By Ian Berger, JD
Many sections of the tax code are confusing, but section 457(b) is one of the major offenders. Within that section are the rules for two different types of company retirement plans — governmental plans, and “top hat” plans for management employees of tax-exempt employers like hospitals. The two types of 457(b) plans are subject to a number of different rules. Here are the major differences:
Eligibility. Governmental 457(b) plans can cover all employees, including rank-and-file workers. But top hat plans must be limited to employees who are key management or are highly paid. In a hospital setting, this typically means doctors and high-level executives.
Employee contributions. If you’re in a governmental 457(b) plan, you can make pre-tax deferrals and, if offered by the plan, Roth contributions (but not “traditional” after-tax employee contributions). In a top hat plan, you can only make pre-tax deferrals.
Plan loans. Municipal 457(b) participants can borrow against their accounts (if the plan allows). Top hat plan participants can’t make plan loans.
Accessibility. If you’re in a governmental 457(b) plan and 59 ½ or older, you can take withdrawals while still working. That’s not allowed in a top hat plan.
Rollovers. Municipal workers can roll over 457(b) funds to an IRA or to another employer plan that accepts rollovers. By contrast, top hat funds can’t be rolled over to an IRA or another plan.. However, if the plan allows, they can be transferred tax-free to another employer’s top hat plan that accepts them. If a direct transfer isn’t available (or is available, but isn’t elected), the top hat payout is taxable in the year of distribution.
Creditor protection. A governmental 457(b) participant in personal bankruptcy can completely protect their account from bankruptcy creditors. But someone facing a non-bankruptcy lawsuit only receives the protection offered by state law.
Governmental 45(b) plan funds must be held apart from the employer’s assets in a trust fund. By contrast, top hat plan funds must remain property of the employer. So, even though top hat assets can’t be reached by the employee’s creditors, they can be reached by the employer’s creditors at all times. This makes top hat plans riskier than governmental plans. That level of risk is why Congress limited eligibility to highly-paid employees who can better bear that risk.
To reduce this risk, some employers with top hat plans offer “rabbi trusts,” first offered by a congregation to its rabbi. With a rabbi trust, top hat plan funds still remain subject to the employer’s creditors, but the employee is protected if the employer refuses to pay the promised benefits due to a change of heart or because another entity becomes the employer as a result of a corporate transaction.