Final Regs Shed Light on 457 Programs

July 10, 2003 ( - Sponsors of Section 457 plans got the promised final regulations on those programs today, including some key changes and clarifications to the proposed regulations issued in 2001.

>Significantly, the final regulations have clarified and liberalized several aspects of the rules permitting an asset transfer from one 457 plan to another.   The final regulations note that in consideration of comments received, where a receiving plan allows for the receipt of transfers, transfers are permitted in three situations:

  • Where the participant/beneficiary has had a severance with the transferring employer and is performing services for the entity with the receiving plan (regardless of whether they are in the same state),
  • Where the transferring and receiving programs are within the same state, and
  • Where the transferring and receive programs are eligible government plans of the same employer.

>The proposed regulations (see  At Last! 457 Guidance! ) had restricted transfers to programs within the same state.   The final regulations also allow a plan-to-plan transfer from an eligible plan to a governmental defined benefit plan for permissive service credit, without regard to whether the defined benefit plan is maintained by a governmental entity that is in the same state.

>In another significant change, the final regulations permit a tax-exempt sponsored 457 plan to correct excess deferrals, whereas under the proposed regulations, a tax-exempt sponsored 457 plan with excess deferrals became an ineligible plan.

Another Concern?

The final regulations do retain a provision that strips the tax benefits from discounted mutual fund options used to compensate executives of tax-exempt organizations.   Section 457(f) requires that deferred compensation be included in gross income in the first taxable year in which there is no substantial risk of forfeiture, with an exception for transfers of property described in Section 83.   

That section also requires inclusion of deferred compensation in gross income in the first year in which there is no substantial risk of forfeiture, but does not apply to the transfer of an option without a readily ascertainable fair market value. Thus, nonqualified stock options have traditionally been tax-deferred until exercise.   According to BNA, nonprofit employers commonly issue discounted mutual fund options to executives and require that the options cannot be exercised until a certain date in order to retain the executive until that time, allowing executives to foresee the exact point in time at which they will take a tax hit on the option.

>On plan-to-plan transfers among eligible plans of tax-exempt entities, the regulations maintain the rule from the 1982 regulations allowing a plan-to-plan transfer after a participant has had a severance from employment.

>The final regulations do not permit an eligible governmental plan to distribute rolled-in assets to a participant who is not yet eligible for a distribution until future guidance of “general applicability” is published to address the issue.   The regulations state that Treasury and the IRS intend to issue this guidance in the “near future,” resolving the issue in coordination with the applicable rules for qualified plans and section 403(b) contracts.

>The new regulations say that a 457 plan that accepts a rollover from a non-457 plan must account separately for the rollover for purposes of applying the 10% premature distribution penalty on a subsequent distribution. The regulations specify permissible separate accounting and provide for the ability of the 457 plan to "order" the subsequent distributions as being from 457 or non-457 rollover accounts.

>The regulations clarify that 457 plans can make participant loans without creating a taxable distribution, noting that a loan from an eligible governmental plan can avoid being treated as a distribution depending on the facts and circumstances of the loan, including whether the loan has a fixed repayment schedule, bears a reasonable rate of interest, and has repayment protections that a prudent lender would accept.  

QDRO Clarity

>Additionally, the final regulations clarify that an eligible plan maintained by a state government or by a tax-exempt entity does not lose its eligibility solely because its administrator or sponsor complies with a qualified domestic relations order (QDRO) - including an order requiring the distribution of a participant's benefits to an alternate employee in advance of the general rules for eligible plan distributions.

>The regulations permit a terminating employee to defer accumulated vacation pay, sick pay, and back pay under more liberal terms than under the proposed regulations.   They also add a definition of "family member" to unforeseeable emergency distributions.

>The final 457 regulations generally are effective for taxable years commencing after December 31, 2001. However, taxpayers are entitled to good faith EGTRRA operational compliance until the end of the 2003 taxable year.   The final regulations do not address a timetable for employers to update their plans to reflect the final regulations.