Sec. 457 government plan distributions compared to 401(k) distributions.

• Author: Blankenship, Vorris J.

State and local governments and their agencies and instrumentalities (state government units) may establish as many as three different types of tax-favored retirement plans, including qualified plans. If they are public school systems, they may establish Sec. 403(b) plans, generally known as tax-sheltered annuities (TSAs). (1)

In addition, they may establish Sec. 457 government plans. (2) Most have done so, and those plans are in widespread use by state government units throughout the country. Thus, tax and financial planners who counsel retirees should have more than a nodding acquaintance with the tax treatment of distributions from this type of plan.

Sec. 457 government plans originated as unfunded deferred compensation plans, a historical fact that in some respects makes them fundamentally different from most other tax-favored retirement plans. Not until 1996 did Congress require that state government units actually fund the plans using trusts, annuity contracts, or custodial accounts. (3) Since then these plans have assumed a significantly larger role as a substitute for 401(k) plans, particularly since state government units are generally not allowed to maintain 401(k) plans. (4)

A comparison of 457 government plans with 401(k) plans seems particularly apt since practitioners are generally more familiar with 401(k) plans, and cash or deferred arrangements are significant features of both types of plans. (5) Under a cash or deferred arrangement, a participant may generally elect either cash compensation or employer contributions to a retirement plan. This article refers to such elective contributions as qualifying elective contributions (QECs), even though some types of plans use the term elective deferrals or salary reductions. QECs are generally excluded from gross income; however, QECs that are Roth contributions are taxable. (6)

Over the years, Congress has substantially conformed the treatment of 457 government plans to the treatment of 401(k) plans. The latest conforming change was the reduction of the age of qualification for in-service distributions from 70% to 59% for years after 2019. Other conforming changes over the years have included changes in the timing of income inclusions, the treatment of plan loans, required minimum distributions, and the availability of Roth conversions. Nevertheless, some of the tax rules for distributions from 457 government plans continue to differ in significant ways from those for 401(k) plans. (7) Those differences are discussed in this article.

Note that this article does not explain the differences between 457 government plans and 401(k) plans to the extent those differences relate to formation and administration of the plans. Nor does it attempt to compare the rules governing the extent of coverage of employees (nondiscrimination rules) or the qualifications for coverage for various types of employees. Instead this article focuses on a comparison of accumulations in and distributions from 457 government plans and 401(k) plans and on other closely related matters that more directly affect individuals who are admittedly qualified participants in valid plans.

Statutory limitations on contributions to 457 government plans and other plans

Generally, QECs for a tax year are limited by statute to the lesser of an employee's compensation or an inflationadjusted dollar amount ($19,500 for 2020 and 2021). (8) This basic limit applies to the aggregate of all QECs made on behalf of an employee to 401(k) and 403(b) plans. (9) This same basic limit is, however, determined and applied separately to QECs made to 457 government plans (i.e., without regard to application of the limit to 401(k) and 403(b) plans). (10)

If an employee over age 50 has already made the maximum allowed QECs (equal to the basic limit) to 401(k) and 403(b) plans for the tax year, the plans may nevertheless allow the employee to make additional QECs that are catch-up contributions. (11) Catch-up contributions for a tax year are limited in the aggregate to the lesser of (1) an inflation-adjusted dollar amount ($6,500 for 2020 and 2021), or (2) the amount of the employee's compensation reduced by the QECs already made under the basic limit. (12)

In addition, if an employee has completed 15 years of service, 403(b) plans of certain educational, medical, welfare, and church organizations may allow an employee to make additional QECs that are special catch-up contributions. This special catch-up provision is specifically designed to compensate for allowable QECs not taken in prior years. It is limited to $3,000 in any one tax year and to an aggregate of $15,000 for all tax years. (13) An employee eligible to take both the special catch-up contribution and the over-50 catch-up contribution may elect both without offsetting one against the other. (14)

In addition, 401(k) and 403(b) plans are subject to various complicated nondiscrimination provisions that might have the effect of further limiting contributions by or for highly compensated employees. (15) Of note is a provision that limits the amount of an employee's compensation that may be taken into account in computing contributions to the plan (maximum compensation of $285,000 for 2020 and $290,000 for 2021). (16)

Finally, for each employee, the aggregate of contributions and forfeitures to 401(k), 403(b), and other defined contribution plans (not including 457 government plans) generally may not exceed an overall inflation-adjusted dollar amount ($57,000 for 2020 and 58,000 for 2021). (17) Rollover funds and over-50 catch-up contributions are, however, not subject to this limitation. (18)

Separate limitations on deferrals in 457 government plans

Similar to 401(k) and 403(b) plans, annual deferrals in a 457 government plan are limited to the lesser of an employee's compensation or an inflationadjusted dollar amount (also $19,500 for 2020 and 2021). Unlike 401(k) and 403(b) plans, however, this basic limit for 457 government plans applies not only to QECs but also to all other non-QEC contributions to the plan by or for the employee (except rollover contributions). On the other hand, as noted above, the basic limit is not reduced or otherwise affected by contributions made to 401(k) or 403(b) plans. (19)

If a 457 government plan permits, an employee who is over age 50 by the end of the tax year, or his or her employer, may also be able to make catchup contributions in excess of the basic deferral limit. (20) These catch-up contributions are themselves limited to the lesser of (1) an inflation-adjusted dollar amount ($6,500 for 2020 and 2021), or (2) the amount of the employee's compensation reduced by deferrals already made under the basic limit. (21) But unlike for 401(k) or 403(b) plans, the over-50 catch-up contributions for a 457 government plan are not reduced or otherwise affected by catch-up contributions made to other types of plans. (22)

Alternatively, if a 457 government plan permits, an employee or his or her employer may make special catch-up contributions for each of the three years ending before the employee reaches his or her normal retirement age. The total amount of these special catch-up contributions generally may equal the amount of contributions the employee could have made, but did not make, for prior years. Nevertheless, total contributions for a tax year, including both contributions equal to the basic limit and the special catch-up contribution, may not exceed twice the normal dollar limit on contributions for the tax year (e.g., twice $19,500, or $39,000 for 2020 and 2021). (23)

If an employee participating in a 457 government plan is eligible for both the over-50 catch-up and the special catchup, the employee may take only the one yielding the larger overall contribution for the tax year. (24)

Potential doubling-up of QECs to a 457 government plan and a 403(b) plan

An employee who participates in both a 457 government plan and a 403(b) plan may be able to make QECs to the plans that are double the QECs available if he or she had participated in only one of the plans. For example, for 2020 and 2021, the employee could potentially make QECs totaling $19,500 to the 457 government plan and QECs totaling $19,500 to the 403(b) plan, for a total QEC deferral of $39,000. (25) Observe though that, because the 457 plan limitation on contributions also applies to non-QEC contributions to the plan, non-QEC contributions may crowd out potential QEC contributions. (26)

The employee may also double up permitted over-50 catch-up contributions since the catch-up limitation ($6,500 for 2020 and 2021) is applied separately to the 403(b) plan and to the 457 government plan. (27) In addition, an employee of a qualifying educational, medical, or welfare organization who is participating in both types of plans may still potentially take advantage of the special 403(b) catch-up contribution for employees with 15 years of service (limited to $3,000 per year, as discussed above). (28)

Furthermore, if the 457 government plan permits, the employee or his or her employer may also be able to make the special catch-up contributions to the plan that are generally available to employees in the last three years ending before they reach normal retirement age. But, as discussed above, the special catch-up is available only in lieu of the over-50 catch-up and only if the special catch-up is larger than the permitted over-50 catch-up. (29)

Unfortunately, though, only a limited number of state government units with 457 government plans can also maintain a 401(k) plan or a 403(b) plan. A state government unit may adopt and maintain a 403(b) plan only if the governmental unit is a public school system (30) or if it is a 501(c)(3) organization with significant governmental attributes. (31) A state government unit may generally maintain a 401(k) plan only if the plan was adopted before May 7, 1986. (32) Note though that an employee participating in both a...