Vacation, Sick Pay Deferrals Sticking Point for 457 Plans

State and local government deferred compensation plans, or Section 457 plans (so called because they are established in Section 457 of the Internal Revenue Code), are tax-deferred plans available to state and local public employees. These plans are voluntary, supplemental, long-term retirement programs that give employees of states, counties, cities, towns, and special-purpose local governments an opportunity to defer receipt of income until retirement or termination of employment.

For the very most part, state and government sponsors of Section 457 programs were thrilled with the final regulations issued on those programs last summer (see  Government Works! ), and with good reason (see  Final Regs Shed Light on 457 Programs ).

Open Issue?

The proposed regulations would have allowed participants of an eligible plan to defer compensation, including accumulated sick and vacation and back pay, but only if the participant had made an election to do so before the beginning of the month in which the amounts would otherwise be paid or made available – IF the participant was an employee in that month.   Responding to comments during the review process, the final regulations liberalized that requirement under a special rule that allowed such an election for those type deferrals after the beginning of a month in which they were retiring or having a severance from service, IF it would have otherwise been payable before the employee has a severance from employment and the election is made before the date on which the vacation pay would otherwise have been payable (see  final regs, page 7 ).

So, what’s the issue?   Speaking at the annual American Society of Pension Actuaries Conference (ASPA) in ,, Cheryl Press, senior counsel, tax exempt and government entities at the Internal Revenue Service, acknowledged that complaints had been received about the provision, notably from the National Association of Government Defined Contribution Administrators (NAGDCA).   However, she told PLANSPONSOR.com that 457 plan participants now could defer those amounts, whereas they weren’t able to previously.   At one time the IRS looked at these amounts like a non-qualified deferred compensation arrangement where, “as long as you make the election before you get your check, you could defer it,” she said.   However, the Internal Revenue Code was changed to place these amounts on what was effectively a cash, rather than an accrual basis, and the Code required “the month before” language on salary deferrals.  

In practice, that means that if a worker is leaving on October 15, he/she would have to make the election to defer by September 30 in order to defer being taxed on those amounts.   The new regulations provided an exception that would allow that deferral up to October 14, if they were still an employee.   Press admitted that the law currently affords no lag time administratively - and said that in preparing the final regs the IRS had considered offering a 30 day window.   However, she went on to note that some employers have told the IRS that it takes six to eight months to perform these calculations - which means that even a window that might be reasonable from a tax standpoint wouldn't work for plan administrators.   Press said that 457 plan sponsors appear to want an open-ended window that can accommodate any number of possible end dates, an approach that she described as inconsistent with tax policy.   "There is a concern about the nexus between deferrals and deduction," she said.

Gina Vessels, NAGDCA Senior Project Coordinator, told PLANSPONSOR.com that NAGDCA's Legislative committee is currently working with the Treasury department to try and come up with more concrete regulations regarding these deferrals.   An update on the association's proposals should be available soon on their Web site ( www.nagdca.org ).

Assistant Attorney General for the State ofand past NAGDCA President John Barry told PLANSPONSOR.com that, in his opinion, the regulations clearly allow for the deferral of pay; however, most of the commentary coming out of the IRS would suggest that deferral can only take place under very limited circumstances, if at all.   Barry said the way the regulations are currently written, payment of sick/vacation time can come to an employee only after they are gone, if they elected the deferral. However, the real problem, according to Barry, is that no particular rules are ever cited by the IRS as to when these practices are applicable and when they are not - and he said that he is working with the legislative committee to remedy this situation.

Eric Hazard assisted with the reporting of this story.