State and Local Government Deferred Compensation Programs
Harm, Kathy, Government Finance Review
Since 1979, Section 457 of the Internal Revenue Code (the Code) has permitted state and local governments to offer deferred compensation programs to their employees. This employer-sponsored retirement accumulation vehicle is the single most important voluntary, tax-deferred retirement supplement available to employees of state and local governments.
Section 457 deferred compensation programs have grown to hold approximately $28 billion in assets and be available to as many as 95 percent of the employees who would be eligible to participate. Several factors exist which make these employee benefit programs extremely attractive to local government employers and their employees. The following discussion is intended to briefly describe these deferred compensation programs and provide a review of the programs' benefits to participants and employers.
Deferred Compensation Program
An "eligible deferred compensation plan" of a state or local government (or its agency or instrumentality) complies with Code Section 457 and allows employees to set aside, through payroll deduction, an amount up to 33 1/3 percent of Form W-2 reported taxable compensation or $7,500, whichever is less. (In the absence of any other tax-advantaged employee benefit programs, 33 1/3 percent of taxable compensation is generally equivalent to 25 percent of gross income.)
The contributions and any gains from investments are excluded from federal income tax until paid or made available to the participant. All funds must remain the property of the employer, a tax-exempt entity, until paid or available to the participant.
The Code additionally has distribution provisions, allowing payment of benefits not earlier than separation from service, attainment of age 70 1/2 or due to an unforeseeable emergency and requiring certain minimum distributions.
Program Benefits to Participants
Employees who participate in deferred compensation programs derive three primary benefits: lower taxable income through current deferral, accumulation of tax-deferred assets to produce income in retirement when individual tax rates may be lower and a portable retirement benefit.
Tax Deferral Advantages. The importance of tax deferral to the individual taxpayer cannot be stressed too strongly. Over time, the effect of tax deferral on contributions and earnings results in a significantly larger accumulation of assets than the same savings on an after-tax basis. This is true even for those taxpayers who do not lower their marginal tax rates in retirement.
Deferring compensation from current income tax allows the same dollar amount dedicated to savings to result in a higher immediate investment than an investment made after the current tax liability is paid. Most states follow the federal tax treatment on compensation deferred through Section 457 plans, and this can provide substantial additional savings. Not only does the individual have the advantage of saving more initially, the deferral of taxes on earnings results in higher effective returns being credited during the accumulation phase.
These tax advantages may be particularly important to individuals who lost the deductibility of individual retirement arrangement contributions when the Tax Reform Act of 1986 linked deductibility to adjusted gross income where a single person or either taxpayer on a joint return was eligible to benefit from an eligible employer-sponsored retirement plan.
Accumulation of Tax-deferred Retirement Savings Assets. The Social Security Administration has estimated that for retirees with more than $20,000 of income annually, only 40 percent is derived from pension and Social Security benefits. Thirty-four percent, the largest single component category, comes from investments. Exhibit 1 displays the typical sources of income for more than $20,000 annual income. The tax advantages and convenience of deferred compensation make it a logical building block in an employee's investment portfolio. …