For most life insurance and financial service professionals, non-qualified deferred compensation calls to mind executive benefit plans used in the for-profit world: bonus plans, split-dollar arrangements, salary-continuation and salary-reduction packages used to recruit, reward and retain top management talent.
Often overlooked among advisors who specialize in executive compensation are packages available to execs who work in government and the not-for-profit arena. These plans, governed by Internal Revenue Code Section 457, supplement 403(b) qualified plans set up for tax-exempt organizations’ rank-and-file workers.
While they function in like fashion to their for-profit counterparts, 457 plans also have unique regulatory requirements. And these differences, sources tell National Underwriter, can have negative tax or other consequences for organizations that fail to take cognizance of them.
“A lot of executives and board members think they can implement at non-profits the same non-qualified plans as they use in the business world,” says Michael Sirkin, an attorney and co-chair of the employee benefits, executive compensation and ERISA litigation practice group of the law firm Proskauer Rose LLP, New York. “When they do this, they violate the tax laws and have to redo the plans. I’ve seen this happen many times.”
Example: Exceeding elective deferral limits imposed on IRC 457(b) public plans for state and local government employees, and private plans for a select group of managers or highly compensated “top hat” employees working at non-governmental, 501(c)(3) organizations (hospitals, charitable organizations, unions, and others) that have been widely adopted to provide supplemental retirement benefits.
Participants under age 50 can contribute up to $16,500 into a plan in 2011; those over age 50 can tack on an additional $5,500. If the plan is for government employees, then participants can defer (excluding catch-up contributions) an aggregate $33,000 in 2011 between the 457 plan and a qualified 403(b) plan.
The plans also offer tax benefits. Employees can defer compensation on a pre-tax basis. Unlike the 401(k) plan, a 457(b) plan entails no 10% tax penalty for withdrawals before the age of 59½. Additionally, 457 plans (both governmental and non-governmental) allow independent contractors to participate.
Sources point out, however, that 457(b) plans come with caveats. Whereas, for example, ERISA-governed public plans—which must be held in a trust, a qualifying annuity or custodial account for the exclusive benefit of plan participants and beneficiaries—are free from the claims of creditors, those implemented by tax-exempt organizations for top-hat execs are not.
“If I were a non-profit executive, before accepting an employee-funded 457(b) plan, I would want to know about the financial worthiness of the organization,” says Sirkin. “When the plans are employer-funded, financial issues are less important because the contributions represent extra money to the participant. But when employee-funded, the financial strength of the organization is very important.”
It is much of the time. Andy Dalgliesh, director of nonqualified benefits consulting at Principal Financial Group, Des Moines, Iowa, observes that most 457(b) plans established by Principal-affiliated advisors—the company counts 3,300 participants in the 457 plans it administers, or which about two-thirds are in (b) plans—are funded with employee deferrals.
Because of the creditor risk, Sirkin advises tax-exempt clients to first maximize contributions to 403(b) plans—which, as qualified plans, are protected from creditors—before contributing to a 457(b) plan. Many non-profit executives, he notes, fail to do this, believing the 457(b) contributions to be more advantageous.
Such creditor risk extends as well to those participating in 457(f) plans, which are available to non-profit executives who are looking defer compensation beyond the 457(b) plan contribution limit. The 457(f) plans can be (and generally are) customized to the needs of the individual executive, but sources say that IRS requirements have limited their appeal for tax-exempts.
Among the technical challenges: designing a worthwhile plan given that the deferred comp is taxed when the plan vests. Such vesting violates the IRS requirement that the plan be subject to a “substantial risk of forfeiture,” meaning that distribution of benefits are tied to a contingency (such as the performance of “substantial future services” for the company). By contrast, 457(b) plan participants enjoy tax-deferral status until benefits are distributed.
“Many non-profit executives find it difficult to defer vesting until benefits are paid out,” says Marc Stockwell, a principal of Findley Davies, Columbus, Ohio. “Nor would most execs be willing to accept this restriction. For someone who is 48 years old and has to wait 17 years before becoming vested at age 65, the requirement can be hard to stomach.”
To make the plans more palatable, Stockwell often recommends implementing a “graded” or “class-year” vesting schedules that vest every three to five years. At vesting, income tax is paid from the account value, and the after-tax amount is left in the plan. The advantage: Earnings on the after-tax balance can continue to grow tax-deferred until retirement. Thereafter, the plan balance can be rolled into an individual retirement account.