Vesting Schedule Considerations for Eligible 457(b) Plans

“We are a public university that sponsors a 403(b) and an eligible 457(b) plan. We have a vesting schedule in our 403(b) plan for employer contributions. We are considering adding employer contributions for certain employees to our 457(b) plan (currently, our 457(b) is limited to elective deferrals), and were wondering if we could use the same vesting schedule that we have in our 403(b) plan in our eligible 457(b) plan for consistency purposes. Can we have a vesting schedule in our 457(b)?”

Charles Filips, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, senior financial adviser at CAPTRUST, answer:

In short, yes. A plan sponsor of an eligible 457(b) plan may set the conditions necessary for participating employees to become vested or partially vested in employer matching and/or nonelective contributions. Typically, an employer may look to an employee’s length of service or age and service to determine when an employee becomes vested in employer contributions.

Although 457(b) plan sponsors are permitted to include a vesting schedule for employer contributions, there are certain aspects of 457(b) plans that may give you pause before adopting a vesting schedule consistent with your 403(b) plan’s vesting schedule. First, employer contributions to eligible 457(b) plans are considered annual deferrals when they become vested. See Treasury Reg. 1.457-2(b)(2). As such, vesting schedules might cause excess deferrals for the year of vesting. Put differently, because only fully vested contributions are included toward the 457(b) deferral limit, if several contributions vest all at once, the vesting year’s contribution limit might be exceeded. For example, if an employer contributes $5,000 per year for five years, and the amounts become vested only in year 5 (assume year 5 is 2021), then you have to deal with excess deferrals in year 5 ($25,000 – $19,500 = $5,500 in excess deferrals) for affected participants.

Second, there might be some tax challenges owing to vesting of employer contributions, which are taken into account as wages for FICA tax purposes when vested. I.R.C. §3121(v)(2). In general, while certain university employees might be exempt from FICA under IRC Section 3121(b)(10), to the extent a sponsor of an eligible 457(b) plan has employees who are not exempt from FICA, employer contributions need to be taken into account for FICA purposes in the year that they vest. As such, it is important to synchronize with payroll to take into account these contributions for FICA purposes.

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.

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