Supplemental Retirement Benefits Part I: Section 457(a) and 457(f) Plans.

Senior association executives, especially CEOs, are often provided with retirement benefit programs separate from, and in addition to, those provided to other employees of their associations. In a two-part article, Kurt Lawson outlines the major alternatives for supplemental retirement benefit programs, identifying revisions called for by The Economic Growth and Tax Relief Reconciliation Act of 2001. Part I describes Section 457(a) and Section 457(f) plans, the differences between defined benefits and defined contributions, and the meaning of unfunded plans. In next month's column, Part II will conclude with discussions of deferred compensation from taxable subsidiaries, enhanced tax-qualified plans, severance benefits, and consulting contracts.

Retirement benefits for highly paid executives participating in plans offered to all employees of a nonprofit organization, such as a traditional pension plan or Section 401(k) plan, tend to have various limits on the amounts that executives or their associations can contribute. Additional benefits for association executives take a number of forms. The alternatives outlined here are not mutually exclusive; they can sometimes be used in combination with one another. The Economic Growth and Tax Relief Reconciliation Act of 2001 calls for some changes in the rules for these plans and are noted here as well.

Section 457(a) plan

A limited amount of additional retirement income may be provided to a nonprofit organization executive through a Section 457(a) plan--so called because it satisfies the requirements of Section 457(b) of the Internal Revenue Code and therefore its tax treatment is determined under Section 457(a). Among other things, a Section 457(a) plan of a nongovernmental employer must be unfunded (as explained in this column) and generally must limit the amount that can be deferred each year for each employee to the lesser of 1) 33 1/3 percent of the employee's taxable compensation from the employer or 2) $8,500. The tax relief act increases the percentage limit to 100 percent effective January 1, 2002, and increases the dollar limit gradually from $11,000 in 2002 to $15,000 in 2006--and thereafter provides that it will increase based on inflation (as under current law).

The amount that can be deferred tax-free under a Section 457(a) plan generally is reduced by the executive's elective deferrals under a Section 401(k) plan, deferrals under a Section 403(b) annuity arrangement, and deferrals under certain other types of tax-qualified plans, even if they are sponsored by a different employer. The tax relief act eliminates this coordination rule effective in 2002 and later years, which will result in the executive's allowable deferrals under Section 457(a) no longer being reduced by the amount of his or her other elective deferrals. This is a significant change that will make Section 457(a) plans much more useful for association executives who already maintain Section 401(k) plans or other plans currently coordinated with Section 457.

Benefits under a Section 457(a) plan are subject to income tax when they are paid (or made available), timing generally similar to that of a Section 401(k) or other tax-qualified plan.

A Section 457(a) plan can be either a defined contribution plan or a defined benefit plan.

Defined contribution plan. This is a plan under which each executive has a separate account, to which a contribution (based on a specified contribution formula) and earnings (based on a specified interest rate, stock market index, or similar factor) are credited each year. The executive's ultimate benefit depends on the amount credited to the account at the point in time in which the executive decides to receive the benefit. Contributions, in the form of elective deferrals of compensation made by the executive or nonelective contributions, can be made by the employer.

Defined benefit plan. In this plan, benefits do not depend on the amounts credited to executives' accounts but instead are determined using a specified benefit formula. If the plan is a defined contribution plan, the limit on deferrals (described above) applies to annual contributions under the plan. If the plan is a defined benefit plan, the limit on deferrals applies to the present value of annual increases in benefits promised under the plan. The main advantage of a defined benefit plan to nonprofit organization executives is that it provides more benefit security in that poor investment performance will not reduce retirement benefits.

A plan is considered unfunded--for purposes of the requirements of Section 457(b)--if the executive's rights under the plan are limited to contractual rights that are no greater than those of a general creditor--for example, a commercial vendor to which the association owes a bill. A plan is not considered funded merely because funds to pay benefits are set aside in a trust, as long as the association's general creditors have access to the funds in the event of bankruptcy. A trust that satisfies this requirement is known as a rabbi trust after the beneficiary of the trust first approved by the Internal Revenue Service. If the plan is a defined contribution plan, earnings credited to an executive's account can be based on the actual earnings of the trust. Furthermore, the executive can be allowed to direct the way in which amounts set aside in the trust will be invested.

Like a Section 401(k) plan or other tax-qualified plan, a Section 457(a) plan may permit in-service distributions if the executive experiences an unforeseeable emergency. However, unlike the aforementioned plans, a Section 457(a) plan generally may not make loans available to participants.

Section 457(f) plan

Another vehicle for providing additional retirement income for nonprofit organization executives is a 457(f) plan, so called because it fails to satisfy one or more of the requirements of Section 457(b) and therefore its tax treatment is determined under Section 457(f) of the Internal Revenue Code. There are no limits on the amount of deferred compensation that can be provided under such a plan. In fact, the absence of any limit on deferrals often is the very feature that causes a plan that otherwise would qualify as a Section 457(a) plan to become a Section 457(f) plan.

Unlike a Section 457(a) plan, the present value of benefits under a Section 457(f) plan is subject to income tax as soon as the executive's right to the benefits vests. Therefore, in order to accomplish the desired goal of deferring income tax, vesting typically is delayed until the executive has completed some minimum period of service, has reached the normal retirement date, has completed the term of an executive employment agreement, or has reached another similar milestone.

Like a Section 457(a) plan, a Section 457(f) plan can be either a defined contribution plan or a defined benefit plan and typically is unfunded. The same standards are used to determine whether a Section 457(f) plan is funded as are used for this purpose in the case of a Section 457(a) plan.

Amounts deferred under either a Section 457(a) plan or Section 457(f) plan are subject to Social Security and Medicare taxes when the services giving rise to the deferrals are performed or when the deferrals vest, if later.

Author Kurt L. P. Lawson is a partner at the law firm of Shaw Pittman, Washington, D.C. Jerald A. Jacobs is a partner at Shaw Pittman and general counsel to ASAE, and he edits this column.