Excess deferrals made to an eligible deferred compensation plan may result in the loss of the plan's eligible status under IRC Section 457(b) unless they're timely corrected. The requirements for timely correction of deferrals are different for an eligible 457(b) plan maintained by a non-governmental tax-exempt organization ("tax exempt 457(b) plan") and a 457(b) plan maintained by a governmental entity ("governmental 457(b) plan"). This Issue Snapshot discusses correction of excess deferrals under a 457(b) plan maintained by a tax-exempt entity and a government, respectively. IRC Section and Treas. Regulations IRC Section 457(b) IRC Section 457(b)(2) IRC Section 457(b)(3) IRC Section 457(c) IRC Section 457(e)(1)(A) IRC Section 457(e)(1)(B) IRC Section 457(e)(15) IRC Section 457(e)(18) IRC Section 457(f) IRC Section 414(v) Reg. Section 1.457-2(b) Reg. Section 1.457-4(c) Reg. Section 1.457-4(e) Resources (court cases, Chief Counsel Advice, Revenue Rulings, internal resources) Notice 2003-20 PDF Notice 2020-79 Revenue Procedure 2004-56 Revenue Procedure 2021-30 PDF Analysis An "annual deferral" is compensation deferred under an eligible plan by salary reduction or by nonelective employer contribution. It is taken into account as an annual deferral in the later of the taxable year deferred or the year in which it's no longer subject to a substantial risk of forfeiture. See Reg. Section 1.457-2(b)(1). The term "annual deferral," used in this Issue Snapshot, means an annual deferral vested for the year in question. Maximum limitations on annual deferrals: Basic annual limit A 457(b) plan must provide that annual deferrals for a taxable year (the plan ceiling) can't exceed the lesser of the applicable dollar amount in effect for the participant's taxable year or 100 percent of a participant’s includible compensation. The applicable dollar amount equals $15,000, as adjusted for cost-of-living increases under IRC Section 415(d). See IRC Section 457(e)(15). For 2021, the applicable dollar amount equals $19,500. Increased limit for catch-up contributions The basic annual limit may be increased by amounts available under the special 457 catch-up or the age 50 catch-up. Under the special 457 catch-up, an eligible plan may provide for an increased plan ceiling during the last three taxable years ending before a participant attains normal retirement age. (For normal retirement age, see Reg. Section 1.457-4(c)(3)(v).) The increased ceiling is the lesser of twice the applicable annual dollar amount, or the "underutilized limitation." The underutilized limitation is the sum of the plan ceiling for each year of participation, less the amount of deferrals made in prior years, disregarding any deferrals made under the age 50 catch-up. The age 50 catch-up applies to governmental 457(b) plans, but not to tax exempt 457(b) plans. The age 50 catch-up limit is the applicable dollar amount for the taxable year, determined under IRC Section 414(v)(2). The applicable dollar amount in IRC Section 414(v)(2) is $5,000, as adjusted for cost-of-living increases. For 2021, the applicable dollar limitation for catch-up contributions to a governmental 457(b) plan for individuals age 50 or over equals $6,500. Under a governmental 457(b) plan that permits contributions under the age 50 catch-up and the special 457 catch-up, the catch-up that yields the larger amount applies. Excess deferrals: Annual deferrals made for each participant under a 457(b) plan cannot exceed the above maximum deferral limitations (“plan limitation”). Annual deferrals that exceed the plan limitation are considered excess deferrals. In determining whether there is an excess deferral under an employer’s 457(b) plan resulting from a failure to comply with the plan limitation, all 457(b) plans of the employer are treated as a single plan. The maximum deferral limitations also limit the total annual deferrals for each individual (“individual limitation”). Annual deferrals that exceed the individual limitation are also considered excess deferrals. In contrast to the plan limitation, the individual limitation is applied by counting annual deferrals under all eligible 457(b) plans of all of an individual’s employers for the taxable year. See IRC Section 457(c). Correction of excess deferrals due to plan limitation: Tax Exempt 457(b) plans Excess deferrals to a tax-exempt 457(b) plan arising from a failure to apply the plan limitation must be corrected by April 15 of the taxable year following the close of the taxable year of the excess deferrals. If the plan distributes the excess deferrals (plus allocable earnings) by that date, the plan will continue to be treated as an eligible 457(b) plan. If the excess deferrals aren't corrected by such a distribution, the plan is an ineligible plan under IRC Section 457(f) (“457(f) plan”). See Reg. Section 1.457-4(e)(3). Governmental 457(b) plans In a governmental 457(b) plan, excess deferrals arising from application of the plan limitation must be distributed, along with allocable net income, as soon as administratively practicable after the plan determines there is an excess deferral. Failure to correct the excess deferral as soon as administratively practicable causes the plan to become an ineligible plan and benefits under the plan are taxable as required under Reg. Section 1.457-11. See Reg. Section 1.457-4(e)(2). The Employee Plans Compliance Resolution System (EPCRS) doesn't apply to 457(b) plans; however, Revenue Procedure 2019-19 provides that the IRS will accept a submission relating to a 457(b) plan on a provisional basis outside of EPCRS through standards similar to those that apply to the Voluntary Correction Program. The availability of correction is generally limited to governmental 457(b) plans. Correction of excess deferrals due to individual limitation: An eligible plan may provide that an excess deferral that results solely from a failure to comply with the individual limitation for a taxable year may be distributed to the participant, with allocable net income, as soon as administratively practicable after the plan determines that the amount is an excess deferral. Such a distribution of excess deferrals will not cause a plan to fail to comply with IRC Section 457(b). See Reg. Section 1.457-4(e)(4). When excess deferrals caused by application of the individual limitation aren't distributed, a plan will still maintain eligible status; however, the participant must include the excess deferrals in income. See Reg. Section 1.457-5(a). Tax treatment and reporting: Excess deferrals, when corrected timely, are taxable in the year of deferral (or, if later, the first taxable year in which there is no substantial risk of forfeiture). The earnings on the excess are taxable in the year of distribution. In a governmental 457(b) plan, the excess deferrals must be distributed as soon as administratively practicable after the plan determines that there is an excess deferral. If the excess deferrals aren't corrected by such a distribution, the plan may be a 457(f) plan under which benefits are taxable in accordance with Reg. Section 1.457-11. See Reg. Section 1.457-4(e)(2). (See also Reg. Section 1.457-9(a), regarding when a plan of a State ceases to be an eligible plan under IRC Section 457(b).) In a 457(b) tax exempt plan, the excess deferrals are taxable in the year of deferral and must be distributed prior to April 15th of the following year. Only the earnings on the excess deferrals are subject to income tax in the year of distribution, and such earnings should be reported on Form W-2 for the year of distribution. If an eligible plan becomes an ineligible plan under IRC Section 457(f) because excess deferrals aren't timely distributed, benefits become taxable in accordance with Reg. Section 1.457-11. See Notice 2003–20, 2003–19 I.R.B. 894, for information regarding the withholding and reporting requirements applicable to eligible plans in general. Issue indicators or audit tips Review W-2, Box 12 to determine if deferrals exceed the IRC Section 457(b) dollar limit in effect for the year. Verify if these excess amounts were due to allowable catch-up contributions. Annual deferrals made to eligible 457(b) plans are reported in Box 12 of Form W-2, using Codes G and EE (Roth contributions). Request documentation to verify timely distribution of excess deferrals. Review Forms W-2 and 1099-R for proper reporting of distributions.
