By Ian Berger
In the recently proposed Build Back Better Act, Congress attempts to fix what it perceives as abusive retirement account schemes, such as “Mega IRAs,” “Backdoor Roth IRAs” and “Mega Backdoor Roth IRAs.” But Congress continues to overlook another arrangement that some may view as a similar loophole: the ability of executives and other high-paid employees of tax-exempt companies (like hospitals) to defer compensation in amounts far above what is available to other employees.
There is nothing illegal about these arrangements. Hospitals (and other tax-exempt entities) have simply taken advantage of several Internal Revenue Code rules that apply when executives are allowed to participate in both a 403(b) plan and a 457(b) “top-hat” plan. (A top-hat plan is only available to tax-exempt employers and has different rules than 457(b) plans for state and local government employers.)
First, top-hat plans can only be offered to a small percentage of the employee population who are key management or highly paid. By contrast, 403(b) plans must be offered to most employees, and 401(k) plans must cover at least a minimum number of lower-paid employees. The reason for the strict top-hat plan eligibility rule is that deferrals made under those plans must remain company assets and subject to claims of the employer’s creditors. This makes them riskier than governmental 457(b) plans, which must be held in a trust fund. Congress determined that this risk should only be borne by highly-paid employees.
The Annual Elective Deferral Limit
Second, 457(b) top-hat plans are considered separately in applying the annual elective deferral limit when an executive is also covered by a 403(b) plan. That limit restricts annual deferrals in 401(k), 403(b) and governmental 457(b) plans to a maximum of $19,500 (or $26,000 if age 50 or older) in 2021. (The limits are $20,500/$27,000 for 2022). Top hat participants are subject to the $19,500 maximum but cannot take advantage of the age-50 extra deferral.
Generally, when someone participates in more than one plan at the same time (or at different times during the same year), deferrals in all plans are aggregated for purposes of the deferral limit. This is the case even if the employers sponsoring the plans are considered unrelated under the tax rules. But that’s not the case when one of the plans is a 457(b) plan. This is a huge advantage for executives or other high-paid employees who are eligible for both a 403(b) plan and a top hat plan. They can double up on their elective deferrals – and even take advantage of the age-50 extra deferral in the 403(b) plan.
Example: Amy, age 51, is CFO of a tax-exempt hospital and is eligible for both a 403(b) plan and a 457(b) top-hat plan. Since her 457(b) and 403(b) deferrals are not aggregated, she could defer up to a total of $47,500 in 2022 ($20,500 to the 457(b) and $27,000 to the 403(b)).
The Annual Overall Contribution Limit
Third, 457(b) contributions do not count towards the annual overall contribution limit (sometimes known as the “415 limit”). This limit applies to combined employee and employer contributions made by or on behalf of an employee, as well to as any forfeitures allocated to his account. In 2021, that maximum is $58,000, or $64,500 if age-50 deferrals are made. (The limits increase to $61,000/$67,500 for 2022.) When someone participates in multiple plans sponsored by the same employer (or separate employers considered one employer under the tax rules), contributions made to all of those plans are normally aggregated for purposes of the overall limit. However, when one of the multiple plans is a 457(b) plan, 457(b) contributions are not taken into account.
Example: If Amy (the hospital CFO) defers $20,500 to her 457(b) plan and $27,000 to her 403(b) in 2022, she could also theoretically receive up to $40,500 ($67,500 - $27,000) in 403(b) employer contributions without exceeding the overall limit. This is because her 457(b) contributions are disregarded for the $67,500 limit. Practically, however, Amy would likely be unable to receive such a high employer contribution because of rules requiring those contributions to be made proportionately among all employees. However, a smaller employer contribution could be possible.
The 3-Year Catch-Up Contribution
Finally, 457(b) participants can make a special catch-up contribution for each of the last three years before the employee’s “normal retirement age” under the plan. However, this catch-up is available only to the extent employees have not maximized prior-year 457(b) deferrals. This extra deferral opportunity allows some employees near retirement to make 457(b) deferrals up to twice the usual elective deferral limit for three years. When added to the elective deferrals and employer contributions available under the 403(b) plan, this can be incredibly lucrative.
Example: Dr. Westphall, age 62, is chief of the medical staff at a tax-exempt hospital that offers a 403(b) plan for all employees and a 457(b) top hat plan. Dr. Westphall is eligible for both, but he has not previously deferred into the 457(b). He will retire on Dec. 31, 2024. If the plan permits, Dr. Westphall could defer in 2022 up to twice the 2022 elective deferral limit ($41,000) in the 457(b) and another $27,000 in the 403(b), for a total of $68,000. For the three-year period before retirement (2022-2024), his total deferrals could be as high as $204,000 – and even more if the deferral limit goes up. And this doesn’t include any employer contributions he might receive under the 403(b) plan.
Several unique tax rules governing 457(b) plans make top-hat plans extremely valuable perks for management and other high-paid employees of tax-exempt companies – especially when combined with 403(b) plans.
Keep in mind, however, that top-hat plans do have their downside. As discussed above, employee deferrals must remain company assets and are not protected from the company’s creditors.
In addition, top hat participants may not roll over their distribution to IRAs or other employer plans (although transfers to other top hats plans are permitted). This inability to roll over top hat plan assets to an IRA could mean large taxable distributions at retirement. Still, all in all, the top hat/403(b) combination offers a powerful tool for eligible employees to defer large amounts of their compensation.
About the author: Ian Berger, J.D., is an IRA Analyst with Ed Slott and Company, LLC with over 30 years of experience with retirement plan and IRA issues working in both the private and public sectors. Get more information on Ed Slott and Company’s Virtual 2-Day IRA Workshop, Instant IRA Success. Plus, See Slott’s updated and No. 1 new book, "The New Retirement Savings Time Bomb." Click here to receive Ed Slott and Co.’s monthly IRA Updates eNewsletter, featuring important breaking news and trending topics in the IRA world.