Understanding Nonprofit 457(b) and 457(f) Plans: Use Cases, Misconceptions, and Key Considerations

Nonprofits and associations use deferred compensation, namely 457(b) and 457(f) plans, to attract and retain key staff.  They provide tax-deferred savings opportunities but have distinct structures, use cases, and implications. This article explores their purposes, common misconceptions, pros and cons, and logistical considerations.

Use Cases: Goals and Purpose

457(b) Plans: Supplemental Retirement Savings

A 457(b) plan is a tax-advantaged deferred compensation plan available to certain nonprofit employees. Its primary purpose is to supplement retirement savings, particularly for executives and other highly compensated employees that have maxed out their annual 401(k) or 403(b) contributions.   These plans function similarly to 401(k)s or 403(b)s but have key differences and misconceptions:

• They allow for employee and employer contributions, similar to 401(k) and 403(b) plans, subject to annual contribution limits.
• The tax benefit is a result of the funds being held (owned) by the nonprofit organization, and as a result are at risk to the employer’s creditors.  Until the 457(b) funds are distributed, you are deferring ownership of those dollars. 
• Withdrawals are subject to ordinary income tax upon separation from service, regardless of age.
• Distributions cannot be rolled into an IRA and are taxed as ordinary income in the year the distribution occurs.
• Pursuant to the plan document, distributions may be spread across multiple years, allowing participants to spread out the tax impact.

457(f) Plans: Retention and Incentive Tool

A 457(f) plan, on the other hand, is a deferred compensation arrangement designed to retain and incentivize key executives. Unlike 457(b) plans:

• There are no employee contributions – only employers can set aside funds for their key employees.
• There are no specific contribution limits—employers can set aside substantial sums.
• Funds become taxable when they are vested, not when distributed.
• Employers often structure vesting schedules to encourage long-term commitment (e.g., a lump sum payout after 5-10 years of service).

Pros and Cons

457(b) Plan

Pros:

• Provides tax-deferred retirement savings beyond 401(k)/403(b) limits.
• No early withdrawal penalty upon separation from service.
• Employer contributions (if any) are also tax-deferred.

Cons:

• Assets are technically owned by the employer until withdrawn, meaning they could be at risk in the event of the employer’s financial trouble.
• No rollover options, distributions are taxable as ordinary income.

457(f) Plan

Pros:

• No IRS-imposed contribution limits—allows for significant deferred compensation.
• Highly customizable vesting schedules to retain key executives.
• Strong recruitment and retention tool.
• Wide range of investment options as funds are typically held in a brokerage account, similar to a nonprofit’s reserve portfolio.

Cons:

• Full vesting triggers immediate taxation, which can create significant tax liability.
• Cannot be rolled into an IRA or other tax-advantaged account.

Logistical Considerations

• Tax Implications: Employees should work with financial and tax advisors to plan for large taxable events, especially with 457(f) lump sum distributions.
• Creditor Risk: Since these are non-qualified plans, assets are subject to employer solvency risk, meaning if the nonprofit faces financial difficulties, participants’ deferred compensation could be at risk.
• Plan Document: 457(f) plans require a customized plan document for each employee to govern plan provisions including eligibility, vesting, and the timing of distributions.  

Final Thoughts

457(b) and 457(f) plans serve distinct purposes in nonprofit executive compensation and retirement planning. While 457(b) plans provide a valuable supplement to retirement savings, 457(f) plans act as strategic retention tools with significant tax and liquidity implications. Understanding the differences, limitations, and financial planning needs of each is crucial for both employers and employees to maximize benefits while avoiding unexpected tax burdens or risks.

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