Tax-exempt organizations, such as colleges, hospitals, and other nonprofits, have traditionally struggled to attract and retain key talent due to their inability to compete with the executive retirement benefits offered by for-profit companies.
For-profits can, for example, offer phantom stock, stock options, and restricted stock units while tax-exempts cannot. Tax-exempts are also subjected to additional IRS codes. While both for-profits and tax-exempts must follow IRC Section 409A, which regulates any arrangement that defers compensation, only tax-exempts must adhere to IRC Section 457 as well. This code defines non-qualified, tax-advantaged deferred compensation retirement plans and applies additional restrictions.
IRC 457 does, however, have one bright spot in that it allows tax-exempts the ability to establish two additional options: 457(b) and 457(f) plans.
BENEFITS AND LIMITATIONS OF 457 PLANS
457(b) plans can be offered in addition to 401(k) or 403(b) plans and allow for the same contribution limits as traditional defined contribution plans, thus allowing employees to double their annual contributions (currently $20,500 for 2022 into each plan). Contributions to 457(b) plans can also be employer-paid. Tax-exempts can utilize these plans in combination, but they still don’t come close to providing the retirement packages necessary to recruit highly-paid, executive talent.
If a tax-exempt institution wants to provide benefits above and beyond what this combination provides, then they need to follow the rules of 457(f), which allows for any amount of compensation to be deferred for an executive. However, 457(f) has some onerous requirements:
Amounts deferred are subject to creditors.
If the executive voluntarily leaves the organization, the account balance will most likely be forfeited.
Most importantly, as soon as any amount deferred becomes vested to the executive, it is taxable.
From a planning perspective, rolling vesting amounts reduce the effectiveness of the plan’s retention goals. Having a plan that only vests at retirement might discourage an executive from joining the organization or staying with it. Also, having a plan that is taxable once vested requires that payments be made in a lump sum, meaning the executive must immediately have the funds available to pay the taxes.
In addition, IRC Section 4960 applies a 21% excise tax to tax-exempt organizations that pay an executive total compensation in excess of $1 million annually. Taken together, these restrictions and conditions can create a high bar for tax-exempt organizations that want to take advantage of 457 plans.
Read full article to view a 457(f) account accumulation example, how a split-dollar life insurance can be used as an alternative way of providing executive retirement benefits and stress testing a split-dollar agreement.