Tax-Exempt Employers Should Evaluate the Benefits of IRC 457 Plans

When non-governmental tax-exempt employers aim to provide future benefits to their employees, such as retirement benefits, they have several options. Often employers offer retirement benefits under a qualified plan, like a 401(k) or 403(b).

However, if the employer wants to provide benefits that exceed qualified retirement plan limits or provide benefits only to a select group of management or highly compensated employees, adopting an Internal Revenue Code Section 457 (IRC 457) plan might be the right choice.

Introduction to IRC 457 plans

IRC 457 applies to deferred compensation paid by governmental and tax-exempt employers. It establishes two types of plans for non-governmental tax-exempt employers: 457(b) eligible plans and 457(f) ineligible plans. This blog post discusses the federal income tax treatment of IRC 457 plans.

For employment tax purposes, non-qualified deferred compensation is subject to a special timing rule, which generally requires FICA and FUTA to attach the later of when the services are performed or the amounts vest (generally the amounts contributed to a 457(b) plan are fully vested and subject to immediate employment taxes).

Eligible 457(b) plans

An eligible 457(b) plan must meet several specific requirements. Notably, limited deferral amounts and specific payment timing. Annual contributions under 457(b) plans cannot exceed the lesser of 100% of the participant's includible compensation or the elective deferral limit ($23,500 for 2025). In addition, an eligible 457(b) plan must not allow a participant's benefit to be paid or made available before:

• the calendar year in which the participant reaches the age of 70 ½,
• the participant's severance from employment with the plan sponsor, or
• an unforeseeable emergency.

If these rules are met, the amount deferred under an eligible 457(b) plan is generally not taxable for federal income tax purposes until paid or made available to the participant.

Ineligible 457(f) plans

If a deferred compensation plan fails to meet the 457(b) eligible plan requirements, all compensation deferred under the plan is currently includible in the gross income of the participant for federal income tax purposes when it becomes vested under IRC 457(f). This timing is earlier than under a 457(b) eligible plan, so generally, a 457(f) ineligible plan is adopted only when the exempt employer wishes to fund a benefit greater than allowed under 457(b) or allow for that benefit to be paid under different timing.

How CLA can help with employee benefit plans

While both 457(b) and ineligible 457(f) plans provide federal income tax deferral benefits for non-governmental tax-exempt employers, they have distinct requirements and implications. Eligible 457(b) plans offer structured deferral limits and more rigid payment timing, but also the opportunity to defer without federal income taxes after vesting. In contrast, ineligible 457(f) plans, though more flexible in terms of benefit amounts and timing, require that funds be taxed upon vesting.

Employers should carefully assess their goals and compliance capabilities when selecting the appropriate plan. As always, consulting with a tax professional is recommended to effectively navigate these difficult decisions.