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By Ian Berger
In the recently proposed Build Back Better Act, Congress is trying to fix what it perceives as abusive retirement account systems, such as “Mega IRAs,” “Backdoor Roth IRAs,” and “Mega Backdoor Roth IRAs.” . But Congress continues to overlook another arrangement that some may see as a similar loophole: the ability for executives and other well-paid employees of tax-exempt businesses (like hospitals) to defer compensation by an amount well in excess of what which is available to other employees.
There is nothing illegal in these arrangements. Hospitals (and other tax-exempt entities) have simply taken advantage of several Internal Revenue Code rules that apply when executives are allowed to participate in both a 403(b) plan and a 457( b) “top-hat”. (A higher plan is only available to tax-exempt employers and has different rules than 457(b) plans for state and local government employers.)
Eligibility rules
First, high-end plans can only be offered to a small percentage of the employee population who are key or high-paying executives. In contrast, 403(b) plans must be offered to most employees, and 401(k) plans must cover at least a minimum number of the lowest paid employees. The reason for the strict hat scheme eligibility rule is that deferrals made under these schemes must remain assets of the company and subject to claims by the employer’s creditors. This makes them riskier than government 457(b) plans, which must be held in a trust fund. Congress has determined that this risk should be borne only by the highest paid employees.
The annual limit of optional deferral
Second, senior 457(b) plans are considered separately in applying the annual optional deferral limit when an executive is also covered by a 403(b) plan. This limit limits annual carryovers in 401(k), 403(b), and government 457(b) plans to a maximum of $19,500 (or $26,000 if age 50 or older) in 2021. (Limits are $20,500/$27,000 for 2022). Top hat participants are subject to the $19,500 maximum but cannot take advantage of the additional deferral at age 50.
Generally, when a person participates in more than one plan at the same time (or at different times during the same year), deferrals of all the plans are grouped together for the purposes of the deferral limit. This is the case even if the employers sponsoring the plans are considered unrelated under the tax rules. But this is not the case when one of the plans is a 457(b) plan. This is a huge advantage for executives or other high-paying employees who are eligible for both a 403(b) plan and a high-end plan. They can double their elective deferrals — and even take advantage of the additional 50-year deferral in the 403(b) plan.
Example: Amy, age 51, is the CFO of a tax-exempt hospital and is eligible for both a 403(b) plan and a superior 457(b) plan. Since her 457(b) and 403(b) deferrals are not cumulative, she could defer up to a total of $47,500 in 2022 ($20,500 in 457(b) and $27,000 in 403(b). )).
The overall annual contribution limit
Third, 457(b) contributions do not count towards the overall annual contribution limit (sometimes referred to as the “415 limit”). This limit applies to the combined employee and employer contributions paid by or on behalf of an employee, as well as any forfeitures allocated to his account. In 2021, this maximum is $58,000, or $64,500 if deferrals to 50 years are made. (Limits increase to $61,000/$67,500 for 2022.) When a person participates in multiple plans sponsored by the same employer (or separate employers considered to be one employer under tax rules), contributions made to all of these schemes are normally grouped together for the purposes of the aggregate limit. However, when one of the multiple plans is a 457(b) plan, the 457(b) contributions are not taken into account.
Example: If Amy (the hospital’s chief financial officer) defers $20,500 to her 457(b) plan and $27,000 to her 403(b) plan in 2022, she could also theoretically receive up to $40,500 ( $67,500 – $27,000) in 403(b) employer contributions without exceeding the aggregate limit. This is because his 457(b) contributions do not count towards the $67,500 limit. In practice, however, Amy would probably not be able to receive such a high employer contribution due to rules requiring that such contributions be made proportionately among all employees. However, a lower employer contribution may be possible.
Catch-up contribution over 3 years
Finally, 457(b) participants can make a special catch-up contribution for each of the last three years before the employee’s “normal retirement age” under the plan. However, this catch-up is only available to the extent that employees have not maximized 457(b) carryovers from the prior year. This additional deferral opportunity allows certain employees nearing retirement to make 457(b) deferrals up to twice the usual elective deferral limit for three years. When added to the optional deferrals and employer contributions available through the 403(b) plan, it can be incredibly lucrative.
Example: Dr. Westphall, 62, is chief medical staff at a tax-exempt hospital that offers a 403(b) plan for all employees and a 457(b) top hat plan. Dr. Westphall is eligible for both, but he has not yet referred to 457(b). He will retire on Dec. 31, 2024. Plan permitting, Dr. Westphall could carry over into 2022 up to twice the elective carry-forward limit from 2022 ($41,000) in 457(b) and an additional $27,000 in the 403(b), for a total of $68,000. For the three-year period preceding retirement (2022-2024), its total carryover could reach $204,000 – and even more if the carry-over limit increases. And that doesn’t include any employer contributions he might receive under the 403(b) plan.
Several unique tax rules governing 457(b) plans make high-end hat plans extremely valuable benefits for management and other high-paying employees of tax-exempt businesses – especially when combined with 403 plans. (b).
Keep in mind, however, that premium plans have their downsides. As noted above, employee deferrals must remain company assets and are not protected from company creditors.
Additionally, top hat participants cannot defer their distribution to IRAs or other employer plans (although transfers to other top hat plans are permitted). This inability to transfer assets from the top plan to an IRA could mean large taxable distributions in retirement. Yet, overall, the top hat/403(b) combination offers a powerful tool for eligible employees to defer large amounts of their compensation.
About the Author: Ian Berger, JD, is an IRA Analyst at Ed Slott and Company, LLC with over 30 years of experience dealing with retirement plans and IRA issues in both the private and public sectors. Get more information on Ed Slott and Company’s 2-Day Virtual IRA Workshop, Instant IRA Success. Plus, check out Slott’s new, updated #1 book, “The new retirement savings time bomb.” Click here to receive Ed Slott and Co’s Monthly. IRA Updates eNewsletter, featuring important news and hot topics in the IRA world.
