Section 457 plans are forms of deferred compensation that allow employers to delay, or defer, current salary to a future date. Most active 457 plans are 457(b) plans, which fall in line with the limits and rules of normal 403(b) retirement plans – so much so that 457(b) plans are normally considered to be retirement plans instead of deferred compensation plans.
457(f) plans are quite a bit different. These plans are often used to defer bonuses to highly compensated employees, such as physicians or executives. 457(f) plans don’t replace 457(b) plans; they complement each other.
What Are the Differences of 457(b) and 457(f)?
The primary difference between 457(b) and 457(f) plans is who is funding each plan. Employees fund their own 457(b) plans, which makes it feel like a retirement plan. The 457(b) plan is the employee electing to defer their own salary, with some exceptions for governmental institutions.
The 457(f), on the other hand, is generally employer-funded. The employee typically doesn’t fund these plans, which is what makes these plans great for deferring bonuses, because employers can use these plans to store unpaid compensation until a specified date.
How do 457(f) Plans Work?
Funding the 457(f)
An employer will set up a 457(f) to ensure a key employee stays employed for periods of time to receive promised compensation at a specified date. The employer contribution can be set up as a specific annual amount or a percentage of income. There is generally no statutory annual contribution limit.
Structure of Plan
457(f) are similar to other forms of deferred compensation in that these plans promise salary to key employees at a future date, and then payment is ultimately made. The 457(f) plan typically has a vesting date, which can be defined as a specific date or a designated time of service, such as two years of employment.
Once that vesting period has been satisfied, the compensation is no longer subject to a substantial risk of forfeiture and becomes taxable to the employee.
Vesting and distribution of the 457(f) plan assets aren’t always during the same time. A plan could be designed to vest prior to the employee being able to receive the funds. This can create phantom income, where tax is owed even though no cash is received.
Any funds inside the 457(f) plan are considered unpaid wages, and they are subject to the employer’s creditors. This poses a risk to the employee that the employer remain solvent during the vesting period. Additionally, if the employee does not withdraw the funds from the 457(f) after the vesting period has been satisfied, the unclaimed funds – even though they are vested and owed to the employee – are still subject to the employer’s creditors. Many employees prefer a plan that’s designed to allow the vesting and distribution of the funds to occur close together.
Investments Inside the 457(f)
An employee may or may not have the ability to direct the way the funds are invested. Some 457(f) plans allow the employee to direct the investments from a set list of investments, much like a retirement plan. Some employers will direct all 457(f) funds at their own discretion, retaining control on how the 457(f) funds are always handled. Other times, an employer will credit a set interest rate to the funds inside a 457(f) plan, based on a fixed crediting rate.
If an employee is allowed to view or direct funds inside a 457(f) plan, it is possible the funds are “phantom investments,” as the funding of the plan doesn’t need to occur until the 457(f) is fully vested. The investments within the plan, if the plan is not yet funded, may serve as a placeholder for tracking how much an employee is owed when the account is vested.
Taxation of 457(f) Plans
From the Employer’s Perspective
The employer has several options for funding 457(f) plans: they can actually fund the account, fund a separate trust for the benefit of the account (called a Rabbi Trust), or they can informally fund the account by not funding anything until the 457(f) is vested. For taxable employers, investment earnings are generally taxable as they occur. When the 457(f) vests and becomes available to the employee, the employer gets a tax deduction for the full amount vested to the employee.
From the Employee’s Perspective
Funds are not taxable to the employee until the vesting period is met. Once an employee has satisfied his or her vesting period and is eligible for the funds in the plan, he or she will be taxed on 100% of the account balance at the time the account is vested. This balance is the sum of all the contributions plus any growth.
Once the compensation has vested, the employer cannot take it back, although the timing of actual payment may still depend on the terms of the plan.
A Practical Example:
A hospital pays its physicians bonuses through a 457(f) plan. The hospital contributes 6% of salary annually to the 457(f) plan, and the plan vests every two years. Vesting and distribution are allowed to occur simultaneously. The hospital system directs the investments. The physician makes $500,000 per year.
The physician will not notice the 457(f) plan in the first year because the hospital funds the plan in addition to the physician’s normal salary. The hospital contributes $30,000 in year one and $30,000 in year two, assuming the physician’s salary does not increase. The account grows by $5,000 over the two years.
In year two, the physician receives $65,000 of taxable income in addition to normal salary. This amount is included in wages and reported on a W-2. If the plan vested but did not distribute, the physician would still owe tax on $65,000 without receiving the cash. Once the plan vests and is paid, the cycle may repeat depending on plan design.
Usage and Relevance of 457(f): The Golden Handcuffs
Once the 457(f) plan vests, the plan will either end entirely or reset for a new funding and vesting schedule, depending on the employer’s goal in the plan. Some employers may use 457(f) plans to keep key employees with a company for a specified time prior to retirement or for key project-driven dates. Other employers utilize 457(f) to deliver bonuses to high earning and critical employees on a periodic basis to manage retention and compensation timing.
457(f) plans are often referred to as “Golden Handcuffs” because they can be used to pay physicians, executives, and other key employees large sums of money, but only if they remain employed for a set time. If an employee leaves prior to the vesting period, the obligation to pay the 457(f) funds is waived. With no contribution limits, an employee may have significant incentive to stay with the employer until the 457(f) vests.