12.3 Section 403(b) and 457 Deferred Compensation Plans

Section 403(b) and 457 Deferred Compensation Plans

Quick Answer: Section 403(b) plans (Tax-Sheltered Annuities) serve 501(c)(3) non-profits and public educational institutions, requiring compliance with the Universal Availability Rule and funded exclusively via annuity contracts (§403(b)(1)) or mutual fund custodial accounts (§403(b)(7)). Section 457(b) plans provide deferred compensation for state/local governments and tax-exempt organizations; however, while Governmental 457(b) plans must be held in trust, allow rollovers, and are exempt from the 10% early withdrawal penalty under §72(t), Tax-Exempt 457(b) plans must remain completely unfunded top-hat arrangements subject to general creditor claims. Ineligible Section 457(f) plans are taxed immediately upon vesting.

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1. Section 403(b) Tax-Sheltered Annuities (TSAs)

Codified under IRC §403(b), Tax-Sheltered Annuity (TSA) plans are specialized retirement arrangements designed for two specific classes of tax-exempt employers:

1. Tax-Exempt Organizations: Non-profit entities organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes under IRC §501(c)(3) (e.g., non-profit hospital systems, research foundations, charities, private universities).
2. Public Educational Organizations: State, county, or municipal public school systems, state colleges, and public universities established under state law (IRC §170(b)(1)(A)(ii)).

┌────────────────────────────────────────────────────────────────────────┐
│                     PERMISSIBLE 403(b) FUNDING VEHICLES                │
├──────────────────────────┬─────────────────────────────────────────────┤
│ Vehicle Type             │ Statutory Citation & Operating Criteria     │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 1. Annuity Contracts     │ IRC §403(b)(1): Individual or group annuity │
│                          │ contracts issued by an insurance company    │
│                          │ (fixed, variable, or indexed annuities).    │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 2. Custodial Accounts    │ IRC §403(b)(7): Custodial accounts invested │
│                          │ exclusively in regulated investment company │
│                          │ (mutual fund) shares held by a custodian.   │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 3. Retirement Income     │ IRC §403(b)(9): Specialized defined         │
│    Accounts              │ contribution or defined benefit accounts    │
│                          │ established strictly for church employees.  │
└──────────────────────────┴─────────────────────────────────────────────┘

Important Restriction: Unlike 401(k) plans, 403(b) plans cannot invest directly in individual stocks, individual bonds, or collective investment trusts (CITs) (pending potential federal legislative expansion), nor can they hold real estate directly.

The Universal Availability Rule

Unlike 401(k) plans which utilize ADP testing, elective deferrals in a 403(b) plan are governed by the Universal Availability Rule (IRC §403(b)(12)(A)(ii)). If a plan sponsor allows any employee the opportunity to make salary reduction elective deferrals, it must offer that opportunity to ALL employees of the organization without age or service barriers.

Statutory exclusions from Universal Availability are strictly limited to:

• Employees who will contribute less than $200 annually.
• Students performing services described in IRC §3121(b)(10) (work-study students).
• Employees who normally work fewer than 20 hours per week (subject to Long-Term Part-Time employee participation rules under SECURE Act reforms).
• Employees eligible to participate in another 401(k), 403(b), or 457(b) plan of the employer.

Note on Employer Contributions: While elective deferrals follow Universal Availability, non-elective employer contributions and employer matching contributions in a 403(b) plan must satisfy standard ERISA coverage testing under IRC §410(b), non-discrimination testing under IRC §401(a)(4), and ACP testing under IRC §401(m).

Special 403(b) Catch-Up Rules: The 15-Year Rule

In addition to standard age 50+ catch-up ($8,000 for 2026) and SECURE 2.0 super catch-up ($11,250 for ages 60–63), Section 403(b) permits a unique statutory catch-up:

• The "15-Year Rule" (Special §403(b) Catch-Up): An employee of a qualified organization (health care organization, educational organization, hospital, church, or home health service agency) who has completed at least 15 years of service with the same employer may increase their elective deferral limit by up to $3,000 per year, subject to a $15,000 lifetime cap (further reduced by any special catch-up deferrals utilized in prior years). When both apply, deferrals are applied first against the 15-year rule, preserving the age 50+ catch-up.

ERISA vs. Non-ERISA 403(b) Plans

┌────────────────────────────────────────────────────────────────────────┐
│                     ERISA VS. NON-ERISA 403(b) REGULATORY DIVIDE       │
├──────────────────────────┬─────────────────────────────────────────────┤
│ Plan Category            │ Regulatory Status & Compliance Mandates     │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 1. Governmental &        │ Statutorily exempt from ERISA Title I under │
│    Church 403(b) Plans   │ ERISA §4(b)(1) and §4(b)(2).                │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 2. Private 501(c)(3)     │ FULLY SUBJECT to ERISA Title I (Form 5500,  │
│    with Employer Match   │ annual audit, SPD/SMM, ERISA §404 fiduciary │
│    or Directives         │ standard, §410(b) coverage, §401(a)(4)).    │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 3. DOL Safe Harbor       │ EXEMPT from ERISA Title I under DOL Safe    │
│    Voluntary 403(b)      │ Harbor (29 CFR §2510.3-2(f)) if: (a) strictly│
│    (Deferral-Only)       │ voluntary; (b) no employer contributions;   │
│                          │ (c) employee rights enforceable solely by   │
│                          │ employee; (d) employer involvement limited  │
│                          │ to payroll processing and vendor selection. │
└──────────────────────────┴─────────────────────────────────────────────┘

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2. Section 457 Deferred Compensation Plans

Codified under IRC §457, these plans govern non-qualified deferred compensation arrangements established by:

1. State and Local Governments: States, counties, municipalities, public water/transit authorities, and public universities (Governmental 457).
2. Non-Governmental Tax-Exempt Organizations: Private 501(c) non-profit entities such as trade associations, labor unions, private hospitals, and charitable foundations (Tax-Exempt 457).

┌────────────────────────────────────────────────────────────────────────┐
│          GOVERNMENTAL 457(b) VS. TAX-EXEMPT NON-PROFIT 457(b)          │
├──────────────────────────┬──────────────────────┬──────────────────────┤
│ Dimension                │ Governmental 457(b)  │ Tax-Exempt 457(b)    │
├──────────────────────────┼──────────────────────┼──────────────────────┤
│ Funding / Asset Custody  │ MANDATORY TRUST for  │ MUST REMAIN UNFUNDED │
│                          │ exclusive benefit of │ Subject to claims of │
│                          │ participants (§457(g)│ general creditors!   │
├──────────────────────────┼──────────────────────┼──────────────────────┤
│ Eligible Employees       │ All eligible workers │ RESTRICTED to Top-Hat│
│                          │ across municipality  │ (select management)  │
├──────────────────────────┼──────────────────────┼──────────────────────┤
│ Early Distribution       │ EXEMPT from 10% early│ EXEMPT from 10% early│
│ Penalty (IRC §72(t))     │ penalty upon sep.    │ penalty upon sep.    │
├──────────────────────────┼──────────────────────┼──────────────────────┤
│ Rollover Portability     │ Eligible to roll to  │ NO ROLLOVERS to IRAs │
│                          │ IRAs, 401(k), 403(b) │ Only to other exempt │
│                          │                      │ 457(b) plans         │
├──────────────────────────┼──────────────────────┼──────────────────────┤
│ ERISA Title I Coverage   │ Statutorily exempt   │ Exempt via Top-Hat   │
│                          │ (Governmental plan)  │ non-funded exemption │
└──────────────────────────┴──────────────────────┴──────────────────────┘

Contribution Limits & Special 3-Year Catch-Up

• Standard Limit: The elective deferral limit under IRC §457(b) mirrors the §402(g) limit ($24,500 for 2026). Unlike 401(k) and 403(b) plans which share a single aggregated §402(g) cap, Section 457(b) limits are completely independent. A municipal employee participating in both a 403(b) and a 457(b) can contribute the full $24,500 to each, deferring $49,000 total in 2026.
• Governmental Age 50+ Catch-Up: Governmental 457(b) plans permit the standard age 50+ catch-up ($8,000 for 2026) and SECURE 2.0 super catch-up ($11,250 for ages 60–63). Note: Tax-exempt non-profit 457(b) plans are not eligible for age 50+ catch-up contributions.
• Special 3-Year Prior to Normal Retirement Age Catch-Up (IRC §457(b)(3)): In the three consecutive taxable years ending prior to the year the participant attains Normal Retirement Age (NRA) under the plan, the participant may utilize a special catch-up limit equal to the lesser of:
  1. Twice the standard regular annual limit ($24,500 × 2 = $49,000 for 2026), or
  2. The standard annual limit plus previously unutilized deferral capacity from prior years since 1979. Rule: In governmental plans, a participant cannot combine both the age 50+ catch-up and the special 3-year catch-up in the same taxable year; the participant automatically receives whichever formula yields the larger contribution.

Taxation and Early Withdrawal Exemption (IRC §72(t))

A paramount advantage of Section 457(b) plans is that distributions upon separation from service are not subject to the IRC §72(t) 10% early withdrawal tax penalty, regardless of whether the participant is under age 59.5. However, if a participant rolls governmental 457(b) assets into a traditional IRA or 401(k) plan, subsequent distributions from that rollover account prior to age 59.5 become subject to the 10% early withdrawal penalty.

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3. Section 457(f) Ineligible Deferred Compensation Plans

When a tax-exempt organization desires to provide executive retirement benefits exceeding the statutory $24,500 ceiling of Section 457(b), it establishes an Ineligible Deferred Compensation Plan under IRC §457(f).

┌────────────────────────────────────────────────────────────────────────┐
│                     SECTION 457(f) REGULATORY MECHANICS                │
├────────────────────────────────────────────────────────────────────────┤
│ • No Statutory Contribution Ceiling: Employer can defer hundreds of    │
│   thousands of dollars per year for top executives / university heads. │
│ • Substantial Risk of Forfeiture (SRFO): Benefit rights must be strictly│
│   conditioned upon future performance of substantial services (e.g.,  │
│   remaining employed for 5 continuous years).                          │
│ • Taxation Upon Vesting: The instant the SRFO lapses (i.e., at vesting),│
│   the ENTIRE present value of the accumulated benefit is taxed as      │
│   ordinary income to the executive, EVEN IF NO MONEY IS DISTRIBUTED!   │
│ • IRC §409A Compliance: Must strictly comply with non-qualified        │
│   deferred compensation timing, acceleration, and distribution rules.  │
└────────────────────────────────────────────────────────────────────────┘

Because taxation occurs immediately upon vesting under §457(f), plan designers frequently implement "rolling risk of forfeiture" extensions or structure liquidity payouts to provide the executive with cash to settle the immediate income tax liability.