What is a 457(f) Supplemental Retirement Plan?
A 457(f) nonqualified deferred compensation arrangement is a nonqualified retirement plan which gives the tax-exempt employer an opportunity to supplement the retirement income of its select management group or highly compensated employees by contributing to a plan that will be paid to the executive at retirement. All nonqualified plans for tax-exempt employer executives must satisfy 457(f) requirements.
How does it work?
A 457(f) nonqualified deferred compensation arrangement is made up of a written agreement between the employer and each eligible executive to pay benefits when the executive retires, dies, or is disabled. The agreement contains certain conditions that executives must meet before benefits are paid to them. There is no limit on the amount o money that can be deferred on behalf of qualifying executives. In addition, executives can invest up to 100% of their compensation. Deferred amounts and their earnings are employer assets and subject to the claims of general creditors.
How the executives pay income taxes, Social Security (FICA) and Federal Unemployment (FUTA), depends on the written agreement with each eligible executive. Ordinary income tax is paid on the entire value of the fund when there is no longer a risk that the money will be forfeited for non-performance of the agreement. This means that ordinary income tax will be paid on the entire amount in the plan in the year of retirement, regardless of the method of payment. Typically, FICA and FUTA taxes are paid when the benefits become payable or the substantial risk of forfeiture lapses.
What is Substantial Risk of Forfeiture?
In qualified retirement plans, the employer typically sets up a vesting schedule based on years of service. Once an executive is vested, he or she cannot lose the employer’s contribution to the plan so long as the executive works until a stated retirement date. In a 457(f) plan, the vesting schedule determines how quickly participants earn the benefit; once vested, the executive has a contractual right to the money. However, the risk of forfeiture represents a service requirement which is not fulfilled until a pre-determined date is reached.
For most executives, the risk of forfeiture schedule may be the most critical component of a 457(f) plan, because benefits are subject to income tax when the participant’s rights to the benefit are no longer “conditioned upon the future performance of substantial services.” So, when the benefit is earned and their rights are vested, the benefits are taxed, even if the dollars are not then payable. It is not possible to have an arrangement whereby the executive is vested but not taxed on the account if they have a right to access the account either while employed or in the event of voluntary termination of employment. Care must be taken to ensure that “retirement” is defined in the agreement between the employer and the executive. The age at retirement or date of retirement must be specified in order to satisfy the IRS.
What are the benefits?
- Easy to administer
- Low plan administration costs
- Employer and executive may contribute to the plan
- Helps attract and retain valued executives
- Contributions are made with pre-tax dollars
- Earnings compound tax-deferred
- Earnings are paid when the executive is likely to be in a lower tax bracket
Factors to consider:
Who is eligible for the plan? (Note: Only highly compensated employees or a select group of management employees are eligible.)
- What age will they be eligible for the payouts?
- Will it be offered only to the chief executive officer, or will other executives be included?
- Will the payouts begin at the normal retirement age, a retirement age earlier than age 60, or will retirement be deferred with payments at a future date? (Remember, mandatory retirement may apply to certain “bona fide” executives. That group may or may not include executives eligible for these plans.)
What is the benefit formula? If the employer’s objective is to reward the executive based on operating results, a defined contribution plan is most suitable. In this case…
- What will be the contribution level?
- How will it be invested?
- What are the anticipated returns?
A defined benefit formula is usually used to recognize years of service when the employer wishes to guarantee a certain level of retirement income for the executive. In determining a defined benefit formula, factors to consider include:
- What are the replacement percentages?
- What is the accrual rate?
- What is the base pay?
- How many years of service will be recognized?