457f Plans: An Explanation of Rules and Taxation

A 457(f) plan is a non-qualified, tax-deferred compensation arrangement available to certain employees of tax-exempt organizations and state or local governments. These plans allow employers to provide supplemental retirement income to key employees, operating under a framework governed by Section 457(f) of the Internal Revenue Code. The plan’s main feature is its connection to a “substantial risk of forfeiture,” which dictates when the compensation becomes taxable to the employee. The structure allows for contributions that are not limited by the annual deferral caps imposed on other retirement plans, making them a tool for recruiting and retaining executive talent. The assets deferred, along with any earnings, remain the property of the employer and are subject to the claims of the employer’s general creditors until paid out.

Eligibility and Plan Establishment

Only specific employers can establish a 457(f) plan, including state and local governments and their agencies, as well as non-governmental organizations that are tax-exempt under Internal Revenue Code Section 501(c).

Participation is also narrowly defined. For non-governmental tax-exempt employers, these plans must be limited to a select group of management or highly compensated employees, known as a “top-hat” group, to avoid the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). While governmental plans are exempt from ERISA’s participation limits, they are also used to provide supplemental benefits to executives.

The foundation of any 457(f) plan is a formal, written plan document. This legally binding agreement outlines all terms, including the conditions for receiving benefits, payment timing, and the benefit calculation formula. The clarity of this document is important, as it governs the entire lifecycle of the compensation, from deferral to final distribution.

The Substantial Risk of Forfeiture

A substantial risk of forfeiture (SRF) exists if an employee’s right to compensation is conditioned on the future performance of substantial services. Until this condition is met, the employee has no guaranteed right to the funds and will forfeit the entire amount if they fail to meet the condition.

A common example of an SRF is a time-based vesting schedule. The plan document might stipulate that an executive must remain employed for a continuous five-year period to become entitled to the deferred compensation. If the executive leaves before completing the service, they lose their right to the funds, directly linking the payment to their continued service.

Another valid SRF involves tying vesting to achieving specific, objective performance goals, such as financial targets or programmatic milestones. These goals must be substantial and their attainment uncertain when the agreement is made. The determination of whether a risk is substantial depends on the specific facts and circumstances of the arrangement.

Conversely, not all conditions create an SRF. A requirement to provide minor consulting services after retirement is often not deemed substantial enough to qualify. A covenant not to compete can create an SRF, but only if the agreement is written, the employer has a legitimate business interest, and the employee has a genuine ability to compete. The IRS scrutinizes these arrangements to ensure the risk is genuine; if vesting is practically a certainty, the SRF may be disregarded, leading to immediate taxation.

The risk must be legitimate throughout the deferral period. Arrangements using “rolling risk of forfeiture” provisions, where an employee can elect to extend the forfeiture period just before it is set to lapse, are viewed critically by the IRS. This is because the practice could allow an employee to indefinitely postpone taxation.

Taxation of Plan Assets

Taxation of a 457(f) plan is tied to the lapse of the substantial risk of forfeiture (SRF). The taxable event occurs in the year the benefits become vested, not when funds are contributed or later distributed in cash.

In the year of vesting, the entire value of the vested benefit is subject to taxation. This includes the principal amounts contributed by the employer and all accumulated earnings credited to the account up to that date, which are treated as ordinary income.

The vested amount is reported as wages on the employee’s Form W-2 for the year the SRF lapses. Consequently, the income is subject to all applicable employment and income taxes, including federal income tax withholding, Social Security (FICA), and Medicare taxes, as well as state and local taxes.

An employee must pay taxes on the vested amount even if they do not receive any cash from the plan in that year. For example, if a benefit vests in 2025 but is not scheduled to be paid out until retirement in 2030, the tax liability is triggered in 2025. This can create a liquidity challenge for the employee, who must have other funds available to cover the tax bill.

Employers may also be subject to a 21% excise tax on compensation over $1 million paid to a covered employee. The value of the 457(f) benefit is included in this calculation in the year it vests, which can trigger this tax for the employer.

Distributions and Subsequent Tax Treatment

The timing and method of distribution are governed by the terms in the written plan document. Common triggers for distribution include separation from service, reaching a specified age or date, death, or disability.

The tax treatment at distribution builds on the taxation that occurred at vesting. The portion of the distribution that represents the amount previously included in the employee’s income—the principal and pre-vesting earnings—is received tax-free. This is because the employee has already paid ordinary income tax on this value, which represents their basis in the plan.

Any additional earnings that have accrued on the assets between the vesting date and the actual distribution date are taxable. This subsequent growth is taxed as ordinary income in the year it is received by the employee.

For example, if an account was worth $500,000 at vesting and grew to $550,000 by the time it was paid out, the employee would owe ordinary income tax on the $50,000 of post-vesting earnings upon distribution.