How a 457 Plan Works

Similar to qualified retirement plans, the mechanics of participating in a government or Code Sec. 457 plan are fairly straightforward. An eligible employee contributes as much as possible to the 457 plan and the contributions, plus interest, grow tax-free until distributed from the employee's account. To take advantage of the benefits of tax deferral, a 457 plan must meet the following requirements:

• The plan must restrict participation to individuals who work for a state or state subdivision or certain tax-exempt nongovernmental organization.
• The maximum amount of compensation that an employee can generally defer under a 457 plan in 2007 and 2008 is the lesser of $15,500 ($15,000 in 2006; this amount may be indexed for inflation) or 100 percent of the employee's compensation.
• The plan must provide that a deferral for a given month will not be made unless an agreement has been entered into before that month begins.
• The plan must meet the minimum distribution rules.
• Amounts deferred under a 457 plan maintained by a state or local government must be held in a trust, a custodial account, or an annuity contract for the exclusive benefit of plan participants and their beneficiaries.

Warning The trust requirement that applies to state and local government 457 plans does not apply to a tax-exempt organization that is not a governmental entity. This means that those who participate in a tax-exempt organization's 457 deferred compensation plan run the risk that their employer may not have sufficient funds to pay a participant with. For similar reasons, the rules for rollovers and distributions from nongovernmental 457 plans are not friendly to the plan participants. If you work for a tax-exempt employer that is not a government entity, these factors may cause you to reconsider whether you want to participate in the plan. Perhaps a better alternative for you would be to make contributions to an IRA instead.

For a tax-exempt organization that is not a governmental entity, the plan must provide that all compensation deferred and all earnings on that compensation remain the property of the employer, subject to the employer's general creditors, until paid out to plan participants.

Tip A 457 plan may authorize loans to plan participants. To avoid treatment as a taxable distribution, however, the loan must have a fixed repayment schedule, charge a reasonable rate of interest, and be executed according to the repayment safeguards imposed by prudent lenders. These requirements are the same as those for loans from qualified plans.

Increased contributions. Beginning in 2002, the tax code allows those who are at least 50 before the end of the plan year to make increased catch-up contributions to help those nearing retirement to save more. In 2006, 2007 and 2008, an eligible 457 plan participant can contribute an additional $5,000.

Tip Don't forget about the retirement savings tax credit available to low- and middle-income taxpayers from 2002 through 2008. This credit provides an immediate tax break on top of any existing tax advantages for contributing to such a plan.

Under another special catch-up rule that applies only to 457 plans, a 457 plan participant may make increased contributions to the plan during the last three years before retirement. Beginning in 2002, the increased contribution amount is twice the otherwise applicable dollar limit for the year. However, the catch-up provision for those age 50 and over does not apply during this period. Contributing twice the dollar limit more than makes up for the loss, though.

Example Jebediah (Jeb) Shrub is a state government employee and a participant in a 457 plan. In 2002, he was 61 years old. Jeb retired at the end of 2006 when he was 65. The maximum amounts Jeb could contribute each year until retirement are as follows: Contribution Limits 2002 annual limit $11,000 50+ catch-up contribution 1,000 2002 total $12,000   2003 annual limit $12,000 50+ catch-up contribution 2,000 2003 total $14,000   2004 annual limit $13,000 pre-retirement catch-up contribution 13,000 2004 total $26,000   2005 annual limit $14,000 pre-retirement catch-up contribution 14,000 2005 total $28,000   2006 annual limit $15,000 pre-retirement catch-up contribution 15,000 2006 total $30,000

Coordination with other plans. Before 2002, the maximum amount that could be contributed by a 457 plan participant saving for retirement had to be reduced dollar-for-dollar when the participant also made contributions to another type of retirement plan. Participants had a tough time coordinating their deferrals and contributions. In addition, 457 plan participants were hindered from saving adequate amounts for retirement because they were essentially locked into the 457 contribution ceiling which was much lower than the ceiling for other plans. The problems with coordination also inhibited state and local governments and tax-exempt organizations from establishing deferred compensation plans.

Starting in 2002, the coordination requirement for 457 plans is repealed. The only limitation placed on 457 plan deferrals is the maximum annual deferral amount that may apply to the participant in a given the tax year.

Example Kitty Cop is an enterprising young woman who works as a policewoman by day and as an exotic dancer by night. Each year, she contributes as much as she can to a 457 plan through her daytime job and to a 401(k) through her nighttime job. In 2001, the maximum deferral limit for a 457 plan was $8,500 and $10,500 for a 401(k) plan. Kitty contributed $2,000 to her 401(k) plan. Kitty also wanted to contribute $8,500 to her 457 plan. Because of the 457 coordination requirements, however, she could only contribute a maximum of $6,500 to her 457 plan. The total contribution allowed between the two plans was $8,500. In 2007, the maximum deferral limit for both a 457 plan and a 401(k) is $15,500. Now Kitty can contribute up to $31,000 ($15,500 x 2) between the plans for the year.