Milliman worked with a tax-exempt not-for-profit organization to improve its benefits plan so that employees could benefit fully from their savings and employer contributions. In the 1990’s, the organization adopted a Section 457(f) plan as a vehicle for making tax-deferred allocations to its executives. Each year the board of directors approved the amounts, which ranged from $15,000 to $30,000.
Changing legislation brings compliance challenges
Compliance was a major issue for the original plan. When the American Jobs Creation Act of 2004 was enacted, the plan became subject to the new deferred compensation rules under Internal Revenue Code 409A. Noncompliance could have resulted in severe consequences, such as an additional 20% excise tax on the deferred amounts. Our consultants worked with the organization to determine the liability for executives by obtaining past benefit statements from the organization’s mutual fund providers and creating spreadsheets to isolate contributions and earnings. Together with the organization’s attorney, Milliman developed an action plan to ensure that the existing 457(f) plan complied with Section 409A and to determine the portion of the 457(f) subject to current taxation.
Using recent legislation to maximize plan value
While reviewing the plan for compliance, Milliman inquired as to whether the organization utilized any other deferred compensation plans. It quickly became apparent that by solely relying on the decade-old plan, the organization was not taking advantage of recent changes to tax law. The major downside of the existing plan was that the 457(f) rules required participants to be taxed as soon as the benefits were vested, rather than when the benefits were distributed. This outcome was not desirable because executives could be bumped into a higher tax bracket, as the inclusion of these distributions in taxable income occurred in years when they also were earning salaries.
Milliman consultants suggested that the organization consider the benefits of adding a Section 457(b) plan, which had become a viable, attractive option for deferred bonus plans for not-for-profit organizations in 2002. In contrast to Section 457(f) plans, Section 457(b) plans do not require that the amounts accumulated under the plan become taxable as they become vested. In addition, the Section 457(b) rules allow much more flexible distribution and deferral options than their Section 457(f) counterparts. Furthermore, Section 457(b) plans are not subject to the rigid requirements and severe penalties of Section 409A. In exchange for this greater flexibility, there is an annual limit on the amount of contributions that may be allocated to these plans. While this limit is tied to the 401(k)/403(b) dollar limit (i.e. $15,500 for 2007), 457(b) contributions do not count toward the 401(k)/403(b) $15,500 maximum deferral limit. Therefore, executives can defer as much as $15,500 in their 401(k) or 403(b) plans and another $15,500 in a 457(b).
Milliman proposed a two-tiered benefit program for the executives. Each year they would first receive a contribution under the 457(b) plan equal to the lesser of the bonus approved by the board of directors of the organization or the maximum amount legally permitted to be contributed to the 457(b) plan for that year. If any portion of the bonus exceeded the 457(b) limit for a year, the spillover amount would be contributed to the 457(f) plan. For example, if the organization wished to contribute $20,000 to an executive in 2007, the executive would receive the full $15,500 in the Section 457(b) and the remaining $4,500 would go into the Section 457(f) plan.
A plan for the future: better benefits, more accurate administration
Milliman achieved two challenging objectives for optimizing the organization’s outdated deferred compensation program. First, we brought the existing plan into 409A compliance and created an easy, systematic approach for administering the plan. The new procedures will ensure that both the organization and its executives will be accurately alerted when funds vest and become subject to taxation. Second, our consultants were able to enhance the organization’s deferred compensation program by assisting to implement a new plan that provides longer tax deferral and greater flexibility for executives. As a result, employees are now realizing greater value from the new program without additional contributions from the organization.
