Thursday, December 13, 2012

Timely Elections of 457(b) Distributions

If you sponsor a non-governmental 457(b) tax-exempt plan for your key management and highly compensated employees, perhaps the most significant administrative task occurs at the time participants sever employment.  Each 457(b) plan has a specified time period by which a participant may make an election to defer payment and timely postpone taxation by electing a future distribution date.  If no timely election is made by the end of the specified time period (“default date”), payment will commence within a generally brief period of time after the default date elapses, which may not be what the participant intended.

Why must there be a default date?
457(b) tax-exempt plans are non-qualified plans, and in accordance with the Internal Revenue Code, all non-qualified plan assets are taxed at the point the funds are made available to the participant. This is also referred to as “constructive receipt.”  Regardless of whether the funds are actually distributed to the participant, the funds are taxable when made available, unlike a 403(b) or 401(k) plan where the terminated participant may generally wait until the later of the participant’s attainment of age 70½ or their retirement date before making a decision regarding distribution.

What are the typical plan default dates?
The default date can vary depending on the terms of the plan document.  For clients using the HANYS Section 457(b) Deferred Compensation Plan Document, the default date is 30 days following his/her termination of employment.  Other typical default dates are effective 60 or 90 days after the date of severance.  When no distribution election is made prior to when the plan’s default date expires, most plans (including HBS’) require a lump sum payment within 30 days following the expiration of the default date. Some plans may even require the participant to make an election prior to severance; otherwise, the funds will be automatically distributed within 30 days after severance of employment.

The following are distribution rules applicable to all 457(b) tax-exempt plans:

Note: Each plan will have a different default date and different distribution payment options specified in the plan document, which must be communicated to participants.
  • When distributions are made (either based on the participant’s timely distribution election or by the plan’s default date), the distribution is reported on a Form W-2.  The Internal Revenue Service (IRS) requires mandatory 25% federal income tax withholding.  New York is among the certain states that also require state income tax withholding (which is based on the state of employment, rather than the participant’s state of residence).
  • If a future distribution election is not made timely (prior to the default date) as noted above, a taxable event has occurred in the year of default (even if the assets haven’t been distributed from the account). This effectively means that a W-2 for the entire account balance should be issued to the participant for the year in which the default date occurs or the distribution would otherwise have occurred, regardless of when the assets are actually distributed to the participant.  It is important to note that currently, there are no IRS correction programs available for 457 plans (and no indication from IRS that they have any plans to provide a correction program). So, there is no guidance from IRS as to whether an untimely distribution election can be permissibly corrected and if so, how.
  • No distributions may be made earlier than the default date stated in the plan document, i.e., the funds have not been made available by means of constructive receipt.
  • All distributions must be approved by the employer prior to the actual distribution date.  This is required  since 457(b)  assets are subject to the general creditors of  the employer and must be available to be distributed.  Future distribution elections must be tracked since they will be the dates assets will be made available to the participants as taxable under the constructive receipt rule.
  • When a future distribution election is made, it may not be accelerated.  For example, a participant elects January 1, 2017 as the date he will begin to receive periodic payments or a lump sum payment.  The participant may not change their election to receive the funds prior to January 1, 2017.
  • A future distribution election may be changed one time to a later date.  For example, a participant elects January 1, 2017 as his payment date, but wishes to change it to January 1, 2018. This is permissible if the change is elected prior to attaining the initial election date (in this case, January 1, 2017).  Note: this is not a mandatory provision, but the HANYS Plan, and most other plans offer this additional opportunity to make a future distribution election change as an option.
  • When distributions commence, no change is permissible even if the one-time change election opportunity was not utilized.
  • When electing the distribution date, participants must adhere to IRS regulations for age 70½ Required Minimum Distributions (RMD), as these are applicable to participants in a 457(b). There is an IRS exception to RMD’s for age 70½ participants who have not yet separated from service.
  • All periodic payments must be based on a period no longer than the life expectancy of the participant (or the participant and spouse) or on an accelerated schedule regardless of the age the periodic payments commence.
  • If prior to a default date or timely future election date, a participant is working for an employer who also sponsors a non-governmental 457(b) tax-exempt plan, a transfer of assets to the new employer’s plan may be possible.  Such transfers must be allowed in the plan documents of both the delivering and the receiving plans.  The HANYS Plan Document allows for transfers to, and from, another non-governmental 457(b) plan. (Rollovers to an IRA or other qualified plan are not permitted.)
What can employers do to avoid a premature taxable event?
Make sure that plan participants and the employer’s staff responsible for the day-to-day administration of the plan are aware of the plan’s default date and the time period the plan provides to make an election before the default date is reached . This can be communicated by the employer by means of annual reminders as well as part of exit interviews at the time a participant is terminating employment.
Maintain careful records of all participant elections while making certain that the distribution date and payment schedule are stated on the distribution election form and that it is dated with the participant’s signature and employer’s signature.

Employers can request that participants make a future distribution election while still employed. Even though the timing may not be ideal since the employee is still working and may be unsure of when they would like distributions to commence, at the very least, a “backup” election will be in effect if a subsequent election is not made prior to the default date.

Conclusion
To avoid unintended tax consequences, it is critical that the employer and participants are made aware of the distribution rules that are applicable to their 457(b) tax-exempt plan accounts.  Many participants erroneously assume that the same distribution rules that are applicable to their 403(b) or 401(k) accounts also apply to their 457(b) accounts, and as a result, could end up with an unplanned tax burden.

HANYS Benefit Services will continue to provide as much education and support as possible to our clients regarding the 457(b) tax-exempt distribution rules, but it is essential that plan sponsors are diligent in monitoring the severances of their 457(b) participants and the distribution requirements that must be honored.

If you have any questions concerning this topic, please contact your HBS representative.