This article is the fifth in the series addressing the 81 pages of guidance on the legislation known as SECURE 2.0 (the Act) enacted on December 29, 2022, issued by the IRS on December 20, 2023 as Notice 2024-02 (Notice). The first article addressed the extension of the deadline for written amendments and de minimis financial incentives to enroll in a 401(k) or 403(b) plan. See Notice 2024-02 Extends Deadline For SECURE 2.0 Amendments And Provides Other Guidance. The second article discussed Roth employer nonelective and matching contributions. See Guidance on Roth Nonelective or Matching Contributions in IRS Notice 2024-02. The third article addressed guidance on the Act’s requirement that new 401(k) and 403(b) plans after December 31, 2024 must provide for automatic enrollment. See New Plan Automatic Enrollment Guidance Under IRS Notice 2024-02. The last article addressed guidance under the Notice for the Act’s safe harbor for self-correcting reasonable administrative errors in administering automatic enrollment and automatic escalation features in 401(k), 403(b) and other plans with such features. See When Automatic Isn’t Automatic: Notice 2024-02 Guidance on Self-Correcting Auto-Enrollment And Auto-Escalation Failures. This article discusses guidance on the Act’s allowing penalty-free distributions to terminally ill participants.

Distributions to the Terminally Ill.

The Act provides that after the date of enactment (December 29, 2022), a qualified retirement plan may provide that an employee under the age of 59 1/2 that has been certified by a physician as being terminally ill can receive a distribution (Terminally Ill Distribution) from the plan and such distribution is not subject to the 10% additional penalty tax for early withdrawals. The distribution is still taxable income. The Notice clarifies that the types of plans that can provide for Terminally Ill Distributions are both defined contribution and defined benefit qualified plans under Code section 401(a), annuity plans under both 403(a) and 403(b), and IRAs. It also points out that eligible deferred compensation plans under Code section 457(b) sponsored by state or local governments are not eligible to provide Terminally Ill Distributions because they are not considered qualified retirement plans. While not stated in the Notice, 457(b) plans sponsored by tax exempt organizations are not considered qualified retirement plans either.

Physician Certification Required. To be eligible for a Terminally Ill Distribution, an individual must be certified by a physician as having an illness or physical condition that can reasonably be expected to result in death in 84 months or less after the date of certification. The physician generally must be a doctor of medicine or osteopathy legally authorized to practice medicine and surgery by the State in which the doctor performs such function. This definition is in keeping with the definition under the Social Security Act. The certification must contain the following information:

  1. A statement that the illness or condition can reasonably be expected to result in death in 84 months or less from the date of certification;
  2. A narrative description of the evidence used to support the above statement;
  3. The name and contact information of the certifying physician;
  4. The date the physician examined the individual or reviewed the evidence provided by the individual; and
  5. A signed and dated attestation from the physician that by signing the statement, the physician confirms that the physician composed the narrative description based on an examination of the individual or review of the evidence provided by the individual.

The employee must provide the certification to the Plan Administrator before receiving the Terminally Ill Distribution. However, the employee need not provide the Plan Administrator with the underlying documentation on which the certification is based. The Notice points out that a Plan Administrator may not rely on a self-certification that the employee is terminally ill even if the employee is a physician.

Terminally Ill Distribution Is Optional But In-Service Distribution Required. The Notice makes clear that whether to permit Terminally Ill Distributions is voluntary in the discretion of the employer. However, the Terminally Ill Distribution provision of the Act is an exception to the 10 percent additional tax, not the distribution restriction requirements of 401(k) or 403(b) plans. For such a plan to allow Terminally Ill Distributions, it must first permit in-service distributions or hardship distributions. If a plan does not permit Terminally Ill Distributions and an employee otherwise receives a permissible in-service distribution, the employee may treat the distribution as a Terminally Ill Distribution on their federal income tax return using Form 5329. In this case, the employee must still obtain the physician’s certification prior to the distribution and retain it with their tax files in case the IRS requests it later. The Notice provides an example where the employee receives a hardship distribution after obtaining the physician certification and avoids the 10% penalty tax by filing Form 5329.

Ability to Pay Back. Similar to qualified birth or adoption distributions, any or all of the Terminally Ill Distribution amount may be re-contributed by the employee. It can be re-contributed to the same plan or another qualified retirement plan in which the employee is a beneficiary and to which rollovers may be made, including an IRA. In the case of a situation where the distributing plan did not permit Terminally Ill Distributions, but the employee treated an allowed distribution as such, the employee can recontribute to an IRA. This means Terminally Ill Distributions may be recontributed at any time during the 3-year period beginning on the date of the distribution the same as qualified birth or adoption distributions.

Conclusion.

It remains to be seen whether employer’s will adopt provisions allowing Terminally Ill Distributions. They have until the deadline for amendments required by SECURE 2.0 to adopt written amendments. See Notice 2024-02 Extends Deadline For SECURE 2.0 Amendments And Provides Other Guidance. However, given that terminally ill employees participating in 401(k) and 403(b) plans that already permit in-service or financial hardship distributions can treat such a distribution as a Terminally Ill Distribution on their income tax return, employers may not want to amend such plans and have the increased burden of administering requests for such distributions.

This article is the fourth in the series addressing the 81 pages of guidance on the legislation known as SECURE 2.0 (the Act) enacted on December 29, 2022, issued by the IRS on December 20, 2023 as Notice 2024-02 (Notice). The first article addressed the extension of the deadline for written amendments and de minimis financial incentives to enroll in a 401(k) or 403(b) plan. See Notice 2024-02 Extends Deadline For SECURE 2.0 Amendments And Provides Other Guidance. The second article discussed Roth employer nonelective and matching contributions. See Guidance on Roth Nonelective or Matching Contributions in IRS Notice 2024-02. The last article addressed guidance on the Act’s requirement that new 401(k) and 403(b) plans after December 31, 2024 must provide for automatic enrollment. See New Plan Automatic Enrollment Guidance Under IRS Notice 2024-02. This article will now address guidance under the Notice for the Act’s safe harbor for self-correcting reasonable administrative errors in administering automatic enrollment and automatic escalation features in 401(k), 403(b) and other plans with such features.

Expired EPCRS Safe Harbor.

The Employee Plans Compliance Resolution System set forth in Rev. Proc. 21-30 (EPCRS), contains a self-correction safe harbor for correcting the excluding of eligible employees in automatic enrollment or automatic escalation failures (Automatic Failures) in 401(k) and 403(b) plans. It permits Automatic Failures to be self-corrected within the earlier of the first payment of compensation after: 1) 9.5 months of the end of the plan year in which the Automatic Failure occurred; or 2) being notified by the affected employee of the failure (Correction Deadline). The safe harbor allows employers to begin making the correct automatic enrollment elective deferrals by the above Correction Deadline without having to make-up the missed elective deferrals by making QNEC contributions of 50% of the missed deferrals otherwise required under EPCRS. All affected employees have to be corrected and if they also missed out on applicable matching contributions, the employer had to make corrective matching contributions, adjusted for earnings, as if the deferrals were timely made. The employer is required to provide a notice of the failure to all affected employees within 45 days after correct deferrals begin. The notice has to include a statement that the correct deferrals have begun and that the employee may increase their elective deferrals to make up for the missed deferrals. However, this safe harbor expired on December 31, 2023.

SECURE 2.0 Safe Harbor.

The Act codified, made permanent, and expanded the expired safe harbor in EPCRS. It expanded it to include governmental 457(b) plans and certain SEP and SIMPLE plans that can have automatic enrollment. It also clarified that the safe harbor correction could be made after an employee has terminated employment and even after the failure was identified under an IRS examination.

Notice Guidance.

The Notice generally provides that to self-correct under the Act, employers would follow the rules under the expired safe harbor of EPCRS. However, it provides guidance on: the effective date of the Act’s safe harbor correction; how to self-correct for failures relating to terminated employees; and when corrective matching contributions must be made.

Effective Date. The Notice clarifies that the safe harbor correction is available for Automatic Failures which began before 2024, so long as the Correction Deadline for the failure is after December 31, 2023. The Notice provides an example where the employer failed to automatically enroll an eligible employee in a calendar year 401(k) plan on January 1, 2023, and the employee did not inform the employer of the error. Therefore, the Correction Deadline is the first compensation payment date after October 15, 2024 (9.5 months after 2023). Since the Correction Deadline is after December 31, 2023, the employer can use the safe harbor.

Terminated Employees. The Notice provides an employer would correct Automatic Failures for terminated employees in the same manner as active employees, including making matching contributions and earnings. However, while still having to provide a notice of the failure, the notice to such terminated employees would not have to include a statement that correct amounts have begun to be deducted from compensation as elective deferrals or that the employee could increase elective deferrals.

Matching Contributions. The Notice provides that corrective matching contributions and earnings (Matching Contributions) must be made within a reasonable period after the correct elective deferrals begin (or would’ve begun for terminated employees). If the Matching Contributions are made within six months after the correct elective deferrals begin (or would’ve begun if not terminated) they are deemed made within a reasonable period. In addition, with respect to an Automatic Failure in a 401(k) or 403(b) plan that begins before December 31, 2023 and qualifies under the expired EPCRS safe harbor, the employer could make the Matching Contributions by the end of the third plan year following the year in which the failure occurred.

Conclusion.

The Act’s safe harbor correction for Automatic Failures is a welcomed extension of the expired EPCRS provision. The guidance under the Notice also provides some important and beneficial clarification as more employers are going to be dealing with automatic enrollment when it becomes mandatory for plans established after 2024.

This article is the third in the series addressing the 81 pages of guidance on the legislation known as SECURE 2.0 (the Act) enacted on December 29, 2022, issued by the IRS on December 20, 2023 as Notice 2024-02 (Notice). The first article addressed the extension of the deadline for written amendments and de minimis financial incentives to enroll in a 401(k) or 403(b) plan. See Notice 2024-02 Extends Deadline For SECURE 2.0 Amendments And Provides Other Guidance. The second article discussed Roth employer nonelective and matching contributions. See Guidance on Roth Nonelective or Matching Contributions in IRS Notice 2024-02. This article will address guidance on the Act’s requirement that any 401(k) plan or 403(b) plan (collectively, Plans) established on or after December 31, 2024, must provide automatic enrollment. However, Plans that are established prior to the date of enactment of the Act, December 29, 2022, are exempt from such requirement (Grandfathered Plans). The Notice discusses when a Plan is established in order to be a Grandfathered Plan. It also discusses how the new requirements affect mergers and acquisitions, multiple employer Plans, spun off Plans and the new deferral only Plans created by the Act. These are addressed below.

Establishment of a Plan. Under the Notice, a 401(k) plan is established on the date plan terms providing for the cash or deferred arrangement are initially adopted. It is important to note, that it is the adoption date and not the effective date that governs. The Notice provides an example where a 401(k) plan is adopted on October 3, 2022, but not effective until January 1, 2023. The Notice concludes that the 401(k) plan is a Grandfathered Plan because it was established prior to December 29, 2022, even though not effective until afterward.

A 403(b) plan is a Grandfathered Plan if the Plan was established prior to December 29, 2022, regardless of whether it provided for salary reduction contributions when initially adopted. Presumably this means that if the 403(b) plan were adopted January 1, 2022, and only provided for employer contributions, it could be amended in 2025 to permit salary reduction contributions and still be exempt from the automatic enrollment requirement.

Mergers and Acquisitions. If two Grandfathered Plans of single employers are merged, the surviving Plan remains grandfathered. Likewise, if a single employer Grandfathered Plan merges with a multiple employer Grandfathered Plan, the surviving Plan remains a Grandfathered Plan. However, if a single employer Plan that is not a Grandfathered Plan is merged into a multiple employer Plan that is a Grandfathered Plan, then the single employer Plan that merged would not be considered a Grandfathered Plan but the remaining employers in the grandfathered multiple employer Plan remain grandfathered.

If a single employer Plan that is not a Grandfathered Plan is merged into a single employer Plan that is a Grandfathered Plan, the Grandfathered Plan will generally lose its Grandfathered Plan status unless, the transaction uses the Code section 410(b)(6)(C) transition relief for meeting coverage. In that case, the ongoing Plan will continue to be considered a Grandfathered Plan, provided the merger occurs by the end of the Code section 410(b)(6)(C) transition period.

Spun Off Plans. The Notice provides that, generally, if a new Plan is spun off from a single employer Grandfathered Plan, the spun off Plan will be considered a Grandfathered Plan. However, if the Plan was spun off from a multiple employer Grandfathered Plan, then the spun off Plan will only be considered a Grandfathered Plan if it were so considered while part of the multiple employer Plan.

Deferral Only Plans. SECURE 2.0 created two new types of deferral only Plans beginning after December 31, 2023. These are the starter 401(k) deferral-only arrangement and the safe harbor deferral-only 403(b) plan. These plans allow employers who do not otherwise offer a retirement plan to permit employees to make elective deferrals only. The Notice provides that the automatic enrollment rules will generally apply to such plans for plan years beginning after December 31, 2024, unless another exception applies. There are exceptions from the automatic enrollment rules for small employers with less than 11 employees and new plans that have been in existence for fewer than 3 years.

Stay tuned for future articles on more guidance under the Notice such as correcting autoenrollment failures, distributions for the terminally ill, and the increased tax credit for adopting plans.

This article is the second in the series addressing the 81 pages of guidance on the legislation known as SECURE 2.0 (the Act) enacted on December 29, 2022, issued by the IRS on December 20, 2023 in Notice 2024-02 (Notice). The first article addressed the extension of the deadline for written amendments and de minimis financial incentives to enroll in a 401(k) or 403(b) plan. See Notice 2024-02 Extends Deadline For SECURE 2.0 Amendments And Provides Other Guidance. This article will address guidance on the Act’s permitting participants in a qualified plan, 403(b) plan or governmental 457(b) plan (collectively, “Plan”) to elect to have employer matching and nonelective contributions made to the Plan on an after-tax basis (Employer Roth Contributions). The provision was effective on the date of enactment of the Act.

Importantly, the Notice points out that a Plan can permit after-tax elective deferrals to be treated as Roth contributions without having to permit participants the opportunity to elect employer matching or nonelective contributions to be treated as Employer Roth Contributions. Likewise, a Plan can permit participants to elect to have matching or nonelective contributions treated as Employer Roth Contributions without permitting elective deferrals to be treated as such. Rollovers from a designated Roth account in another Plan can only be rolled over to a Roth account. Such rollovers can be rolled into the employee’s Employer Roth Contribution account under the Plan. Provided the Plan uses a safe harbor definition of compensation under Code section 415 such Employer Roth Contributions will not be considered compensation for Code section 415 purposes.

Timing of Elections. Any election to designate an Employer Roth Contribution must be made by the employee no later than when the contribution is allocated to the employee’s account under the Plan and are irrevocable when made. The Employer Roth Contribution will be includible in income of the employee in the year in which it is allocated to the employee’s account. No such designation is permitted unless the employee is 100% vested in the Employer Roth Contribution when it is allocated. Partially vested employer contributions cannot be designated Employer Roth Contributions.

Tax Treatment and Reporting. The Notice provides any designated Employer Roth Contributions are generally not considered wages subject to income tax, FICA or FUTA withholding despite the fact that they are taxable income to the employee. Therefore, affected employees will likely have to voluntarily adjust withholding or pay estimated tax payments to avoid a penalty for not paying enough taxes throughout the year. The lone exception to this general rule is that Employer Roth Contributions of employees in governmental 457(b) plans sponsored by state or local governments that are subject to FICA taxes (e.g., the entity has entered into an an agreement to be subject to the Social Security Act) will be subject to FICA when the Employer Roth Contributions are allocated because they are 100% vested.

Roth Contributions must be reported for the year allocated on a Form 1099-R as if it were the only contributions made to the participant’s account under the plan and had been directly rolled over to a designated Roth account under the plan. Thus, it is reported in boxes 1 and 2a, and box 7 with a code of “G”.

Stay tuned for upcoming articles on the Notice’s guidance on distributions to the terminally ill, correcting missed deferrals, auto-enrollment, and more.

On December 20, 2023 the IRS gave plan sponsors an early Christmas gift of 81 pages of guidance on a myriad of employee benefit plan law changes in the legislation known as SECURE 2.0 (Act) when it issued IRS Notice 2024-02 (Notice). This is the first of a series of blog articles that will discuss such guidance. This article will address the extension of the deadline for making necessary amendments to plans and guidance on de minimis financial incentives to participate in a 401(k) or 403(b) plan.

Extended Amendment Deadline. One of the most significant provisions in the Notice is an extension of the deadline for plan sponsors to adopt amendments required under SECURE 2.0. Under the Act, plan amendments generally had to be made by the end of the 2025 plan year (the 2027 plan year for governmental plans and collectively bargained plans). Plan amendment deadlines under SECURE 1.0, the CARES Act, and the Taxpayer Certainty and Disaster Tax Relief Act of 2020 were also aligned to these new dates. The notice extends the deadline for these plan amendments. Plans still must be operated in accordance with with the law change as of the effective date of the requirement. Only the time to adopt the written amendment has been extended. The new deadline depends on the type of plan and plan sponsor as set forth below:

  • For qualified plans sponsored by for profit employers that are not collectively bargained the deadline is extended to December 31, 2026;
  • For qualified plans that are collectively bargained the deadline is December 31, 2028;
  • For qualified plans thar are governmental plans the deadline is December 31, 2029;
  • For 403(b) plans sponsored by tax-exempt organizations that are collectively bargained the deadline is December 31, 2028;
  • For 403(b) plans sponsored by public schools the deadline is December 31, 2029;
  • For all other 403(b) plans the deadline is December 31, 2026;
  • For 457(b) plans sponsored by state or local governmental entities the deadline is the later of December 31, 2029, or, if applicable, the first day of the first plan year beginning more than 180 days after the date of notification by the secretary of the Treasury that the plan was administered in a manner that is inconsistent with the requirements of Section 457.

De minimis Financial Incentive Clarified. The Notice also clarifies the Act’s provision allowing employers to provide de minimis financial incentives to employees to encourage participation in a 401(k) or 403(b) plan. The Notice provides to be de minimis the incentive cannot have a value exceeding $250. There is no mention of this amount being adjusted for inflation in the future. Also, de minimis financial incentives can only be provided to employees for whom an election to defer is not already in effect. Thus, they cannot be used to incentivize participants to increase their already made deferrals. However, it seems that maybe a plan that requires a new deferral election each year (as opposed to having “evergreen” elections) could offer it to anyone who has not yet made their election for the year.

Also, the Notice makes clear that the financial incentive will be considered taxable wages to the employee unless it meets some other exception from income. For example, a gift card is a cash equivalent and would not qualifiy as an excludable de minimis fringe benefit like a Christmas turkey would.

Stay tuned for additional blog articles on other topics covered in the Notice.

On November 1, 2023, the IRS announced the inflation adjusted benefit plan limitations effective in 2024 in Notice 2023-75. The good news is the amount that can be electively deferred into a 401(k) or 403(b) plan increases from the current $22,500 to $23,000. However, the age 50 catch-up contribution remains the same as in 2023 at $7,500. The annual limit for contributions to a 457(b) plan also increases to $23,000. However, keep in mind while deferrals to a 401(k) or 403(b) plan share the one limit under Internal Revenue Code (Code) section 402(g), 457(b) plans have a separate independent limit.

Other important increases included the total compensation that can be considered under a qualified plan increasing from $330,000 to $345,000. The amount of compensation to be considered a Highly Compensated Employee under Code section 414(q) goes up to $155,000 from $150,000. The Code section 415 limit on the annual benefit from a defined benefit plan increased from $265,000 to $275,000. And the maximum annual contribution to a defined contribution plan under Code section 415 increased from $66,000 to $69,000.

Last month, in Part 1 of this blog on 10 common mistakes in 457 plans sponsored by tax exempt organizations (EOs), I gave the first five common mistakes I’ve seen in my practice working with these sponsors. See “Ten Common Mistakes in 457 Plans of Tax Exempt Organizations–Part 1“. This Part 2 continues with the next 5 common mistakes I see in these plans, including the taxation of 457(f) plans.

6. Failing to Amend Plans. From time to time 457 Plans must be amended for changes in the law. Some sponsors have a tendency to “set it and forget it” and may miss an important amendment. Likewise, they may have a service provider that alerts them to necessary and permitted changes to their 401(k) or 403(b) plan but not the 457 Plan.

For example, 457(b) plans are subject to the Required Minimum Distribution (RMD) rules. The SECURE Act raised the age at which participants must begin taking RMDs from 70 1/2 to age 72. The SECURE 2.0 Act raised it again to age 73. Many sponsors aren’t aware of this. These changes must be reflected in the plan document which will necessitate an amendment. Additionally, 457(f) plans are subject to Code section 409A and ERISA’s claims procedures and should have been amended to comply with these laws.

7. Income Taxation of 457(f) Plans. Many EOs maintain both a 457(b) and 457(f) Plan for their executives with the 457(f) Plan providing benefits above the annual limit allowed under 457(b) ($22,500 in 2023). The key difference between a 457(f) Plan and 457(b) Plan is taxation in two respects. First, a participant is subject to income tax on the benefits under a 457(f) Plan when they become vested. This can cause mistakes in failing to report and collect the tax upon vesting. Also, it’s important to note that if a 457(f) Plan provides a participant will get a distribution upon separation from service, with nothing more, then the participant is vested immediately because he or she could voluntarily terminate employment at any time and get his or her distribution. Therefore, such a plan would not defer tax. Providing that the participant will receive a distribution upon separation from service after age 65 if he or she was continuously employed until then, would mean the participant becomes vested at age 65, even if still employed. This would mean the entire account balance would be subject to income tax in the year the participant reached age 65, even if he or she did not separate from service. Many sponsors have mistakenly believed if the benefit wasn’t distributed, it wasn’t taxable.

8. FICA Taxation of 457 Plans. Whether it is a 457(b) Plan or a 457(f) Plan sponsored by an EO, the plan is treated as a nonqualified deferred compensation plan for purposes of the FICA employment taxes. FICA taxes consist of Social Security and Medicare taxes which are imposed on the employee and employer.  The employee portion is withheld from the employee’s wages and the employer matches it. However, while there is a limit on the amount of wages subject to Social Security taxes known as the Social Security Taxable Wage Base ($160,200 in 2023), the Medicare portion is unlimited.

The Social Security withholding rate is 6.2% of wages up to the wage limit.  The Medicare tax rate is much lower at 1.45%, however there is no limit on the amount of wages taxed.  There is an additional .9% Medicare tax rate on earned income above a threshold based on filing status ($250,000 for married joint filers). This amount is not withheld but paid by the employee on his or her income tax return.

As mentioned, 457 Plans are considered nonqualified deferred compensation plans for FICA purposes. Nonqualified deferred compensation is subject to FICA taxes on the later of when the services giving rise to the compensation are performed and the date the employee’s right to the deferred compensation is no longer subject to a substantial risk of forfeiture, i.e., vested.  Thus, elective salary reduction contributions to an EO 457(b) Plan are subject to FICA withholding when made because they are fully vested.  That is, the elective deferrals are post-FICA taxes. Employer contributions will be subject to FICA when they vest as will any vested earnings. Therefore, a participant in an EO 457(f) plan will be subject to both income tax and FICA tax upon vesting. Often, employer contributions aren’t made until late in the year, and can escape Social Security taxes altogether because they are not made until after the Participant has already earned the $160,200 Social Security Taxable Wage Base limit for the year and had the maximum Social Security taxes withheld. However, the Medicare Tax still applies.

If the deferred compensation is properly taken into account at vesting, then neither it nor any earnings on it will be subject to FICA taxes again when paid. This can be a significant savings. However, if the EO makes the mistake of not accounting for the deferred compensation at vesting, the contribution and all earnings will be subject to FICA when paid. This can cause both the employer and employee to pay otherwise avoidable Social Security taxes. Additionally, if the plan document says that the employer will account for FICA taxes at vesting but the employer fails to do so, it may be contractually liable to the employee for the FICA taxes due on payment.

9. Code Section 409A. Code section 409A governs nonqualified deferred compensation plans and regulates how amounts can be electively deferred, the time and form of distributions, and generally prohibits acceleration of distributions. The consequences of failing to comply with Code section 409A are that the participant is taxed on his or her entire vested benefit, plus such amount is subject to an additional 20% federal tax (California has its own additional 5% tax), and any interest due is charged at a rate that is a full percentage point higher than the going rate for taxes.

Certain plans such as qualified plans and 457(b) plans are exempt from Code section 409A as not being considered deferred compensation. However, 457(f) Plans are subject to Code section 409A. This makes mistakes in a 457(f) Plan that much more problematic. Often, the same mistake that violates 457(f) will also violate Code section 409A. For example, often when participants are approaching the year of vesting they want to push vesting out further so that they won’t be taxed on their benefit yet. This is permissible under proposed 457(f) regulations, provided the present value of the deferred compensation at the subsequent vesting date is at least 125% of the present value of the benefit at the original vesting date and the subsequent vesting date is at least 2 years later than the original. However, Code section 409A only allows subsequent deferrals if the election to subsequently defer is made at least a year before the payment was scheduled to be made and the deferral is for at least 5 years.

For example, assume a plan provides the participant vests on her 65th birthday but a month before such birthday she approaches her employer explaining she is in a high tax bracket and asking that the plan be amended so that she wouldn’t vest until the January 1 of the year after she turned 65, so she could retire at age 65 and begin receiving benefits in the following year when she no longer has taxable salary. This change, if made, would violate both Code sections 457(f) and 409A. Additionally, as mentioned, if a deferred compensation plan of an EO does not meet the requirements of Code section 457(b), it becomes a 457(f) Plan and subject to Code section 409A, making the consequences of mistakes in 457(b) Plans that much more dire.

10. Excise Tax on Compensation Above $1,000,000. Code section 4960 imposes an excise tax of 21% on an applicable tax exempt organization that pays compensation to an individual in excess of $1 million in any given year.  The amount of deferred compensation included for purposes of Code section 4960 in a given year is the present value of any deferred compensation when it vests.  Thus, the vested portion of a 457(b) or 457(f) plan will count against the $1,000,000 threshold in the year of vesting. As explained above under “”FICA Taxation of 457 Plans”, often employer contributions to EO 457 Plans don’t vest for many years and vest late in the year to save Social Security taxes. However, adding the entire vested benefit to the participant’s other taxable compensation for the year could push them over the $1,000,000 annual threshold subjecting the EO to the excise tax.

Conclusion. This article has listed 10 common mistakes I’ve found in EO 457 Plans. There are others. Fortunately, if mistakes are caught soon enough, they can often be “corrected” to preserve the tax advantages of the plan. The best advice for EO sponsors is to really know and understand the terms and operation of the plans. Additionally, the operation of the plan should be reviewed at least annually so that any mistakes can be identified and addressed timely.

In May, I blogged how 457 plans are bipolar in two ways. First, Internal Revenue Code (Code) section 457 describes the tax consequences of unfunded deferred compensation plans for both tax exempt organizations and state and local governments and the rules for each are quite different. Second, it describes the income tax consequences of eligible plans that meet the requirements of Code section 457(b) (457(b) Plans), and also describes the consequences of those plans that fail to meet Code section 457(b) and are taxed under Code section 457(f)(457(f) Plans).

In the next two blog articles I will discuss 10 common mistakes I’ve seen in 457 plans sponsored by tax exempt organizations (EOs). It’s important to note that they will not be discussing 457 plans sponsored by state and local governments (S&L Plans). However, both 457(b) and 457(f) Plans will be discussed.

  1. Confusion with State & Local Government Plans. As mentioned, EO 457(b) Plans are quite different from S&L Plans. An S&L Plan is much closer to a 401(k) plan in that it can cover all employees, it’s assets must be held for the exclusive benefit of the employees, it can have age 50 catch-up contributions, participant loans, in-service distributions, Roth deferrals, and permit roll overs to and from other types of plans. EO 457(b) Plans cannot have any of these provisions. Inexperienced tax exempt sponsors can adopt a plan with provisions that are not permitted. I’ve seen EOs, with the help of inexperienced advisors, adopt plans designed for state & local governments. It’s important to have advisors who know the difference between EO 457(b) and S&L Plans.
  2. Confusion Between 457(b) and 457(f) Plans. Confusion also happens between a 457(b) Plan and a 457(f) Plan. A 457(b) Plan enjoys the tax advantage that contributions to the plan will not be taxable to the participant until paid or otherwise made available. On the other hand, contributions to a 457(f) Plan are taxable when no longer subject to a substantial risk of forfeiture (or vested) regardless of when paid. Also, there is generally an annual limit on the amount that can be contributed to a 457(b) Plan ($22,500 in 2023). There is no limit under a 457(f) Plan. Some EOs that want to contribute more than the annual limit simply adopt a 457(f) Plan alone. Due to the better tax advantages of a 457(b) Plan, it is highly recommended that an organization adopt a 457(b) Plan for the contributions up to the annual limit and only contribute the amount in excess of the limit to a 457(f) Plan.
  3. Top Hat Requirement. EO 457 plans must be top hat plans designed to benefit a select group of management or highly compensated employees. They cannot cover all employees of the organization. Often an EO will try to cover someone that does not qualify as a member of the top hat group. Also, a top hat plan escapes the requirement to file an annual Form 5500 return, provided it files a top hat statement with the Department of Labor once. EOs sometimes fail to make this filing.
  4. Monthly Elective Deferral Rule. Unlike a 401(k) plan, elective deferrals under an EO 457(b) Plan are only valid for a given month if the deferral election was made by the participant in writing prior to the beginning of the month. This means one cannot make an annual deferral election for the year in January before the first payroll. Such an election would not be valid until February. In order to make it valid for January, it would have to be executed in December of the prior year. SECURE 2.0 eliminated this requirement for S&L Plans but not those sponsored by EOs.
  5. Contributing Too Much to 457(b) Plan. As mentioned, there is an annual limit on how much can be contributed annually for a participant in a 457(b) Plan. That amount is $22,500 for 2023. This happens to be the same amount that can be electively deferred into a 401(k) or 403(b) plan. However, it is a separate limit. A participant can defer $22,500 into a 401(k) plan sponsored by his or her EO employer and still have another $22,500 contributed to a 457(b) Plan sponsored by that employer. Contributions can be employee elective deferrals or employer nonelective or matching contributions. However, the limit is a total limit for employer and employee contributions for the year. Thus, an employee cannot defer $22,500 from salary and receive matching contributions from the employer. It is also important to note that for a 457(b) Plan, unvested employer contributions do not count against the annual limit until they vest. This can cause excess contributions in the year of vesting, if the vested account balance exceeds the annual limit for that year. For example, if an employer contributed the maximum dollar amount annually for a participant but the contributions weren’t vested until year five, the entire vested account balance would be counted as the contribution in year 5. In such case, there would be 4 year’s worth of excess contributions and the excess amount would have to be distributed to the participant by the April 15 following the end of the year of vesting and would be taxable. If not corrected in this manner, the plan will fail to be a 457(b) Plan and be taxed as a 457(f) Plan.

Stay Tuned For Part 2. This Part 1 has addressed five of ten common mistakes seen in EO 457(b) Plans . Part 2 of this article will address 5 more common mistakes found in EO 457(b) Plans . It will address employment taxes, taxation of 457(f) Plans, Code section 409A, the excise tax on compensation over $1,000,00, and plan amendments.

I am pleased to announce I will be attending the Western Benefits Conference at the Westin Kierland in Scottsdale, AZ in October. After a few years without having a conference due to the pandemic, the Western Pension & Benefits Council is bringing back the WBC. With its excellent program and top notch speakers this in-person conference is an excellent educational and networking event. Won’t you join me? See more details and register on the WPBC website.

On May 8, 2023, I wrote how guidance was sorely needed on SECURE 2.0’s self-correction of eligible inadvertent failures. See Guidance Sorely Needed On SECURE 2.0 Self-Correction of Inadvertent Failures. On May 25, the IRS issued Notice 2023-43 (Notice) providing guidance in the form of questions and answers meant to provide taxpayers guidance in advance of an update to Rev. Proc. 2021-30 containing the current version of the Employee Plans Compliance Resolution System (EPCRS). However, while the Notice provides some answers, many questions remain, requiring more substantive guidance. The Notice provides answers to two of the questions I raised in my prior article regarding a specific commitment to implementing self-correction and what is a reasonable period to complete correction. The statute provides that self-correction of an eligible inadvertent failure is not available if such failure was identified by the Secretary of the Treasury prior to any actions which demonstrate a commitment to implement self-correction with respect to the failure or the self-correction is not completed within a reasonable period after discovery.

Specific Commitment. The Notice provides that prior to EPCRS being updated, a determination as to whether an employer’s actions demonstrate a specific commitment to implement the self-correction of an identified eligible inadvertent failure will be based on all the facts and circumstances. However, the actions must generally demonstrate that the employer is actively pursuing correction. The mere completion of an annual compliance audit or general statement of intent to correct failures when they are discovered are not actions demonstrating a specific commitment.

Under this guidance it appears the example given in my earlier article of the employer having identified that some employees were not automatically enrolled that is in the process of calculating the necessary correction amounts would be considered to have made a specific commitment.

Reasonable Period. The Notice provides that whether an eligible inadvertent failure is corrected within a reasonable period after being identified by the employer is also determined by considering all relevant facts and circumstances. It then provides a safe harbor by stating that a failure that is corrected within 18 months of being identified will be treated as having been completed within a reasonable period. For an employer eligibility failure where an employer adopts a plan that it is not eligible to adopt (e.g., a for-profit employer adopting a 403(b) plan) to be corrected within a reasonable period all contributions to the plan must cease as soon as reasonably practicable and in no event later than 6 months after the failure is identified.

Identification By The Secretary. Somewhat surprisingly the Notice provides that an eligible inadvertent failure is treated as having been identified by the Secretary when the plan or employer comes under examination. Thus, once the plan or employer comes under examination, the eligible inadvertent failure cannot be self-corrected unless prior to the examination, the employer has demonstrated a specific commitment to implement self-correction. The failure need not be specifically identified under the examination.

Eligible Inadvertent Failures That Can’t Be Self-Corrected. Interestingly, the Notice provides a list of eligible inadvertent failures that until EPCRS is updated may not be self-corrected. These include the failure to initially adopt a written plan document; failures in orphan plans; a significant failure in a terminated plan; certain demographic failures; excess contributions to a SEP or SIMPLE IRA permitting the contributions to stay in the Participant’s IRA; failures in SEPs or SIMPLE IRAs that do not use model or prototype forms; and a failure in an ESOP involving Code section 409.

EPCRS Provisions That Don’t Apply. The Notice also provides a list of provisions in the current version of EPCRS relating to self-correction that do not apply to self-correcting eligible inadvertent failures. These include: the requirement that a qualified plan or 403(b) plan have a favorable determination letter; the prohibition of self-correction of demographic failures and employer eligibility failures; the prohibition of self-correction for significant failures of SEPs or SIMPLE IRA plans; the prohibition of self-correction of certain loan failures; the provisions regarding self-correction of significant failures that have been substantially completed before the plan or employer are under examination; and the requirement that a significant failure must be completed or substantially completed by the end of the third plan year following the year in which it occurred.

Other Answers. The Notice clarifies that eligible inadvertent failures can be self-corrected before EPCRS is updated even if the failure occurred prior to enactment of SECURE 2.0. If the eligible failure involves an excise tax, self-correction does not automatically waive the excise tax. However, waiver of the tax can be sought through the EPCRS Voluntary Correction Program (VCP). Likewise, before EPCRS is updated, an employer may submit a VCP application to correct an eligible inadvertent failure. An eligible inadvertent failure of an IRA cannot be corrected under EPCRS before EPCRS is updated.

Conclusion. The Treasury Department and IRS are accepting comments on the Notice through August 23, 2023. While the Notice has provided some initial guidance, much more is needed. As previously raised, guidance on the parameters of the necessary practices and procedures that must be in place to even qualify the failure as an eligible inadvertent failure is critical. Additionally, the coordination between the existing Self Correction Program under EPCRS (SCP) and the self-correction of eligible inadvertent failures need to be explained. Generally, a significant operational failure may be self-corrected under the SCP by the end of the third year after its occurrence. However, the Notice says this requirement does not apply to eligible inadvertent failures before EPCRS is updated. This appears to mean that, at least for now, a significant eligible inadvertent failure can be self-corrected later than three years after it occurred. On the other hand, the Notice provides that generally to be self-corrected within a reasonable period after being identified, the eligible inadvertent failure should be corrected within 18 months of being identified. The SCP focuses on when the failure occurred while correcting eligible inadvertent failures focuses on when the failure was discovered or identified. It appears this means that if a significant eligible inadvertent failure first occurred 5 years ago but was not identified until July of 2023, if it were self-corrected by January 1, 2025, it would be timely corrected. At least, I think that is what the Notice says.