Sections 457(b) and 457(f): Designing Deferred Compensation Plans for Tax-Exempt and Governmental Employers

Speaker A: Foreign. Welcome to the Lowenstein Sandler Podcast Series. Before we begin, please take a moment to subscribe to our podcast series@lowenstein.com podcasts or find us on Amazon Music, Apple Podcasts, Audible, iHeartRadio, Spotify, SoundCloud, or YouTube. Now, let's take a listen. Welcome to the latest episode of Just Compensation. I'm Megan Munson, a partner in Lowenstein Sandler's Executive Compensation, Employment and Employee Benefits Practice Group, and I'm joined today by two of my colleagues, Zach and Taryn, who I'll introduce themselves.

Speaker B: Hi, I'm Taryn, counsel in Lowenstein's Executive Compensation, Employment and Employee Benefits Group.

Speaker C: Hi, I'm um, Zach, an associate in Lowenstein Sandler's Executive Compensation, Employment and Employee Benefits Group.

Speaker A: Today we are unpacking two deferred compensation vehicles available to tax exempt organizations and and state and local governments, what's considered an eligible section 457 arrangement and an ineligible 457F arrangement, both of which come from the framework of Internal revenue code sections 457B and 457F. As applicable, we'll cover who can sponsor these plans, what type of contributions can be tax deferred when taxation occurs, and how section 409 overlays with these rules. As always, this is a high level discussion and not legal advice, so please consult your advisors about how these rules apply to your specific facts and circumstances. So Zach, let's start with the big picture. Who does section 457 generally apply to and why does 457 exist in the first place? What was Congress trying to address?

Speaker C: Thanks, Megan. Section 457 applies to two categories of eligible employers state and local governments and their agencies and instrumentalities and tax exempt organizations. Other than governmental entities, churches and qualified church controlled organizations are generally excluded. Practically speaking, we're talking about public sector employers such as schools, public utilities, state governments and nonprofit organizations that often sponsor these types of plans. These employers can offer eligible section 457B plans and or ineligible section 457F arrangements. It's important to note that the rules of IRC 457 differ from 457 Cap A. Code section 457 Cap A applies to tax in different parties, e.g. a foreign or offshore fund. Please see our podcast episode focused on 457 Cap A arrangements. If you're interested in learning more about deferred compensation for those types of entities, we'll put a link in the description. Section 457 was enacted amidst debate about the proper tax treatment of compensation deferred under government plans. There was a concern that unlike taxpaying entities, the employee's desire to defer taxation would not be countered by the employer's desire for an immediate tax deduction. In 1986, the Tax Reform act extended Section 457 to cover deferred compensation plans of tax exempt organizations. The result was that any deferred compensation outside of an eligible 457 plan is subject to income tax when it vests rather than deferring it until it is paid to the participant. Organizations that are not tax exempt are not constrained by section 457.

Speaker A: So Zach, that was a really helpful overview. With that framework in mind, let's turn to the details of eligible 457 plans. Taryn, what are the basic rules of these plans?

Speaker B: An eligible 457 plan generally permits aggregate maximum annual contributions up to the lesser of the IRS 402 limit, which for 2026 is 24,500 or 100% of the participants compensation. Unlike UM 401 plans, there are not separate limits for employee and employer contributions. However, for 2026, individuals age 50 or over can make a catch up contribution of up to $8,000 and those aged 60 to 63 can make a super catch up contribution of $11,250,000 and those limits will change year by year. Note that these maximum deferral limits apply for any one individual during a taxable year. The key phrase there is any one individual, not any one plan. The regulations call this the individual limitation. That means if a participant is in multiple 457 plans of unrelated employers, total deferrals across all 457 plans are capped at the applicable limit for that individual.

Speaker A: What about election timing?

Speaker C: The election timing rules differ by employer type, as uh Secure 2.0 changed this recently. For governmental employers. For governmental employers, a deferral agreement must be entered into before the compensation is currently available to the individual. For tax exempt employers, a UH deferral agreement must be entered into before the beginning of the month in which the compensation is paid. The governmental standard offers greater flexibility.

Speaker A: Taryn, when does income inclusion happen for amounts Deferred under a 457 plan?

Speaker B: For eligible 457 plans, tax timing depends on the type of employer. For a governmental employer, deferred amounts and income attributable to those amounts are taxable when they are paid to the participant or beneficiary. Whereas for tax exempt entities that is not a governmental entity, amounts are taxable when they are paid or otherwise made available to the participant or beneficiary. This means that 457B participants of tax exempt entities can face the possibility of constructive receipt and therefore be taxed on deferred amounts even before they're actually paid.

Speaker A: That's a really helpful distinction to be aware of. When can participants get distributions of their money?

Speaker B: Distributions from a AH457B plan can be made available on the earliest of the calendar year in which the Participant attains age 70 and a half, or 59 and a half if it's a governmental plan, severance from employment with the employer, an unforeseeable emergency death, or for governmental plans only with respect to amounts in a lifetime income investment 90 days before the investment may no longer be held as a plan option. Also, effective December 29, 2025, under Secure Act 2.0, deferred amounts can also be accessed as qualified long term care distributions. This was intended to help participants defray the cost of certified long term care

Speaker A: insurance and how are the plan assets held for section 457B plan?

Speaker C: Well, Megan, this defers whether you are a state or local government or a tax exempt organization. For governmental 457 plans, all assets and income must be held in trust for the exclusive benefit of participants. Similar to a 401k for tax exempt employer plans. All deferred amounts and attributable income and property must remain the property and rights of the employer subject to the claims of general creditors. In other words, tax exempt entity plans must remain unfunded. However, a tax exempt organization may be able to hold such assets and income in a rabbi trust, which is one that is subject to the claims of creditors.

Speaker A: And what about rollovers?

Speaker B: This is another area that differs depending on what kind of employer you are. Rollovers may be made from a governmental 457B plan to another governmental 457B plan, a 401A plan, or a 403B plan or an IRA. However, rollovers may not be made to or from any 457B plan maintained by a non governmental tax exempt employer.

Speaker A: This has been a very helpful overview with respect to 457 plans. I think one item that I've heard

Speaker B: throughout is that there are a lot

Speaker A: of differences between what type of employer you are. So again, just to be mindful of that as you're approaching and thinking about implementing a uh, 457B plan, so let's pivot to ineligible 457F plans. Zach, how do they generally work?

Speaker C: If a deferred compensation plan of state or local government or tax exempt UM entity does not satisfy the requirements of an eligible 457 plan, usually because the amounts exceed the 457 limits or the plan is designed to otherwise operate Outside of the 457 framework, it is an ineligible 457F plan. A 457F plan isn't subject to any contribution limits like a 457 plan. Both employees and employers may contribute to a 457F plan and those contributions and the earnings thereon remain tax deferred until the first taxable year in which there is no substantial risk of forfeiture of such amounts often referred to as vesting.

Speaker A: So that leads us to an important question, Taryn. How is a substantial risk of forfeiture defined for purposes of 457F?

Speaker B: Under 457F, a substantial risk of forfeiture exists if the compensation is quote, conditioned upon the future performance of substantial services by the individual. End quote. The substantial risk of forfeiture definition under 457f is narrower than under section 83. Typically under section 457f, in order for there to be ah, a good substantial risk of forfeiture, there should be a requirement of continued employment for a fixed period, Generally at least 2 years per IRS guidance to be considered substantial. Likewise, mere consulting availability or sporadic consulting may not be recognized as substantial services either.

Speaker A: It sounds like what constitutes a substantial risk of forfeiture is not always clear. Are there any other ways you can have a good substantial risk of forfeiture besides continued employment?

Speaker B: Yes. Unlike sections 83 and 409A, a non compete obligation may be recognized as a substantial risk of forfeiture in limited circumstances. The 457F proposed regulations state that a non compete may be treated as an substantial risk of forfeiture if three conditions are satisfied. First, the right to compensation must be expressly conditioned on the employee complying with a non compete under a written agreement that is enforceable under applicable law. This means that the analysis is going to be sensitive to state law restrictions of non competes. Second, the employer must consistently make reasonable efforts to verify compliance with the non complete. Third, at the time the non compete becomes binding, the facts and circumstances must show that the employer has a substantial and bona fide interest in preventing the employee employee from performing the prohibited services and that the employee has a bona fide interest in engaging and an ability to engage in the prohibited services.

Speaker A: Zach, what about the requirement that these

Speaker C: plans remain unfunded section 457F requires that ineligible plans of tax exempt entities remain unfunded, meaning that the plan must pay benefits out of the employer's general assets and the assets cannot be segregated from the employer's general assets until benefits are distributed. However, a rabbi trust whose assets remain subject to the claims of the employer's general creditors in the event of bankruptcy can be used. The requirement that these plans be unfunded limits the ability of employers subject to ERISA UH to offer an ineligible 457F plan to a broad base of employees instead to comply with ERISA uh. Most section 457F plans of tax exempt entities qualify as top hat plans, which means they are offered only to a select group of management or highly compensated

Speaker A: employ since we are talking about deferred compensation, what about section 409 cap A? Taryn how does section 409A interact with sections 457 and 457F?

Speaker B: Section 409A creates another challenge in structuring deferred compensation for these types of entities. While eligible plans under 457 are not subject to the requirements of 409A, 409A does apply to the ineligible 457F plans. This means that section 457F plans must either be exempt from or comply with the rules of section 409AMany ineligible 457F plans are structured to be exempt from 409A under the Short term deferral rule. However, there is one nuance that's worth noting. Section 409A defines substantial risk of forfeiture more narrowly than 457F does. As I mentioned earlier, specifically, 409A does not recognize a non compete provision as substantial risk of forfeiture, which can create a potential trap under 457F. If you're not being mindful mindful of the rules of both 457f and 409a,

Speaker A: Zach, can you elaborate a little bit on how the non compete divergence plays out in practice?

Speaker C: Sure. As discussed earlier, under the proposed 457F regulations, Conditioning A payment upon compliance with the non competition agreement may result in the payment being treated as subject to a substantial risk of forfeiture for purposes of section 457F, uh, and therefore defer taxation 457F purposes. However, that same payment would not be treated as subject to substantial risk of forfeiture for purposes of 400 NA potentially requiring that the plan comply with the rules of 409A such as the distribution, acceleration election timing requirements. For this reason, practitioners may avoid using compliance with a non compete as a substantial risk of forfeiture under 457F. For this reason, practitioners may avoid using compliance with a non compete as a substantial risk of forfeiture under 457F for the sake of simplicity when it comes to 409A compliance so Taryn and Zach,

Speaker A: you've touched on a lot of really interesting and helpful topics. What are some key takeaways that governmental and tax exempt employers should keep in mind if they want to offer deferred compensation to their employee?

Speaker B: Governmental and tax exempt employers face a, uh, distinctive and complex regulatory landscape when it comes to designing executive compensation arrangements. They have to navigate not only the rules of 457, but also the interplay with the rules of section 409a and ERISA. However, when structured properly, these types of plans can be an important tool for recruiting and retaining top talent. It's important to reach out to legal counsel early if you're interested in implementing one of these plans. Legal counsel can help synthesize these overlapping regulatory requirements and help navigate the design, implementation, and ongoing compliance of deferred compensation arrangements for these types of employers.

Speaker A: Thank you both so much. Today we outlined how section 457 and 457 F arrangements operate for tax exempt and governmental employers, including when deferred amounts are taxed. These are nuanced, complex deferred compensation arrangements and care should be taken when designing, implementing and administrating them. Engage counsel early and regularly to ensure compliance and avoid unintended pitfalls. As always, this episode is intended to be a high level discussion and it is not legal or tax advice. Please consult your own advisors for guidance tailored to your own organization. If you enjoyed today's episode, please subscribe, leave us a review and share this episode with your colleagues. You can also reach out to UH us via email if you have questions or ideas for future topics. We look forward to having you back for our next episode of Just Compensation. We'll see you next time. Thank you for listening to today's episode. Please subscribe to our podcast series@lowenstein.com podcasts or find us on Amazon Music, Apple Podcasts, Audible, iHeartRadio, Spotify, SoundCloud, or YouTube. Lowenstein Sandler podcast Series is presented by Lowenstein Sandler and cannot be copied or rebroadcast without consent. The information provided is intended for a general audience and is not legal advice or a substitute for the advice of counsel. Prior results do not guarantee a similar outcome. Content reflects the personal views and opinions of the participants. No attorney client relationship is being created by this podcast and all rights are reserved.