Take-Away: There are different rules (or traps) depending upon what type of 457(b) plan an individual participates in through his/her employment

Background: From time-to-time we run across reference to an IRC 457(b) retirement plan. There is not much common knowledge about 457(b) plans compared to traditional IRAs, qualified plans, e.g. 401(k) plans,  or even 403(b) tax-deferred annuities. What follows is a brief summary of IRC 457(b) plans for the novice.

Two Types of 457(b) Plans: A 457(b) retirement plan is most commonly a governmental plan that is established for state and local municipal workers. All municipal employees, including rank-and-file, can be covered with this type of retirement plan. For ease of reference, this type will be referred to as a municipal 457(b) plan. A second type of 457(b) retirement plan, less well known, is often called  a ‘top hat’ plan. A top hat plan is established for highly-paid and managerial employees of tax-exempt employers, such as hospitals and universities. 457(b) top hat plans can only be offered to employees who are in key management positions or who are highly paid, e.g. physicians; hospital administrators. These two 457(b) retirement plans are dramatically different in a couple of key aspects. Those differences between the two types of 457(b) plans include the following:

Rollovers: A top hat participant plan cannot make a tax-free rollover when he/she leaves their employment, either to an IRA or to another qualified employer sponsored plan. However, the top hat 457(b) balance can be subject to a tax-free transfer but only if the employee takes a new job with an employer that maintains a top hat plan and both the ‘old’ top hat plan and the ‘new ’top hat plan allow such rollover transfers. In the absence of that statutory exception that both plans must adopt, the result is that a top hat distribution will normally be taxed to the top hat participant in the year of distribution. To mitigate this income tax ‘hit’ some 457(b)  plans permit distributions to be made of the account balance over several years. In contrast, a municipal 457(b) plan permits the participant to make a rollover of his/her 457(b) distribution directly to an IRA, or to another plan that accepts rollovers, much like the flexibility afforded to 401(k) plan participants.

Bankruptcy: Another difference between the two types of 457(b) plans is if the plan sponsor becomes bankrupt. Governmental or municipal 457(b) plan funds, just like any other employee’s 401(k) account balance, are held in a separate trust fund. Consequently, those municipal 457(b) account balances cannot be reached by the municipality’s creditors. However, with 457(b) top hat  plan the contributed funds must remain with and in the name of the 457(b)plan sponsor. Accordingly, if the 457(b) sponsor goes bankrupt, the top hat participant’s account could be reached by the plan sponsor’s creditors. This exposure to creditor claims of the 457(b) plan sponsor causes the limited eligibility imposed by Congress for top hat plans; apparently the belief in Congress was that only highly-paid top hat plan participants should bear the risk of losing their retirement funds to the sponsor’s creditors.

Rabbi Trusts: To protect a top hat participant’s account from the plan sponsor’s creditors often results in what is called a negotiated rabbi trust (which, as the name suggests, originated with such an arrangement made by a congregation for its rabbi.) With a rabbi trust, the top hat funds still remain subject to the plan sponsor’s creditors, but the top hat participant is protected if the sponsor refuses to pay the promised benefits due to a change of heart or because another entity becomes the successor employer after a corporate transaction.

Flexible Features: Several other retirement plan features are available to be included in a municipal 457(b) plan but cannot be a part of a top hat 457(b) plan. Those flexible retirement planning features include: (i) Roth contributions; (ii) the availability of plan loans to the participant; and (iii) non-hardship in-service withdrawals after the municipal 457(b) participant attains age 59 ½.

Conclusion: Participants in 457(b) plans need to understand what type of 457 plan in which they participate, and they further need to understand that the limitations and restrictions associated with a top hat 457 plan may not apply to them, or vice versa.