3602 / How are the participants in a Section 457(b) “eligible” plan taxed?

Amounts deferred under a governmental Section 457(b) “eligible” plan, and any income attributable to such amounts, are includable in the participant’s gross income for the taxable year in which they are distributed/paid to the participant (or to the beneficiary).¹

From time to time, Congress and the IRS provide relief for victims of federally declared disasters. Unless a taxpayer elects otherwise, any amount of a qualified disaster distribution required to be included in gross income shall be so included ratably over the three-year taxable period beginning with such year. Qualified disaster distributions are distributions not exceeding $100,000 in the aggregate from qualified retirement plans, individual retirement plans, Section 403(b) tax-sheltered annuities, or eligible governmental Section 457 plans made in accordance with IRS guidance.

Nongovernmental (Private) Tax-Exempt Section 457(b) Eligible Plan

Distributions of amounts deferred under Section 457 eligible plans sponsored by nongovernmental tax-exempt organizations (private charitable organizations and colleges, etc.) are includable in the participant’s gross income for the taxable year in which they are made available to the participant (or to the beneficiary), without regard to whether they actually have been distributed.² These amounts are not considered to be available simply because the participant or beneficiary is permitted to direct the investment of amounts deferred under the plan.³

Amounts generally are considered made available and, hence, includable in income as of the earliest date on which the plan permits distributions to be made on or after the severance of employment, but not later than the date on which the required minimum distribution rules of IRC Section 401(a)(9) would require commencement of distributions.⁴

Section 457(b) plans of private nongovernmental tax exempts may provide a period during which participants are permitted to elect to defer the payment of all or a portion of amounts deferred until a fixed or determinable date in the future. This election period must expire before the first time when any amounts deferred are considered made available to the participant.⁵ If the participant fails to make this election, the amounts deferred generally would be includable in income when made available as discussed above. Plans may provide, however, for a “default payment schedule” to be used if no election is made, in which case amounts deferred are includable in income for the year in which such amounts first are made available under the default payment schedule.⁶ In addition, a plan may provide for a second, one-time election to further defer payment of amounts deferred beyond the initial distribution deferral.

Participants may not elect to accelerate commencement of such distributions, however. Amounts deferred are not treated as available merely because the participant may elect this second deferral. Participants may be permitted to make this second deferral election even if they:

(1)   have previously received a distribution on account of an unforeseeable emergency;

(2)   have previously received a cash-out distribution of an amount of $7,000 or less ($5,000 or less prior to 2024);

(3)   have previously made (or revoked) other elections regarding deferral or mode of payment; or

(4)   are subject to a default payment schedule deferring the commencement of benefit distribution.⁷

A plan may provide participants with an opportunity to elect among methods of payment, provided such election is made before the amounts deferred are to be distributed according to the participant’s (or beneficiary’s) initial or additional distribution deferral election. If the participant does not make an election regarding the mode of payment, the amounts deferred are included in the participant’s gross income when they become available pursuant to either the participant’s initial or additional election, unless such amounts are subject to, and includable in income according to, a default payment schedule.⁸

In addition, amounts are not considered made available to a participant or beneficiary solely because a participant or beneficiary may elect to receive a distribution on account of an unforeseeable emergency or a cash-out distribution of $7,000 or less ($5,000 or less prior to 2024).⁹

The use of a properly drafted and operated rabbi trust in connection with a nongovernmental private tax-exempt Section 457 eligible plan should not affect the tax treatment of participants or their beneficiaries.¹⁰

Contrast this treatment to the distribution/payment and detailed and complex subsequent election rules imposed on 457(f) “ineligible” plans under 457(f) rules and those governing Section 409A.