Sec. 457 deferred compensation plans.

• Author: Gilfillan, Sally W.

Employees of governments and nonprofit organizations who participate in Sec. 457 deferred compensation plans should carefully consider the status of the deferred compensation and accumulated earnings. Many participants in Sec. 457 plans are unaware that ownership of "their" deferred compensation and all earnings rests irrevocably with the employer until paid or made available. The irrevocable ownership provision dictates that Sec. 457 plans are subject to the employer's general creditors. In addition, some states' Comprehensive Annual Financial Reports include notes that attorney generals have determined that their governments are not liable to plan participants if investment losses are incurred.

Sec. 457 plans are not required to be funded until retirement. Therefore, future cash flow of the government or nonprofit employer should be carefully assessed. The current and projected future fiscal problems of both governments and nonprofits indicate that now is a good time for tax advisers of Sec. 457 plan participants to weigh carefully the tax benefits of these plans against their risk. This article will discuss solutions available to plan participants who determine that the risk is currently not worth the tax benefit.

Deferred Compensation Plans

Sec. 457(a) offers a tax benefit to employees of governments and nonprofit organizations: taxation of deferred compensation and earnings thereon is delayed until paid or made available to the employee. Generally, the deferred compensation is paid to the employee on retirement, thus effectively deferring the tax at least until then. On retirement, plan balances will be taxed as gross income if a single payment is elected or the tax will be matched to installment payments.

* Compensation, earnings and all assets belong to the employer

Congress originally limited the tax benefits of Sec. 457 plans to employees of state and local governments. The Tax Reform Act of 1986 (TRA) added nonprofits as eligible employers.(1) These entities must offer an elective, eligible plan. For a plan to be eligible, all deferred compensation, all earnings on that compensation and any assets purchased with either must be solely the property of the employer. In addition, the assets are subject to the general creditors of that employer. The deferral tax benefit of the participant is based on this definition of ownership.(2) Until the deferred compensation and its earnings are paid or made available to the participant, ownership rests irrevocably with the employer entity; therefore, the deferred tax and earnings are not taxable income.

* Fiscal problems of governments affect ownership provisions

The current fiscal problems of many states, counties and cities indicate that the ownership provision of Sec. 457 should be assessed carefully in 1993. Plan participants may not be aware that the employer is the sole owner of all assets. Participants who are concerned about the ability of their employer to pay out on their Sec. 457 plan might wish to consider leaving the plan until fiscal conditions improve. A Sec. 457 plan may not be nonelective; therefore, participants should be able to elect out of the plan.(3) At retirement, participants might wish to elect to receive the plan balance in a single payment rather than installments spread over a number of years determined with actuarial tables. Although the single payment requires a...