What Is a 402b Plan and How Is It Taxed?

A 402(b) plan is a specific type of non-qualified deferred compensation arrangement. These plans are named after the section of the Internal Revenue Code that governs their tax treatment. A 402(b) plan is established by an employer for the benefit of its employees, but unlike qualified plans, it does not receive the same preferential tax treatment.

These arrangements are utilized by employers such as tax-exempt organizations and government bodies. They are designed to provide supplemental retirement benefits to a select group of management or highly compensated employees. Because they are non-qualified, these plans are not subject to the stringent participation, vesting, and funding rules of the Employee Retirement Income Security Act of 1974 (ERISA) that apply to plans like 401(k)s.

Core Concepts of a 402(b) Plan

A central concept in a 402(b) plan is the “Substantial Risk of Forfeiture” (SRF). This is a condition stipulated in the plan document that an employee must fulfill to gain a non-forfeitable right to the funds their employer has set aside for them. The most common condition is a time-based service requirement, where the employee must remain with the employer for a specified period. If the employee leaves before this condition is met, they forfeit the entire amount in their account.

The moment this risk of forfeiture is removed, the employee’s benefit is considered “vested.” Vesting schedules are outlined in the plan documents and can vary. For example, with a five-year cliff vesting schedule, an employee becomes 100% vested in the account’s total value on their fifth anniversary of employment.

Taxation of 402(b) Plans

The tax implications of a 402(b) plan are unique and tied directly to the vesting of the assets. The most significant taxable event occurs in the year the employee’s benefits become vested. In that year, the entire fair market value of the employee’s interest in the plan is included in their gross income and taxed as ordinary income.

Following the initial vesting event, the tax treatment of the plan’s earnings depends on the employee’s status. For highly compensated employees, any subsequent investment gains earned within the plan are taxable to them each year, even though the funds remain in the plan. This prevents the tax-deferred accumulation that is a hallmark of 401(k) plans.

When distributions are made from the plan, the funds are received tax-free. This is because the employee has already paid income tax on the principal amount at the time of vesting and, in many cases, on the subsequent investment earnings annually. The employer can claim a deduction for the contributions in the year the employee’s benefit vests and is included in their taxable income.

Comparison with Other Retirement Plans

Unlike 401(k) and 403(b) plans, where employee contributions are made on a pre-tax basis, contributions to a 402(b) plan are not taxed until the benefit vests. The tax on investment growth also differs; 401(k) and 403(b) plans offer tax-deferred growth, while in a 402(b) plan, post-vesting growth is often taxed annually for highly compensated employees.

Contribution limits also present a stark contrast. Qualified plans like 401(k)s and 403(b)s are subject to annual contribution limits set by the Internal Revenue Service. A 402(b) plan, being non-qualified, does not have these specific statutory contribution limits, giving employers more flexibility in how much they can contribute.

Funds from a 401(k) or 403(b) can be rolled over into an Individual Retirement Account (IRA) or another qualified plan, preserving their tax-deferred status. Funds from a 402(b) plan cannot be rolled over into an IRA. Furthermore, assets in qualified plans are strongly protected from creditors under ERISA, while assets in a 402(b) plan remain subject to the claims of the employer’s creditors until they are distributed.

Key Considerations for Employees

The most immediate challenge for an employee is planning for the tax liability at the point of vesting. Since the entire value of the account becomes taxable income in a single year without a corresponding cash distribution, employees must have sufficient liquid assets to cover this tax bill. This requires careful financial planning in the years leading up to the vesting date.

Employees should thoroughly review their specific plan document. This document contains the precise details of the vesting schedule, distribution rules, and any other conditions that apply. Understanding these terms is necessary for accurately projecting future tax obligations and making informed financial decisions.

A 402(b) plan should be viewed as a supplemental executive benefit rather than a primary retirement savings vehicle. It should not replace consistent savings in qualified retirement accounts like a 401(k) or an IRA due to its tax treatment and lack of portability. Instead, it serves as an additional, employer-funded retention tool.