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Financial Planning > Tax Planning

Charting The (Largely) Uncharted: 457 Plans

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Producers looking to establish a market niche might consider one still largely uncharted area of the financial advisory world: nonqualified executive compensation plans for tax-exempt organizations as permitted under Section 457 of the Internal Revenue Code. Interest in such plans has been gathering steam, especially among not-for-profits, as the fortunes of a once-popular option, equity split-dollar plans, has declined, say experts.

“Though split dollar is still a fit in certain circumstances, major revisions to tax laws have prompted many nonprofits to look at Section 457 plans as an alternative,” says Marc Stockwell, a principal and financial advisor at Findley Davies, Toledo, Ohio.

The heightened focus on Section 457 plans, particularly 457(b) arrangements, is also an outgrowth of the Economic Growth and Tax Relief Reconciliation Act of 2001. EGTRRA boosted annual elective deferral limits under 457(b) plans to $11,000 in 2002 from $8,500 in 2001. The law additionally stipulated annual deferral increases of $1,000 for each succeeding year, capping at $15,000 in 2006.

Section 457(f) plans have no annual contribution limit. Observers say the plans generally are reserved for only very high paid execsthose with annual incomes exceeding $200,000 annuallywho want to defer more than the maximum allowed under 457(b).

Many nonprofits do, in fact, use the 457(f) plans as a spillover mechanism in a three-tier supplemental executive retirement plan (SERP), wherein the employer contributes a fixed percent of base salary. This year, for example, a participant may defer up to $13,000 into a qualified 403(b) plan, another $13,000 into a 457(b), and the balance into a 457(f).

Alternatively, the tax-exempt organization might use 457(f) exclusively for a performance-based executive compensation plan, an increasingly popular option, advisors say. In this instance, the employer contribution equals a fixed percentage of base salary plus a variable percentage of pay, depending on the executives performance.

There is, however, a downside to 457(f) plans for participants. Whereas 457(b) plans vest immediately and can be distributed either as lump sum or in installments, 457(f) plans apply vesting in the future and only can be paid as a lump sum.

Section 457(f) arrangements also are subject to a “rolling risk of forfeiture.” The plans account balance is surrendered in the event of the executives failure to satisfy non-compete requirements or upon voluntary termination of employment before the retirement date. But once the account is no longer prone to risk forfeiture (as at retirement), the entire balance is treated as taxable income.

These provisions, advisors say, can make 457(f) plans a tough sell with boards of directors.

“A rolling risk of forfeiture involving a non-compete or consultation agreement, or both, seems to be the biggest hurdle in designing these [457(f)] plans,” says Richard Landsberg, a senior advanced sales consultant at Nationwide Financial, Columbus, Ohio. “The solution should more closely resemble for-profit organizations deferred compensation plans, which are taxed only as paid out.”

Stockwell considers this outcome unlikely. The reason: Jettisoning the forfeiture provision would leave the government without a source of tax revenue, given that tax-exempt organizations dont pay tax on their income. By contrast, the government can recoup any income tax that an executive saves participating in a for-profits deferred comp plan by taxing the business.

Derek Wright, a financial consultant and registered rep at Oak Brook, Ill.-based GCG Financial, asserts the 457(b) plan is initially easier than the 457(f) for most boards of directors “to swallow” because of the (b) plans deferred compensation contribution limit. Wright typically addresses this concern by pointing out that nonprofit execs can make 30% to 40% more in compensation by bolting to a for-profit organization than they can when restricted to the (b) plan.

Caveats aside, advisors observe that both 457(b) and 457(f) plans are gathering substantially more interest among tax-exempt organizations, in part, because of a new tax treatment for a once-popular alternative, equity split-dollar life insurance plans. IRS Notice 2002-8, which became effective on Jan. 1, 2004, created economic benefit and loan regimes for equity split-dollar plans implemented after Sept. 17, 2003.

Under the first, plan participants are taxed on the annual increase in policy equity if they have access to the equity. Under they second, the government treats the nonprofits premium advances as a loan to the employee. If the loan does not provide for “adequate interest,” then the arrangement is taxed as a below-market loan to the employee.

Despite the more restrictive tax treatment, advisors dont see split dollar going away entirely.

“For young execs who are planning to accumulate retirement assets over a long period, split dollar makes a lot of sense,” says Stockwell.

To be sure, life insurance can be used as a funding vehicle for 457 plans as well. Landsberg notes that both life insurance and annuities are “naturally suited” to the 457 market because of the guarantees they can offer.

But Wright observes that life insurance should only play a role if the organization has a “cost recovery objective” (i.e., where a portion of the death benefit goes to the organization upon the plan participants death). Absent that objective, Wright suggests alternative vehicles, including annuities and mutual funds.

He adds, however, that if the IRS were to drop the risk of forfeiture provision from 457(f) plans, as Landsberg recommends, “that would greatly open up the market for life insurance and annuities in designing these arrangements.”

Whatever the funding mechanism, experts strongly encourage advisors to partner with an experienced attorney when setting up a 457 plan because of its complexity.

Reproduced from National Underwriter Edition, November 11, 2004. Copyright 2004 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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