Many governmental 457(b) deferred compensation and 401(a) defined contribution plan sponsors do not take full advantage of the contribution limits for these plans. To do this, you need to understand: the limits, who they apply to, how they coordinate and your ability to target contributions.
First, the limits. Most public agencies have both a defined contribution 401(a) plan and at least one 457(b) plan. The total employer and/or employee contributions (plus forfeiture allocations) to a 401(a) for a given year – generally, the plan year – is limited to an indexed dollar amount or 100 percent of the participant’s compensation, whichever is less. For plan years beginning in 2020, the dollar limit is $57,000. The 457(b) plan is subject to a separate “deferral” limit, which is determined for each calendar year. For 2020, the annual deferral limit is the lesser of $19,500 or 100 percent of the participant’s compensation. Participants in a 457(b) plan also can make “catch-up” contributions either: following their attainment of age 50 (age-50 catch-up) or during their last 3 years prior to normal retirement age (last-three catch-up). The age-50 catch-up amount (adjusted annually) stands at $6,500 and can be made by either the employer or the employee. The last-three catch-up is equal to the lesser of twice the applicable deferral limit or the aggregate of “underutilized” deferral limits for prior years. As a result, a participant who fully used his or her deferral limit each year would not have a last-three catch-up amount available to them. The 457(b) limit is on a per-employee basis, even if you have multiple plans or the employee participates in a 457(b) sponsored by another employer.
Second, coordinating the limits. The 401(a) limit is separate from the 457(b) limit. A 401(a) and 457(b) plan participant who is at least 50 and who makes at least $57,000 annually could theoretically receive a $57,000 employer contribution in the 401(a) and make pre-tax deferrals of $26,000 into the 457(b) – this is without resort to the last-three catch-up, which may still also be available (age 50 catch-up and last-three catch-up can’t be used simultaneously in the same year). Note that the $26,000 “deferral limit” described above can consist of employee pre-tax deferrals, employer pre-tax contributions, or a combination of the two. As a result, an agency could make the full $26,000 contribution to a 457(b) participant who is eligible for the age-50 catch-up, and make a $57,000 employer contribution to its 401(a) – a total of $83,000 for the year!
Third, targeting your contributions. Armed with an understanding of these limits and how they apply, most cities and special districts have several options for better “limit” utilization:
- Match employees’ 457(b) pre-tax deferrals with employer contributions to your 401(a). Because employees can save on taxes by making pre-tax deferrals to the 457(b), many prefer not to have the overall limit used up by employer matching contributions. If you are an employer that makes matching contributions to your 457(b), consider adopting a 401(a) or redesigning your 401(a) so that the matching is done there (and applies against the separate 401(a) limit).
- Use your 457(b) and 401(a) limits to benefit employees on a targeted basis. In a post-PEPRA world, there is more interest in providing “make-up” or “targeted” employee benefits to new hires, certain bargaining groups and mission-critical employees. Public agencies have the freedom to design their 401(a) and 457(b) plans to make special or targeted employer nonelective contributions for certain individuals or groups of individuals. These employer nonelective contributions can be set up as fixed dollar or formula amounts (e.g., 5 percent of pay), or with the right document can be determined annually by the employer on a discretionary basis. If appropriate, the 401(a) plan could use a vesting schedule to “encourage” longevity. If you are doing this, remember that PEPRA contains limitations on the rates of contribution to a defined contribution plan for new hires who also participate in a defined benefit plan, such as CalPERS.
- Use your limits to “convert” excess or unused paid time off. If done properly, amounts of excess or unused PTO can be “converted” by the employer (not at the election of the employee) on a mandatory basis into a 401(a) contribution. This tool may be particularly important to employees who have accumulated more PTO than they can use and who are concerned about building their retirement savings. A mandatory conversion of PTO, if done properly, should not create the tax problems associated with an elective cash-out or conversion.
- Unlike contributions to a 457(b) plan, by the employee or employer, employer contributions to a 401(a) defined contribution plan are not subject to FICA taxes (Medicare and, if applicable, Social Security).
401(a) and 457(b) plans are more useful than many plan sponsors realize. Regardless of how you are using these plans currently, you should consider whether they can be re-designed to help both you and your employees. You should seek expert advice because these plans are subject to many other rules and restrictions.