its just what 457 plan participants have been looking for.”

Another significant change is an increase in the deferral limit to the same amount allowed for 401(k) and 403(b) deferrals, Robins says.

Current law limits 457 participants to annual contributions of up to $8,500, or 33% of “includible compensation” for participants making less than $25,500 in includible compensation.

Under EGTRRA, the 457 plan contribution limit will be $11,000 in 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005, and $15,000 in 2006. The limit will increase in $500 increments after 2006, according to Kilpatrick Stockton L.L.P., Atlanta, a law firm. Participants who make less than the contribution limit will be able to contribute 100% of includible compensation to their 457 plans.

But at Deloitte & Touche, Patterson warns that the executives involved with buying, selling and managing 457 plans must understand that some EGTRRA changes affect only a portion of 457 plan participants.

A number of EGTRRA 457 plan changes affect only members of plans sponsored by state and local governments, not members of 457 plans sponsored by nonprofit agencies.

One example is the EGTRRA change allowing public employees to roll 457 plan assets into IRAs.

A second example is an EGTRRA change that affects taxation of distributions.

Sponsors of 457 plans decide how old participants must be before they are eligible to take distributions.

Currently, 457 plan participants owe taxes when they reach the plan eligibility age, whether they take distributions or not.

Starting in January, EGTRRA will end that automatic taxation for public employees and retirees. Members of 457 plans sponsored by state and local governments will owe taxes on 457 plan distributions only when they take the distributions.

But this EGTRRA change applies only to members of 457 plans for public employees, not to members of 457 plans sponsored by nonprofit agencies, Patterson says.

Two other changes are the relaxation of a rule governing divorced participants and a relaxation of the “same-desk” rule.

The government now taxes 457 plan participants on all distributions made to their former husbands and wives.

Starting in January, ex-husbands and ex-wives of plan participants who receive plan distributions will have to pay the taxes on the distributions.

When plans pay distributions to “alternate payees” other than former spouses, the plan participants will still have to pay the taxes, according to Deloitte & Touche.

The change in the same-desk rule affects plan distributions for employees who keep the same jobs but work for new employers.

Today, an employer can distribute plan assets when employees have to take new jobs as the result of a liquidation, merger or similar corporate transaction.

Employers cannot distribute 457 plan assets when employees keep the same jobs after a major corporate transaction.

The new law permits employers to make distributions based on “severance from employment” rather than “separation from service” according to Kilpatrick Stockton.

Although the EGTRRA changes sound complicated, they should help plan sponsors and their advisers by making the plans easier to explain, Patterson says.

“Its very good just for efficiencys sake that the rules for 457 plans were made a little more compatible with rules for other plans,” Patterson says.”

Patterson recommends that sponsors of affected plans think about their goals and the products they already carry before responding to the EGTRRA changes.

Sponsors “are going to want to very carefully look at which options, if any, they want to adopt,” Patterson says. “For example, will a 457 plan want to accept rollovers? They may decide they wont because theyre unsure of liability and they may not want to jeopardize the tax status of their plan because the previous plan may not have been administered correctly.”

Managers of other plans may object to the idea of employees putting 100% of their salaries in the plan, Patterson says.

Reproduced from National Underwriter Life & Health/Financial Services Edition, October 8, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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