How to Terminate a 457(b) Plan of a Tax-Exempt Sponsor

“How do I terminate a 457(b) plan of a tax-exempt employer?”

Stacey Bradford, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, vice president, Retirement Plan Services, Cammack Retirement Group, answer:

Fortunately, the 457(b) regulations are fairly clear in this regard, as follows:

Ҥ1.457-10, Internal Revenue Service, Miscellaneous provisions

(a) Plan terminations and frozen plans

(1) In general.—An eligible employer may amend its plan to eliminate future deferrals for existing participants or to limit participation to existing participants and employees. An eligible plan may also contain provisions that permit plan termination and permit amounts deferred to be distributed on termination. In order for a plan to be considered terminated, amounts deferred under an eligible plan must be distributed to all plan participants and beneficiaries as soon as administratively practicable after termination of the eligible plan. The mere provision for, and making of, distributions to participants or beneficiaries upon a plan termination will not cause an eligible plan to cease to satisfy the requirements of section 457(b) or the regulations.”

Thus, though termination provisions are fairly straightforward (terminate plan, distribute all accounts as soon as practical), keep in mind that in tax-exempt 457(b) plans, account balances can be quite sizable, since they are held by select management or highly compensated employees. It is not unusual for the Experts to see seven-figure balances for some participants in these plans, all of which will generally be taxable as income in the tax year of distribution. This often results in a significant tax burden for such individuals, with no method of deferring the burden, since such distributions are not eligible for rollover or other favorable tax treatment (with the limited exception of a plan to plan transfer to a 457(b) plan of a new tax-exempt employer for a terminated employee). Thus, plan sponsors should consider this impact carefully before terminating a plan, and effectively communicate the tax consequences to participants.

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.