State and local government deferred compensation programs.

• Author: Harm, Kathy

Since 1979, Section 457 of the Internal Revenue Code (the Code) has permitted state and local governments to offer deferred compensation programs to their employees. This employer-sponsored retirement accumulation vehicle is the single most important voluntary, tax-deferred retirement supplement available to employees of state and local governments.

Section 457 deferred compensation programs have grown to hold approximately $28 billion in assets and be available to as many as 95 percent of the employees who would be eligible to participate. Several factors exist which make these employee benefit programs extremely attractive to local government employers and their employees. The following discussion is intended to briefly describe these deferred compensation programs and provide a review of the programs' benefits to participants and employers.

Deferred Compensation Program

An "eligible deferred compensation plan" of a state or local government (or its agency or instrumentality) complies with Code Section 457 and allows employees to set aside, through payroll deduction, an amount up to 33 1/3 percent of Form W-2 reported taxable compensation or $7,500, whichever is less. (In the absence of any other tax-advantaged employee benefit programs, 33 1/3 percent of taxable compensation is generally equivalent to 25 percent of gross income.)

The contributions and any gains from investments are excluded from federal income tax until paid or made available to the participant. All funds must remain the property of the employer, a tax-exempt entity, until paid or available to the participant.

The Code additionally has distribution provisions, allowing payment of benefits not earlier than separation from service, attainment of age 70 1/2 or due to an unforeseeable emergency and requiring certain minimum distributions.

Program Benefits to Participants

Employees who participate in deferred compensation programs derive three primary benefits: lower taxable income through current deferral, accumulation of tax-deferred assets to produce income in retirement when individual tax rates may be lower and a portable retirement benefit.

Tax Deferral Advantages. The importance of tax deferral to the individual taxpayer cannot be stressed too strongly. Over time, the effect of tax deferral on contributions and earnings results in a significantly larger accumulation of assets than the same savings on an after-tax basis. This is true even for those taxpayers who do not...