Differences Between NQDC Plans Subject to IRC 409A and 457

The nonqualified plans offered to top executives at for-profit companies are subject to different rules than those offered to executives at nonprofits.

There are some differences between the types of nonqualified deferred compensation (NQDC) plans that can be sponsored by for-profit plan sponsors and by nonprofit or government plan sponsors.

An NQDC plan sponsored by for-profit plan sponsors is governed by Internal Revenue Code (IRC) Section 409A, while one sponsored by a nonprofit or governmental plan sponsor is governed under IRC Section 457(b) or 457(f). A 457(b) plan is a NQDC plan or eligible deferred compensation plan that can be sponsored by governments—states and political subdivisions of states. Tax-exempt organizations can sponsor 457(b)s in which only certain highly compensated employees (i.e., the top paid group) can participate. Governments and tax-exempt organizations may also sponsor a 457(f) top hat plan. These plans are established by a specific agreement, have specific payout options and have no contribution limits.

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William Fogleman, of counsel at Groom Law Group, Chartered, says the Employee Retirement Income Security Act (ERISA) subjects retirement plans to rules regarding vesting, participation, funding and nondiscrimination. However, under the “top hat” rule in ERISA, plans offered to a select group of management or highly compensated employees are not subject to ERISA’s strict provisions.

Section 409A Plans

Mark West, national vice president of business solutions at Principal, says 409A plans have no limit on contribution amounts, contributions can be a combination of employee deferrals and employer contributions—match or profit sharing type—and participants have the ability to schedule in-service distributions in addition to distributions at retirement. Section 409A also gives plan sponsors some flexibility in choosing vesting schedules for employer contributions—there are not the same kind of limitations a qualified plan has.

In Section 409A plans, participants make distribution elections at the time they make their deferral elections. However, participants can move the distribution to at least five years later if they change their mind about timing, West says. Participants cannot get distributions earlier than elected.

Fogleman explains that 409A rules generally restrict the timing and form of payments, which have to be set up before amounts are deferred. He warns that if a plan is not administered in accordance with 409A, participants could face tax consequences. The participant will have immediate taxation of the deferred amount in the year the right to the payment vests—even if it hasn’t been received yet by the employee. A 20% penalty tax is imposed on the amount involved, and an increased interest rate is imposed on the late payment of the income tax due on the participant’s benefit.

Section 457(b) Plans

With 457(b) plans, there is a cap on contributions, West says. It is the same amount as with 401(k) or 403(b) plans—$19,500 in 2021. Generally, employer contributions are 100% vested immediately, unlike with 409A plans in which employers have a choice of vesting schedules. Participants can roll over balances between eligible 457(b) plans, but assets can’t be rolled into an individual retirement account (IRA) or another type of plan. West adds that one key distinction between 457(b) plans and 409A plans is that 457(b) plans don’t permit scheduled in-service distributions for participants. “They’re really only saving for retirement,” he says.

A 457(b) plan has to be structured in way that limits amounts that can be deferred every year and limits distribution options, Fogleman says. “It has a strange hybrid of qualified and nonqualified rules,” he says.

Fogleman says a 457(b) plan has some preferential tax treatment that doesn’t apply to 457(f) plans. “One reason a plan sponsor would choose a 457(b) plan is participants can be vested in the amounts they defer without being subject to taxation,” he states. “In 457(f) plans, once benefit amounts are vested, participants cannot defer paying taxes, whether they get a distribution or not.”

Section 457(f) Plans

There is no contribution limit in 457(f) plans, West says. And, he adds, these plans almost always fully consist of employer contributions because there is vesting placed on assets by the plan sponsors. “When the vested date hits is when benefits become taxable, whether they are paid out or not,” he explains.

“Employees can defer into 457(f) plans, but it is uncommon because a participant would be reluctant to put some of his pay into the plan with the risk he could lose it,” West says. “There is a substantial risk of forfeiture in these plans. If a benefit doesn’t vest until 10 years and the participant is no longer with the company at that time, his account is forfeited.”

West says some 457(f) plans could be subject to Section 409A as well, but that doesn’t typically happen. If the plan sponsor determines the vesting date and, at that point, account amounts would be included in the participant’s income, the 457(f) plan would fall under the short-term deferral exemption from 409A, and is not subject to other 409A provisions, he notes. He adds that the vesting and pay design of 457(f) plans make them more likely to be used for recruiting and retention purposes than for participant retirement savings.

West says a primary difference between 457 plans for nonprofits and those for governments concerns ERISA top hat provisions. Governmental plans are not subject to ERISA, but nonprofits still need to follow the rules for only allowing NQDC plans to a select group of management or highly compensated employees.

Fogleman notes that Section 457(f) exists because nonprofits are tax-exempt; they don’t pay taxes so they don’t get the credits for-profit employers do. A for-profit employer will get a tax credit when a NQDC plan participant’s deferred compensation is paid. “They have to keep the amounts on their books because they don’t get the credit until amounts are paid to participants,” Fogleman says. “Tax-exempt employers don’t have to worry about it.”

One final issue Fogleman says nonprofit employers might want to consider is that tax-exempt organizations are now subject to IRC Section 4960 added by the Tax Cuts and Jobs Act (TCJA). “Tax-exempt organizations will be taxed on compensation paid over $1 million, which includes amounts in 457(f) plans,” he says. “Plan sponsors need to be cognizant of any large payments coming out of 457(f) plans that may be taxable to them.”