Deferred Compensation  Plan Under IRC Sec. 457
Employees (or independent contractors) of state and local governments and tax exempt employers can elect to defer future income (and taxation) under an eligible deferred compensation plan described in IRC Sec. 457. Eligible Deferred Compensation Plan The plan must be established and maintained by an eligible employer, which includes states, political subdivisions of states, agencies of state and local governments, as well as any other organization exempt from income tax under IRC Sec. 501(c), e.g., charitable organizations, trade associations, farmers cooperatives, etc. The Small Business Job Protection Act of 1996 requires the assets of state and local government plans to be held in a trust or custodial account. In general, the plan cannot provide for distribution of amounts payable prior to the participant's separation from service or attainment of age 70 1/2, unless the participant is faced with an unforeseeable emergency. However, the plan may adopt provisions permitting in service distribution of benefits if the total benefit is less than a specified amount, currently $5,000. Such in service distributions may be either voluntary or involuntary and are subject to strict conditions. The plan must provide that the amounts of income deferred, plus assets purchased with those funds, plus the income earned on those assets remain the property of the employer. However, the IRS has permitted the use of a rabbi trust to prevent the employer from using the funds for other purposes. See Ltr. Rul. 9205002. There must be a limit of $12,0001 of income that can be deferred in one year. Beginning in 2002, special catch up limits apply to individuals at least age 50.2  During the three years prior to normal retirement age, other catch up limits apply.3 Plan loans can be made under the same rules that apply to qualified plans.. Benefits to Employer Can reward key executives. Selective participation is allowed (no discrimination rules). Costs are tax-deductible. Creation of plan is simple. No administration. Amounts of coverage on various employees can differ. Plan can be terminated without IRS approval or restrictions. Excise and Penalty Taxes The 10% penalty tax on early distributions from qualified plans and 403(b) plans does not apply to IRC Sec. 457 plans. However, the minimum distribution rules effective at age 70 1/2 or later retirement do apply. Life Insurance The premium paid for life insurance in an IRC Sec. 457 plan will not be taxable to the insured if: The employer retains all incidents of ownership in the policy, The employer is the beneficiary, and There is no requirement to transfer the policy or its proceeds. The death benefits paid from an IRC Sec. 457 plan to an employee's heirs are included as taxable income to those heirs under deferred compensation rules. See Treasury Reg. 1.457-1(c).
1 This limit increases as follows: $12,000 in 2003, $13,000 in 2004, $14,000 in 2005 and $15,000 in 2006. Indexed for inflation after 2006. 2 These limits are $1,000 in 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in 2005 and $5,000 in 2006 and later. 3 These other limits are two times the normal contribution limits. Return to Previous Page