Class 6 Governmental And TaxExempt Deferred Compensation Section 457 And Nonqualified Deferred Compe

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Class 6Governmental And Tax-Exempt Deferred
Compensation (Section 457)
AndNonqualified Deferred Compensation

• Prepared by Michael S. Orentlich CFP

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Governmental And Tax-Exempt Employer Deferred
Compensation(Section 457) Plans

• Section 457 applies to nonqualified deferred
  compensation plans of
• 1. A state, a political subdivision of a
  state(such as city, township, etc.), and any
  agency or instrumentality of a state( for
  example, a school district or sewage
  authority)and
• 2. Any organization exempt from federal income
  tax, except for a church or synagogue or an
  organization controlled by a church or synagogue.

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How Much Can You Put Away?

• The amount deferred annually in 2002 by an
  employee cannot exceed the lesser of 100 of the
  employees compensation or the following dollar
  limit
• 2002 11,000
• 2003 12,000
• 2004 13,000
• 2005 14,000
• 2006 15,000
• The dollar limit is applied on a per individual
  basis, not a per plan basis.

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Big News !

• For tax years beginning after 2001, salary
  reductions under 457 plan no longer have to be
  coordinated with elective deferrals to other
  plans.( 401(k) plans, 403(b), SEPs, and SIMPLES)
• Also, after 2001 , participants who are age 50
  and over are eligible for additional salary
  reduction contributions(this is only available
  for a governmental employer)
• 2002 1,000
• 2003 2,000
• 2004 3,000
• 2005 4,000
• 2006 5,000

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Is There Anything Else?

• Additional catch up provisions! but special rules
  do apply.
• This is for all eligible plans
• The elective deferral amounts that I just went
  over for participants over 50 are not available
  in any year in which the participants makes
  additional deferrals under the 3-year catch up
  rule.
• Three year rule
• The contribution ceiling can be increased in each
  of the last three years before normal retirement
  age to the lesser of
• Twice the dollar limit for the year
• The regular limit of the lesser of the dollar
  limit for the year or 100 of compensation, plus
  the total amount of deferral not used in prior
  years.

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Distribution Requirements

• Plan distributions cannot be made before
• 1. The calendar year in which the participant
  attains age 70 1/2
• 2. Severance from employment
• 3. An unforeseeable emergency
• No 10 pre age 59 1/2 penalty!
• A participant may make a one -time election,
  after amounts are available and before
  commencement of distributions to defer
  commencement of distributions.
• Minimum distribution requirements need to be met.

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Unforeseeable Emergency

• I had a feeling that someone would ask me about
  the unforeseeable emergency
• An unforeseeable emergency is defined as severe
  hardship to the participant resulting from a
  sudden and unexpected illness or accident of the
  participant or a dependent, a loss of property
  due to casualty, or other similar extraordinary
  and unforeseeable circumstances arising beyond
  the control of the participant.

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Coverage and Eligibility

• No specific requirements
• For a governmental organization, the plan can be
  offered to all employees or a select group of
  employees.
• Most private, non government tax exempt
  organizations will be subject to ERISA
  requirements. (unfunded)

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Tax Implications of the 457 Plan

• Amount deferred annually by the employee is
  pre-tax.
• Employers not paying federal income taxes so no
  deductibility issues.
• Plan distributions are income taxable when paid
  or otherwise made available(tax exempt, non
  governmental 457 plans.

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Non Qualified Deferred Compensation

• Any employer retirement, savings, or deferred
  compensation plan for employees that does not
  meet the tax and labor law (ERISA) requirements
  applicable to qualified pension or profit sharing
  plans.
• Usually meant to provide benefits to a select
  group of executives or to provide such a group
  with additional benefits beyond those provided by
  the companys qualified plan.

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Non Qualified Deferred Compensation

• Indicated when the cost of a qualified plan would
  be too high because of the large numbers of
  non-executive employees that would have to be
  covered.
• Good if company cannot afford a qualified plan,
  but still wants to give key employees a
  retirement benefit. (4Rs)
• An employer wants to provide additional deferred
  compensation benefits to an executive who is
  already receiving the maximum benefits under the
  employers qualified plan

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Non Qualified Deferred Compensation

• Also used to provide certain employees with tax
  deferred compensation under terms or conditions
  different than other employees.
• A closely held corporation can use these plans to
  compete for employees against publicly held
  companies offering stock and option based
  benefits.

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Advantages

• More flexible than qualified plans
• Allows coverage of any group or single employee
  without regard to nondiscrimination rules.
• Can provide unlimited benefit to one
  employee(subject to reasonable compensation
  requirement for deductibility)
• Allows for customized benefits for different
  employees.
• Minimal IRS, ERISA and other governmental
  regulatory requirements, such as reporting and
  disclosure, fiduciary, and funding requirements.
• Deferral of taxes to employee but not to the
  employer.
• Can be used as a form of Golden Handcuffs that
  helps bind an employee to the company.

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Disadvantages

• The companys tax deduction is generally not
  available for the year in which the compensation
  is earned. It must be deferred until the year in
  which the income is taxable to the employee. This
  could be many years.
• Lack of security to the employee. He/She has only
  the companys unsecured promise to pay to rely
  on.
• Not all employers are equally suited to take
  advantage of nonqualified plans.
• Because they are pass through entities, S-Corps
  and partnerships cannot take full advantage of
  nonqualified deferred compensation plans.
• The employer must be likely to remain viable long
  enough to make payments promised. Even though
  funds could be set aside to make payments either
  way, the employer must be in existence when
  payments are made so it can take its tax
  deduction.

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Types of Benefits and Contribution formulas

• Salary Continuation Formula
• Provides for a specified deferred amount payable
  in the future without any stated reduction of
  current salary. The benefit is in the form of
  salary, or a portion thereof, at retirement,
  disability or other threshold date.
• Generally uses a formula similar to that of a
  Defined Benefit plan.
• A nonqualified salary continuation plan for a
  selected group of executives with similar
  formulas for the entire group is sometimes
  referred to as a SERP-Supplemental Executive
  Retirement Plan

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Types of Benefits and Contribution formulas
Continued...

• Salary Reduction Formula This design allows for
  the deferral of a specified amount of the
  otherwise payable employee compensation.
• The amount deferred each year under a salary
  reduction formula is generally credited to the
  employees account under the plan. When payments
  are due, the amount accumulated in the account
  determines the amount of payments, usually in a
  lump sum.

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Types of Benefits and Contribution formulas
Continued...

• Excess benefit plans These plans are designed to
  provide benefits only for executives whose annual
  projected qualified plan benefits are limited
  under the dollar limits of Code section 415. An
  excess benefit plan makes up the difference
  between the amounts payable under the qualified
  plan and the amount they would have received if
  there were no benefit limitations under Code
  section 415.
• Stock appreciation rights These plans provides
  that the employees future benefits are to be
  determined by a formula based on the appreciation
  value of the companys stock over the period
• Phantom stock plans These plans usually refers
  to a plan formula based upon an amount of shares
  of stock, established for an employee when the
  plan is adopted, with a provision that the
  employee receives the actual shares or cash
  equivalent at the date of payment

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Funded versus Unfunded Plans

• For tax purposes, a plan is funded if the
  employer has set aside money or property to pay
  plan benefits, and this money is in some way
  protected from the companys creditors.
• If this is the case, the Moines are taxable to
  the employee and tax deductible to the employer.
  Usually not the desired result!
• Assets to informally fund, or finance, the
  employers obligation in a non-qualified plan can,
  and usually are, set aside. If these funds are
  accessible by the employers creditors, therefore
  not secure to the employee, the plan is
  considered unfunded for tax purposes.

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Funded versus Unfunded Plans

• Most nonqualified deferred compensation plans are
  unfunded because of tax and ERISA considerations.
• In a funded plan, amounts in the fund are taxable
  to the employee at the time the employee becomes
  substantially vested. This can be well before
  employee ever actually receives funds.
• Funded plans are subject to ERISA vesting and
  fiduciary requirements just like a qualified plan.

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Informal Financing/Funding Approaches

• Reserve account maintained by employer
• The employer maintains an actual account,
  invested in securities of various types.
• No trust. Funds are fully accessible to the
  employer and its creditors.
• Considered unfunded for tax and ERISA purposes.
• Employer reserve account with employee investment
  direction
• As above except employee has the right to
  direct(select) investments in the account.
• May lead to constructive receipt by the
  employee
• Employee direction should be advisory not binding.

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Informal Financing/Funding Approaches

• Corporate Owned Life Insurance
• Policy on employees life owned by and payable to
  employer. Can provide substantial death benefit
  in early years of plan.
• Rabbi Trust
• A trust set up to hold funds used for financing
  the deferred compensation plan.
• Trust remains accessible to the companys
  creditors but that is it.
• Secular Trust
• Irrevocable trust for the exclusive benefit of
  the employee, with the funds placed beyond the
  reach of the employers creditors
• Taxable to the employee
• Tax deductible to the employer

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Constructive Receipt

• IRC Section 451
• An amount is treated as received for income tax
  purposes, even if it is not actually received, if
  it is credited to the employees account, set
  aside, or otherwise made available.
• Requirement of a passage of time until money can
  be received by an employee is usually considered
  a substantial limitation.
• If deferred compensation plan states the amount
  not payable for five years, or until retirement,
  it is not considered constructively received.

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Constructive Receipt

• IRS considers an agreement to defer compensation
  must be before compensation is earned.
• In order to defer compensation after it is
  earned, the plan must have substantial risk of
  forfeiture of the benefits.
• Distributions provision must be structured to
  avoid constructive receipt.
• If employee has right to accelerate payout, in a
  given year, they would have to include in income
  any amount they could have elected to take
  regardless of the actual amount taken.

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Income Taxation of Benefits and Contributions

• Employees pay ordinary income taxes on benefits
  in the first year in which the benefit is
  actually or constructively received.
• Death benefits payable from nonqualified plans
  are payable to a beneficiary are taxable as
  income in respect of a decedent (IRD) (IRC
  section 691)
• For Social Security tax( FICA), the deferred
  compensation is considered income the year in
  which the employee has no substantial risk of
  losing the benefit