[Federal Register Volume 67, Number 89 (Wednesday, May 8, 2002)]
[Proposed Rules]
[Pages 30826-30846]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-11036]



[[Page 30826]]

=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-105885-99]
RIN 1545-AX52


Compensation Deferred Under Eligible Deferred Compensation Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations that would provide 
guidance on compensation deferred under eligible section 457(b) 
deferred compensation plans of state and local governmental and tax-
exempt entities. The regulations reflect the changes made to section 
457 by the Tax Reform Act of 1986, the Small Business Job Protection 
Act of 1996, the Taxpayer Relief Act of 1997, the Economic Growth and 
Tax Relief Reconciliation Act of 2001, the Job Creation and Worker 
Assistance Act of 2002, and other legislation. The regulations would 
also make various technical changes and clarifications to the existing 
final regulations on many discrete issues. These regulations provide 
the public with guidance necessary to comply with the law and will 
affect plan sponsors, administrators, participants, and beneficiaries. 
The document also provides a notice of public hearing on these proposed 
regulations.

DATES: Written and electronic comments must be received by August 6, 
2002. Requests to speak and outlines of topics to be discussed at the 
public hearing scheduled for August 28, 2002, must be received no later 
than August 7, 2002.

ADDRESSES: Send submissions to CC:ITA:RU (REG-105885-99), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered between the hours of 8 a.m. 
and 5 p.m. to CC:ITA:RU (REG-105885-99), Courier's Desk, Internal 
Revenue Service, 1111 Constitution Avenue NW., Washington, DC. 
Alternatively, taxpayers may submit comments electronically directly to 
the IRS Internet site at www.irs.gov/regs. The public hearing will be 
held in the IRS Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, please 
contact Cheryl Press, (202) 622-6060 (not a toll-free number). To be 
placed on the attendance list for the hearing, please contact LaNita 
Van Dyke at (202) 622-7180 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information in this notice of proposed rulemaking 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under 
control number 1545-1580.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to the collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On September 23, 1982, final regulations (TD 7836) under section 
457 of the Internal Revenue Code of 1954 (Code) were published in the 
Federal Register (47 FR 42335) (September 27, 1982) (final 
regulations). The final regulations provide guidance for complying with 
the changes to the applicable tax law made by the Revenue Act of 1978 
(92 Stat. 2779) relating to deferred compensation plans maintained by 
state and local governments and rural electric cooperatives. These 
proposed regulations would amend the final regulations to conform them 
to the many amendments made to section 457 by subsequent legislation, 
including section 1107 of the Tax Reform Act of 1986 (TRA '86) (100 
Stat. 2494), section 1404 of the Small Business Job Protection Act of 
1996 (SBJPA) (110 Stat. 1755) (1996), section 1071 of the Taxpayer 
Relief Act of 1997 (TRA '97) (111 Stat. 788) (1997), sections 615, 631, 
632, 634, 635, 641, 647, 649, and other sections of the Economic Growth 
and Tax Relief Reconciliation Act of 2001 (EGTRRA) (115 Stat. 38) 
(2001), and paragraphs (o)(8) and (p)(5) of section 411 of the Job 
Creation and Worker Assistance Act of 2002 (116 Stat. 21) (2002). These 
proposed regulations would also amend the final regulations to provide 
additional guidance on section 457 issues raised since the final 
regulations were published in 1982. This document also incorporates the 
guidance provided in Notice 98-8 (1998-1 C.B. 355), with respect to 
amendments made to section 457 by the SBJPA and TRA '97, including the 
section 457(g) trust requirement for eligible plans of state and local 
governments (eligible governmental plans).

Explanation of Provisions

Overview

    The proposed regulations would provide broad guidance regarding the 
rules applicable to eligible deferred compensation plans described in 
section 457(b) (eligible plans) and, in particular, provide clear 
standards for the administration and operation of eligible plans. The 
proposed regulations would amend the existing final regulations to 
update them for changes in the law, including the many changes made by 
EGTRRA, and respond to the comments and inquiries received from state 
and local governments and tax-exempt employers that sponsor eligible 
plans, from participants and beneficiaries, and from service providers 
and other advisors.
    The proposed regulations at Secs. 1.457-1 through 1.457-3 include a 
general overview of section 457, as applicable to both eligible plans 
and ineligible plans that are subject to section 457(f), and general 
definitional provisions. Specific rules applicable to eligible plans 
are contained in proposed Secs. 1.457-4 through 1.457-10, while rules 
applicable to those deferred compensation plans that fail to satisfy 
the requirements applicable to eligible plans (ineligible plans) are 
contained in proposed Sec. 1.457-11.
1. General Provisions and Establishment of Eligible Plans
    Section 457, as amended by TRA '86, applies to tax-exempt employers 
as well as to state and local governments. Eligible employers may 
maintain eligible plans, which must satisfy the requirements of section 
457(b) in both form and operation, or may maintain ineligible plans. 
Benefits under eligible plans are excludable from income of plan 
participants until paid, in the case of an eligible governmental plan, 
or, in the case of an eligible plan of a tax-exempt employer, until 
paid or made available. Benefits under ineligible plans are, under 
section 457(f), includible in income when deferred or, if later, when 
rights to the benefits are not subject to a substantial risk of 
forfeiture. Certain types of plans of state and local government and 
tax-exempt entities are not subject to section 457. These types are 
listed in the definition of plan in proposed Sec. 1.457-2.

[[Page 30827]]

    The proposed regulations make clear that the requirements of 
section 457(b) for eligible plans apply to both elective contributions 
and to other types of contributions, such as mandatory contributions, 
nonelective employer contributions, and employer matching 
contributions. Thus, for example, proposed Sec. 1.457-2(b) defines 
annual deferrals to include both elective salary reduction 
contributions and nonelective employer contributions. Annual deferrals 
also include compensation deferred under eligible plans that are 
defined benefit plans.
    An eligible plan must satisfy the requirements of section 457(b) 
and related provisions both in form and in operation. Under the 
proposed regulations, an eligible plan must be established in writing, 
must include all of the material terms for benefits under the plan, and 
must be operated in compliance with the requirements reflected in the 
regulations. Of course, plan sponsors retain flexibility in determining 
whether to provide certain design options permitted under section 457. 
For example, although these proposed regulations permit certain in-
service distributions of smaller account balances in accordance with 
section 457(e)(9), an eligible plan is not required to offer 
participants this distribution option. However, any optional features 
incorporated into an eligible plan must meet the requirements of 
section 457 and the regulations in both form and operation.
    All amounts deferred under an eligible governmental plan are 
required to be set aside in a trust, custodial account, or annuity 
contract for the exclusive benefit of participants and their 
beneficiaries. However, under section 457(b)(6), all amounts deferred 
under an eligible plan of a tax-exempt employer are required to be 
unfunded. This requirement for an eligible plan of a tax-exempt 
employer does not alter any provision of Title I of the Employee 
Retirement Income Security Act of 1974 (ERISA). Accordingly, an 
eligible plan of a tax-exempt employer may be subject to certain of the 
requirements of Title I. In the case of an eligible plan of a tax-
exempt employer that is subject to Title I of ERISA, compliance with 
the exclusive purpose, trust, funding, and certain other rules will 
cause the plan to fail to satisfy section 457(b)(6). See Q&A-25 of 
Notice 87-13 (1987-1 C.B. 432).
    The proposed regulations include certain basic rules regarding the 
taxation of contributions and benefits under ineligible plans, 
especially the relationship between deferred compensation under an 
ineligible plan and property transfers to which section 83 applies, but 
are not intended to provide complete or comprehensive guidance under 
section 457(f). Similarly, the proposed regulations refer to, but do 
not provide specific guidance on, certain arrangements that are not 
treated as plans providing deferred compensation, such as bona fide 
severance pay plans described in section 457(e)(11).
2. Annual Deferrals, Deferral Limitations, and Deferral Agreements 
Under Eligible Plans
a. Annual Deferrals
    Proposed Sec. 1.457-4 sets forth rules regarding deferrals under 
eligible plans under section 457(b). The proposed regulations would 
expand the rules contained in the final regulations. Examples have been 
included in order to illustrate the application of the rules to 
specific circumstances and to address common questions and situations 
encountered in the administration of eligible plans.
    The proposed regulations use the term annual deferrals to describe 
all amounts contributed or deferred under an eligible plan, whether by 
voluntary salary reduction contribution or by other employer 
contribution, and all earnings thereon. If, as is typical, amounts 
contributed to the eligible plan are fully vested, the total of amounts 
contributed to the eligible plan during a taxable year is the same as 
the total of the annual deferrals for the taxable year.
    The proposed regulations would also clarify that the rules 
concerning agreements for deferrals operate on a cash basis. Thus, 
under proposed Sec. 1.457-4(b), an agreement to defer compensation is 
valid if it is made before the first day of the month in which 
compensation is paid or made available. In general, there is no 
requirement that the agreement be entered into prior to the time the 
services giving rise to the compensation are performed. However, 
compensation payable in the first month of employment may be deferred 
only if an agreement is entered into prior to the time a participant 
performs services for the employer. The proposed regulations provide 
explicitly that nonelective employer contributions are treated as being 
made under a valid agreement. In addition, Rev. Rul. 2000-33 (2000-2 
C.B. 142), provides guidance concerning automatic enrollment under 
eligible plans. Contributions made under an automatic enrollment 
arrangement described in that Revenue Ruling may be treated as made 
under a valid agreement.
b. Deferral Limitations
    The proposed regulations under Sec. 1.457-4 explain the annual 
limits that apply to annual deferrals under eligible plans. These 
contribution limits are sometimes referred to as ``plan ceilings.'' 
Generally, the basic annual limit or plan ceiling for a year cannot 
exceed a specified dollar amount for the year or, if less, 100 percent 
of a participant's ``includible compensation.'' Under EGTRRA, the 
dollar amount is $11,000 for 2002; $12,000 for 2003; $13,000 for 2004; 
$14,000 for 2005; and $15,000 for 2006 and thereafter. After 2006, the 
$15,000 amount is adjusted for cost-of-living. As a result of the 
enactment of the Job Creation and Worker Assistance Act of 2002, Public 
Law 107-147 (116 Stat. 21) on March 9, 2002, the calculation of 
includible compensation is no longer reduced by the exclusions from 
gross income under sections 402(g), 125, 132(f), and 457. Thus, for 
years beginning after December 31, 2001, includible compensation is no 
longer reduced by elective deferrals to an eligible plan. If a 
participant's includible compensation is less than the applicable 
dollar limit, the dollar amount equal to 100 percent of includible 
compensation is the basic annual limit for the participant.
    An eligible plan may also permit certain ``catch-up'' 
contributions. First, in accordance with section 414(v) as added to the 
Code by EGTRRA, a plan may allow a participant who attains age 50 by 
the end of the year to elect to have an additional deferral for the 
year. The additional amount permitted under this age 50 catch-up is 
$1,000 for 2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005, and 
$5,000 for 2006. Proposed regulations (REG-142490-01) under section 
414(v) were published in the Federal Register on October 23, 2001 (66 
FR 53555) as Sec. 1.414(v)-1.
    Second, an eligible plan may permit a larger catch-up amount in the 
last three years ending before the participant attains normal 
retirement age. The amount of this special section 457 catch-up is two 
times the basic annual limit (e.g., an additional $15,000 for 2006), 
but only to the extent the participant has not previously deferred the 
maximum amount under an eligible plan or similar tax-deferred 
retirement plan (called the underutilized amount or underutilized 
limitation in the proposed regulations). Alternatively, the age 50 
catch-up is available in the last three years ending before the 
participant attains normal retirement age if the age 50 catch-up amount 
is larger than the special section 457 catch-up amount.

[[Page 30828]]

Under the proposed regulations, a participant may not elect to have the 
special section 457 catch-up apply more than once, unless the 
participant is covered by a plan of another employer. If a participant 
also or later participates in an eligible plan of a different employer 
and otherwise meets the requirements for limited catch-up, the 
participant may elect under the new plan to have the special section 
457 catch-up apply.
    For purposes of the special section 457 catch-up, the proposed 
regulations provide that the plan must designate a normal retirement 
age between the age at which participants have the right to receive 
immediate retirement benefits under the basic pension plan of the state 
or tax-exempt entity without actuarial or similar reduction and age 
70\1/2\. Alternatively, a plan may provide that a participant is 
allowed to designate a normal retirement age within these ages. The 
proposed regulations provide a special rule for defining normal 
retirement age in eligible plans of qualified police or firefighters as 
defined under section 415(b)(2)(H)(ii)(I), taking into account that 
these participants are often eligible for retirement at a younger age 
than other workers.
    The proposed regulations require an eligible plan to set forth the 
plan's normal retirement age. However, as discussed in this preamble 
under Proposed Effective Date, plan amendments to reflect this 
requirement are not required to be adopted until guidance is issued 
addressing when plan amendments must be adopted.
3. Individual Limitation for Combined Annual Deferrals Under Eligible 
Plans
    Before enactment of EGTRRA, a coordination limitation applied under 
which the basic annual limitation and the special section 457 catch-up 
limitation were reduced by amounts excluded from a participant's income 
for any taxable year by reason of a salary reduction or elective 
contribution under a section 401(k) plan or a section 403(b) contract. 
EGTRRA eliminated coordination with section 401(k) plans and section 
403(b) contracts for 2002 and thereafter. However, coordination with 
these types of arrangements is still taken into account for purposes of 
determining the underutilized amount for years before 2002, so that 
these rules continue to be reflected in the proposed regulations for 
that sole purpose.
    EGTRRA did not eliminate section 457(c) under which the maximum 
amount excludable under all eligible plans, including eligible 
governmental plans and eligible plans of a tax-exempt entity, cannot 
exceed applicable section 457 plan limitations. Thus, these 
limitations, including the basic limitation, the age 50 catch-up 
limitation, and the special section 457 catch-up limitation, apply not 
only on a plan basis, but also on an individual basis for cases in 
which an individual participates in more than one eligible plan during 
a taxable year. The proposed regulations include rules for how the 
applicable section 457 limitations apply on an individual basis. The 
rules for applying catch-up limits on an individual basis provide that 
the special section 457 catch-up available in the last three years 
prior to normal retirement age is taken into account only to the extent 
that an annual deferral is made for a participant under an eligible 
plan as a result of plan provisions permitted under the special section 
457 catch-up and, if the applicable catch-up amount is not the same for 
each such eligible plan, the individual limit is applied using the 
catch-up amount under whichever plan that has the largest catch-up 
amount applicable to the participant. However, as discussed above, a 
participant may not elect to have the special section 457 catch-up 
apply more than once, unless the participant is covered by a plan of 
another employer.
    The proposed regulations allow an eligible governmental plan to pay 
out an annual deferral to the extent the deferral exceeds the 
individual limit or to correct a deferral in excess of the plan's 
limit.
4. Sick and Vacation Pay Deferrals
    The proposed regulations would permit an eligible plan to provide 
that a participant may elect to defer accumulated sick pay, accumulated 
vacation pay, and back pay if certain conditions are satisfied. In 
accordance with section 457(b)(4), the plan must provide that these 
amounts may be deferred for any calendar month only if an agreement 
providing for the deferral is entered into before the beginning of the 
month in which the amounts would otherwise be paid or made available to 
the participant. Thus, a participant is not permitted to elect to 
receive the value of accumulated sick and vacation pay on or after the 
date on which the employer makes that pay available to the participant 
in cash. Any deferrals under an eligible plan of sick and vacation pay 
or back pay are subject to the maximum deferral limitations of section 
457 in the year of deferral. Thus, the total amount deferred for any 
year cannot exceed the plan ceiling for the year, taking into account 
the 100 percent of includible compensation limit.
5. Excess Deferrals
    The proposed regulations address the treatment of excess deferrals 
and the effect of excess deferrals on plan eligibility under section 
457(b). The proposed regulations also provide that an eligible 
governmental plan may self correct excess deferrals and will not fail 
to satisfy the applicable requirements of the proposed regulations 
(including the distribution rules and the funding rules) solely by 
reason of a distribution of excess deferrals.
    Under the proposed regulations, if an excess deferral arises under 
the maximum deferral limits of section 457(b) for a plan of a 
governmental employer, an eligible governmental plan is required to 
correct the failure by distributing the excess deferral to the 
participant, with allocable net income, as soon as administratively 
practicable after the plan determines that the amount would be an 
excess deferral. If excess deferrals of this type are not distributed, 
the plan will be an ineligible plan with respect to which benefits are 
taxed according to the rules of section 457(f). If an excess deferral 
arises under the maximum deferral limits of section 457(b) for a plan 
of a tax-exempt employer, the plan is not an eligible plan. For 
purposes of these rules, all plans under which an individual 
participates by virtue of his or her relationship with a single 
employer are treated as a single plan.
    As stated previously, while EGTRRA repealed the coordination 
limitation under section 457(c), EGTRRA did not eliminate the 
requirement that the maximum amount excludable under all eligible plans 
under section 457(c) as revised by EGTRRA, including eligible 
governmental plans and eligible plans of a tax-exempt entity, cannot 
exceed the applicable section 457(b) limitations. Thus, an excess 
deferral that results from the application of the new individual 
limitation for multiple eligible plans under section 457(c) may also 
be, but is not required to be, distributed to the participant. However, 
consistent with the legislative history to section 457(c), the proposed 
regulations make clear that a plan will not lose its status as an 
eligible plan by failing to distribute those excess deferrals that 
result from the application of this requirement (although those amounts 
are currently includible in the participant's income).
    Comments are specifically requested concerning record-keeping 
requirements with respect to excess deferrals that are not distributed 
and, in particular,

[[Page 30829]]

concerning the maintenance of records adequate to keep track of any 
previously taxed excess deferrals that remain in an eligible plan. In 
addition, comments are also requested as to the proper income and 
payroll tax reporting of distributions of excess deferrals.
6. Minimum Distribution Requirements
    EGTRRA eliminated the special minimum distribution rules that 
applied to eligible plans. Thus, the proposed regulations generally 
incorporate by reference the requirements of section 401(a)(9) and the 
regulations thereunder concerning minimum distributions to participants 
and beneficiaries. Final and temporary regulations (TD 8987) under 
section 401(a)(9) were published in the Federal Register on April 17, 
2002 (67 FR 18988). These regulations provide rules for defined benefit 
plans and defined contribution plans. Generally, the rules for defined 
contribution plans apply to eligible deferred compensation plans. 
Beginning in 2003, a simple uniform table generally applies to all 
employees to determine the minimum distribution required during their 
lifetime, including employees covered by an eligible deferred 
compensation plan.\1\ The one exception to this rule for lifetime 
distributions is for an employee with a spouse designated as the 
employee's sole beneficiary and the spouse is more than 10 years 
younger than the employee. In that case the employee can use the 
employee and spouse's joint and last survivor expectancy to determine 
the minimum distribution required during the employee's lifetime.
---------------------------------------------------------------------------

    \1\ Employees may use these new final regulations for 
distributions for 2002 or may use regulations proposed in 1987 or 
2001.
---------------------------------------------------------------------------

7. Loans
    Proposed Sec. 1.457-6(f) sets forth rules governing loans from 
eligible plans. This proposal responds to the numerous inquiries 
received concerning the availability of loans from eligible plans 
maintained by state and local governments, the assets of which are held 
in trust pursuant to section 457(g).
    While section 457(g) does not directly address the issue of 
whether, or under what circumstances, loans may be made available from 
trusteed eligible plans, the legislative history to the SBJPA indicates 
that the new statutory provisions should be interpreted as permitting 
participant loans from the eligible plan trust under the rules 
applicable to loans from qualified plans. H.R. Rep. 104-737, at 251. 
Commentators, some citing this legislative history and some citing pre-
ERISA case law and rulings interpreting the exclusive benefit 
requirement of section 401(a), have urged the IRS to issue formal 
guidance concerning loans from eligible plans. These comments take the 
position that the availability of loans will make savings through 
eligible plans more attractive to participants and will decrease the 
disparity between eligible plans and the other tax-favored voluntary 
retirement savings plans.
    The pre-ERISA requirements applicable to loans from qualified plans 
require a facts and circumstances analysis of the availability of the 
loan feature to all participants, the rate of return, the overall 
prudence of the investment of the trust corpus in the note of an 
individual participant, and the pattern of repayments. See, e.g., 
Central Motor Co. v. United States, 583 F. 2d 470, 488-491 (10th Cir. 
1978); Winger's Department Store v. Commissioner, 82 T.C. 869 (1982); 
Ma-Tran Corp. v. Commissioner, 70 T.C. 158 (1978); and Feroleto Steel 
Co. v. Commissioner, 69 T.C. 97 (1977). See also Rev. Rul. 67-258 
(1967-2 CB 68).
    Under the proposed regulations, a loan from an unfunded eligible 
plan of a tax-exempt organization would be treated as an impermissible 
distribution, in violation of the requirements of section 457. However, 
for loans from an eligible governmental plan, the proposed regulations 
include a facts and circumstances general standard. This general 
standard is intended to apply to determine whether the loan is bona 
fide and for the exclusive purpose of benefitting participants and 
beneficiaries under section 457(g), as was required under pre-ERISA law 
for qualified plans. Among the facts and circumstances are whether the 
loan has a fixed repayment schedule and a reasonable interest rate, and 
whether there are repayment safeguards to which a prudent lender would 
adhere.\2\ The proposed regulations require a loan to bear a reasonable 
rate of interest in order to satisfy the requirement that assets and 
income of an eligible governmental plan be held for the exclusive 
benefit of participants and their beneficiaries. The proposed 
regulations would also clarify that section 72(p) applies with respect 
to loans made under an eligible governmental plan. Regulations 
interpreting section 72(p)(2) are at Sec. 1.72(p)-1.
---------------------------------------------------------------------------

    \2\ See, for example, the standards in Rev. Rul. 69-494 (1969-2 
C.B. 88) for determining when plan investments are primarily for the 
purpose of benefitting employees or their beneficiaries.
---------------------------------------------------------------------------

    If the proposed regulations are finalized in their current form, it 
is anticipated that the IRS will modify its current no-rule position 
regarding the issuance of private letter rulings to eligible plans that 
provide for loans.
8. Distributions From Eligible Plans
a. Eligible Governmental Plans
    EGTRRA substantially altered the taxation of distributions from an 
eligible governmental plan by providing that amounts held under such an 
eligible plan are not included in a participant's or beneficiary's 
gross income until distributed. The proposed regulations would 
interpret this EGTRRA change as applying to all participants in an 
eligible governmental plan. Thus, an eligible governmental plan may 
permit participants who are currently entitled to be paid after 2001 to 
change their previously irrevocable payment elections.
    Under EGTRRA, after 2001, the direct rollover rules applicable to 
qualified plans and section 403(b) contracts will apply to 
distributions from an eligible governmental plan. The direct rollover 
rules for qualified plans and section 403(b) contracts are generally 
explained at Secs. 35.3405-1, 31.3405(c)-1, 1.401(a)(31)-1, 1.402(c)-2, 
and 1.402(f)-1. These direct rollover regulations have not been updated 
since EGTRRA to reflect that rollovers are permitted for distributions 
from eligible governmental plans (nor do those regulations reflect that 
amounts may be rolled over to eligible governmental plans after 2001).
b. Eligible Plans of Tax-Exempt Entities
    Amounts deferred under an eligible plan of a tax-exempt entity 
continue to be taxable when paid or made available. The proposed 
regulations explain these rules, including the exceptions for amounts 
available in the event of unforeseeable emergency and distributions of 
smaller accounts (not in excess of $5,000).
9. Plan terminations and plan-to-plan transfers
    The proposed regulations address the topic of plan terminations and 
plan-to-plan transfers. These topics have become increasingly important 
in light of the recent statutory changes that impose a trust 
requirement on eligible governmental plans. In particular, questions 
have been raised with respect to hospitals and other entities that 
change from government to private entities, whether or not tax-exempt. 
The direct rollovers that will be permitted by EGTRRA beginning in 2002 
for eligible governmental plans provide participants affected by these 
types of events the ability to retain their retirement savings in a 
funded, tax-deferred savings vehicle

[[Page 30830]]

by rollover to IRAs, qualified plan, or section 403(b) contracts. The 
proposed regulations provide a blueprint for the different plan 
termination and plan-to-plan transfer alternatives available to 
sponsors of eligible plans in these situations.
a. Plan Terminations
    The proposed regulations would allow a plan to have provisions 
permitting plan termination whereupon amounts could be distributed 
without violating the distribution requirements of section 457. Under 
the proposed regulations, an eligible plan is terminated only if all 
amounts deferred under the plan are paid to participants as soon as 
administratively practicable. If the amounts deferred under the plan 
are not distributed, the plan is treated as a frozen plan and must 
continue to comply with all of the applicable statutory requirements 
necessary for plan eligibility. The proposed regulations generally 
follow the approach of Rev. Rul. 89-87 (1982-2 C.B. 81), which provides 
guidance on the termination of qualified plans. In that revenue ruling, 
a qualified plan under which benefit accruals have ceased is not 
terminated if assets of the plan remain in the plan's related trust 
rather than being distributed as soon as administratively feasible.
    The proposed regulations also highlight the consequences to the 
plan in the case of an employer that ceases to be an eligible employer 
but fails to terminate the plan or to transfer its assets under the 
rules of the proposed regulations described below.
b. Plan-to-plan Transfers
    The proposed regulations would clarify that transfers between 
certain types of eligible plans do not violate the requirements of 
section 457(b), including the distribution requirements of section 
457(d), if certain conditions are satisfied. Thus, an eligible 
governmental plan may transfer its assets to another eligible 
governmental plan; likewise, an unfunded, tax-exempt plan may transfer 
amounts deferred to another unfunded, tax-exempt plan. However, in the 
same manner that rollovers are not permitted between unfunded plans of 
tax-exempt employers and funded governmental plans (and because of 
potential violations of the exclusive benefit rule applicable to 
eligible governmental plans), amounts cannot be transferred from an 
eligible plan of a tax-exempt employer to an eligible governmental plan 
or from an eligible governmental plan to an eligible plan of a tax-
exempt employer.
    Plan-to-plan transfers within similar types of eligible plans are 
permitted in two kinds of circumstances. First, it is contemplated that 
transfers may occur when a participant in the transferor plan 
terminates employment with the transferor employer and is employed by 
the transferee employer. Transfers with respect to individual 
participants are permitted if both plans agree to the transfer, the 
participant has terminated employment with the transferor, and the 
participant whose amounts deferred are being transferred will have an 
amount deferred immediately after the transfer at least equal to the 
amount deferred immediately before the transfer.
    Second, the proposed regulations also contemplate certain asset 
transfers of all amounts deferred under the plan in the event an 
activity of a state or local government is privatized or otherwise 
ceases to be performed by a governmental entity. Thus, as an 
alternative to plan termination or a plan-to-plan transfer, the 
proposed regulations provide that a government employer that loses its 
eligible status may transfer the eligible plan to another eligible 
government employer within the same state. For example, a county 
hospital that maintains an eligible plan and that ceases to be a 
governmental entity could transfer the plan to the county for continued 
administration.
    The proposed regulations also address transfers between eligible 
governmental plans and qualified defined benefit plans with respect to 
past service credit. Because the proposed regulations specifically 
state that a transfer for past service credit is not treated as a 
distribution for purposes of section 457, such a transfer could be made 
while the participant is still working.
10. Qualified Domestic Relations Orders
    The proposed regulations address the issue of qualified domestic 
relations orders (QDROs). The administration of QDROs has created 
difficulties for eligible employers and section 457 plan administrators 
and participants, and numerous inquiries and private letter ruling 
requests involving the application of judicial domestic relations 
orders to participants' accounts in eligible section 457(b) deferred 
compensation plans have been received. The proposed regulations provide 
that an eligible plan may honor the terms of a QDRO without 
jeopardizing its eligible status.
    Under the proposed regulations, as provided under section 457 as 
amended by EGTRRA, an eligible plan does not become an ineligible plan 
described in section 457(f) solely because its administrator or sponsor 
complies with a QDRO described in section 414(p) (taking into account 
the special rule section 414(p)(11) for governmental and church plans), 
including a QDRO requiring the distribution of the benefits of a 
participant to an alternate payee in advance of the general rules for 
eligible plan distributions under Sec. 1.457-6. In the case of an 
eligible governmental plan, amounts paid to the alternate payee who is 
the spouse or former spouse of a participant under the QDRO are taxable 
to the alternate payee when they are paid.
    In the case of an eligible plan of a tax-exempt entity, amounts 
payable to the alternate payee who is the spouse or former spouse of a 
participant under the QDRO are taxable to the alternate payee when they 
are paid or made available to the alternate payee. In addition, amounts 
deferred under an eligible plan of a tax-exempt entity that are 
attributable to the alternate payee are treated as made available on 
the date the alternate payee is first able to receive a distribution.
11. Rollovers to Eligible Plans
    EGTRRA now allows rollovers contributions to be accepted by an 
eligible governmental plan, but only if the receiving eligible 
governmental plan maintains the rollover amount in a separate account. 
The proposed regulations include such rollovers as part of the amount 
deferred under the receiving plan, but a rollover contribution is not 
taken into account as an annual deferral under the plan for purposes of 
the plan ceiling limit on annual deferrals. While EGTRRA does not 
require a separate account for each type of rollover contributions 
(e.g, an account for rollovers from qualified plans which is separate 
from rollovers from section 403(b) contracts), comments are requested 
on whether there are any special characteristics applicable to 
qualified plans, section 403(b) contracts, or individual retirement 
arrangements (IRAs) under section 72(t) (imposing an additional income 
tax on early distributions from such plans, contracts, or arrangements) 
which could be lost if multiple types of separate accounts are not 
maintained.
12. Correction Program for Section 457(b) Eligible Deferred 
Compensation Plans
    Employee Plans, within the office of the Commissioner, Tax Exempt 
and Government Entities (TE/GE), has comprehensive correction programs 
for sponsors of retirement plans (qualified retirement plans, 403(b) 
plans, and Simplified Employee Pensions). These programs, including the 
Employee Plans

[[Page 30831]]

Compliance Resolution System (EPCRS), Rev. Proc. 2001-17 (2001-7 I.R.B. 
589), permit plan sponsors to correct plan defects and thereby continue 
to provide their employees retirement benefits on a tax-favored basis. 
Employee Plans intends to expand the provisions of EPCRS to include 
appropriate correction procedures for certain failures arising under 
eligible deferred compensation plans. The public is invited to submit 
comments to assist in the development of these procedures. Comments 
should be sent to: Internal Revenue Service, Attention: T:EP:RA:VC, 
1111 Constitution Avenue NW, Washington, DC 20224.
    Pending the update of EPCRS, submissions related to section 457 (b) 
eligible deferred compensation plan failures will be accepted by 
Employee Plans on a provisional basis outside of EPCRS.
13. Ineligible Plans
    The proposed regulations include guidance regarding ineligible 
plans under section 457(f). Section 457(f) was in section 457 when it 
was added to the Code in 1978 for governmental employees, and extended 
to employees of tax-exempt organizations (other than churches or 
certain church-controlled organizations) in 1986, because unfunded 
amounts held by a tax-exempt entity compound tax free like an eligible 
plan, a qualified plan, or a section 403(b) contract. Section 457(f) 
was viewed as essential in order to provide an incentive for employers 
that are not subject to income taxes to adopt an eligible plan, a 
qualified plan, or a section 403(b) contract. \3\ Section 457(f) 
generally provides that, in the case of an agreement or arrangement for 
the deferral of compensation, the deferred compensation is included in 
gross income when deferred or, if later, when the rights to payment of 
the deferred compensation cease to be subject to a substantial risk of 
forfeiture. Section 457(f) does not apply to an eligible plan, a 
qualified plan, a section 403(b) contract, a section 403(c) contract, a 
transfer of property described in section 83, a trust to which section 
402(b) applies, or a qualified governmental excess benefit arrangement 
described in section 415(m).
---------------------------------------------------------------------------

    \3\ See generally the Report to the Congress on the Tax 
Treatment of Deferred Compensation under Section 457, Department of 
the Treasury, January 1992 (available from the Office of Tax Policy, 
Room 5315, Treasury Department, 1500 Pennsylvania Avenue, NW., 
Washington DC 20220).
---------------------------------------------------------------------------

    The proposed regulations reflect the statutory changes in section 
457(f) that have been made since 1982--which is when the current 
outstanding regulations were issued--and clarify the interaction 
between sections 457(f) and 83 (relating to the transfer of property in 
connection with the performance of services). Under the proposed 
regulations, section 457(f) does not apply to a transfer of property if 
section 83 applies to the transfer. Further, section 457(f) does not 
apply if the date on which there is no substantial risk of forfeiture 
with respect to the compensation is on or after the date on which there 
is a transfer of property to which section 83 applies. However, section 
457(f) applies if the date on which there is no substantial risk of 
forfeiture with respect to the compensation deferred precedes the date 
on which there is a transfer of property to which section 83 applies. 
The proposed regulations include several examples, including an example 
illustrating that section 457(f) does not fail to apply merely because 
benefits are subsequently paid by a transfer of property. Comments are 
requested on the coordination of section 457(f) and section 83 under 
these proposed regulations.
    In 2000, the IRS issued Announcement 2000-1 (2000-2 I.R.B. 294), in 
which it provided interim guidance on certain broad-based, nonelective 
plans of a state or local government that were in existence before 
1999. Comments are requested on whether similar guidance should be 
included in the final regulations, and, if so, how the guidance should 
apply to arrangements, such as those maintained by certain state or 
local governmental educational institutions, under which supplemental 
compensation is payable as an incentive to terminate employment, or as 
an incentive to retain retirement-eligible employees, to ensure an 
appropriate workforce during periods in which a temporary surplus or 
deficit in workforce is anticipated.

Proposed Effective Date

    It is proposed that these regulations apply generally for taxable 
years beginning after December 31, 2001. This is the general 
applicability date of the changes made in section 457 by EGTRRA. 
Special effective date provisions apply to provisions relating to 
coordination of sections 457(f) and 83 and for qualified domestic 
relations orders. Plan amendments to reflect EGTRRA, and any other 
requirement under these regulations, are not required to be adopted 
until the later of when guidance is issued addressing when plan 
amendments must be adopted or the date final regulations are issued. 
However, employers may rely on these proposed regulations in taxable 
years beginning after August 20, 1996 (which is the earliest 
applicability date for requirements applicable to eligible plans under 
the SBJPA). Comments are requested on whether an applicability date 
later than taxable years beginning after December 31, 2001 should apply 
when the regulations are issued in final form.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, these 
proposed regulations will be submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on small business

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written or electronic comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and Treasury specifically request comments on the clarity 
of the proposed regulations and how they may be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for August 28, 2002, beginning 
at 10 a.m. in the IRS Auditorium of the Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. All visitors must present 
photo identification to enter the building. Because of access 
restrictions, visitors will not be admitted beyond the immediate 
entrance more than 30 minutes before the hearing starts. For 
information about having your name placed on the building access list 
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section 
of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written 
comments and an outline of the topics to be discussed and the time to 
be devoted to each topic (signed original and eight (8) copies) by 
August 7, 2002. A period of 10 minutes

[[Page 30832]]

will be allotted to each person for making comments. An agenda showing 
the schedule of speakers will be prepared after the deadline for 
receiving outlines has passed. Copies of the agenda will be available 
free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Cheryl Press, Office 
of Division Counsel/ Associate Chief Counsel (Tax Exempt and Government 
Entities), IRS. However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows.

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Par. 2. Sections 1.457-1, 1.457-2, 1.457-3 and 1.457-4 are revised 
to read as follows:


Sec. 1.457-1  General overview of section 457.

    Section 457 provides rules for nonqualified deferred compensation 
plans established by eligible employers as defined under Sec. 1.457-
2(d). Eligible employers can establish either deferred compensation 
plans that are eligible plans and that meet the requirements of section 
457(b) and Secs. 1.457-3 through 1.457-10, or deferred compensation 
plans or arrangements that do not meet the requirements of section 
457(b) and Secs. 1.457-3 through 1.457-10 and that are subject to tax 
treatment under section 457(f) and Sec. 1.457-11.


Sec. 1.457-2  Definitions.

    This section sets forth the definitions that are used under 
Secs. 1.457-1 through 1.457-11.
    (a) Amount(s) deferred. Amount(s) deferred means the total annual 
deferrals under an eligible plan in the current and prior years, 
adjusted for gain or loss. Except as otherwise specifically indicated, 
amount(s) deferred includes any rollover amount held by an eligible 
plan as provided under Sec. 1.457-10(e).
    (b) Annual deferral(s)--(1) Annual deferral(s) means, with respect 
to a taxable year, the amount of compensation deferred under an 
eligible plan, whether by salary reduction or by nonelective employer 
contribution. The amount of compensation deferred under an eligible 
plan is taken into account as an annual deferral in the taxable year of 
the participant in which deferred, or, if later, the year in which the 
amount of compensation deferred is no longer subject to a substantial 
risk of forfeiture.
    (2) If the amount of compensation deferred under the plan during a 
taxable year is not subject to a substantial risk of forfeiture, the 
amount taken into account as an annual deferral is not adjusted to 
reflect gain or loss allocable to the compensation deferred. If, 
however, the amount of compensation deferred under the plan during the 
taxable year is subject to a substantial risk of forfeiture, the amount 
of compensation deferred that is taken into account as an annual 
deferral in the taxable year in which the substantial risk of 
forfeiture lapses must be adjusted to reflect gain or loss allocable to 
the compensation deferred until the substantial risk of forfeiture 
lapses.
    (3) If the eligible plan is a defined benefit plan within the 
meaning of section 414(j), the annual deferral for a taxable year is 
the present value of the increase during the taxable year of the 
participant's accrued benefit that is not subject to a substantial risk 
of forfeiture (disregarding any such increase attributable to prior 
annual deferrals). For this purpose, present value must be determined 
using actuarial assumptions and methods that are reasonable (both 
individually and in the aggregate), as determined by the Commissioner.
    (c) Beneficiary. Beneficiary means a beneficiary of a participant, 
a participant's estate, or any other person whose interest in the plan 
is derived from the participant, including an alternate payee as 
described in Sec. 1.457-10(c).
    (d) Catch-up. Catch-up amount or catch-up limitation for a 
participant for a taxable year means the annual deferral permitted 
under section 414(v) (as described in Sec. 1.457-4(c)(2)) or section 
457(b)(3) (as described in Sec. 1.457-4(c)(3)) to the extent the amount 
of the annual deferral for the participant for the taxable year is 
permitted to exceed the plan ceiling applicable under section 457(b)(2) 
(as described in Sec. 1.457-4(c)(1)).
    (e) Eligible employer. Eligible employer means an entity that is a 
state as defined in paragraph (l) of this section that establishes a 
plan or a tax-exempt entity as defined in paragraph (m) of this section 
that establishes a plan. The performance of services as an independent 
contractor for a state or local government or a tax-exempt entity is 
treated as the performance of services for an eligible employer. The 
term eligible employer does not include a church as defined in section 
3121(w)(3)(A), a qualified church-controlled organization as defined in 
section 3121(w)(3)(B), or the Federal government or any agency or 
instrumentality thereof.
    (f) Eligible plan. An eligible plan is a plan that meets the 
requirements of Secs. 1.457-3 through 1.457-10 that is established and 
maintained by an eligible employer. An eligible governmental plan is an 
eligible plan that is established and maintained by an eligible 
employer as defined in paragraph (l) of this section. An arrangement 
does not fail to constitute a single eligible governmental plan merely 
because the arrangement is funded through more than one trustee, 
custodian, or insurance carrier. An eligible plan of a tax-exempt 
entity is an eligible plan that is established and maintained by an 
eligible employer as defined in paragraph (m) of this section.
    (g) Includible compensation. Includible compensation of a 
participant means, with respect to a taxable year, the participant's 
compensation, as defined in section 415(c)(3), for services performed 
for the eligible employer. The amount of includible compensation is 
determined without regard to any community property laws.
    (h) Ineligible plan. Ineligible plan means a plan established and 
maintained by an eligible employer that is not maintained in accordance 
with Secs. 1.457-3 through 1.457-10. A plan that is not established by 
an eligible employer as defined in paragraph (e) of this section is 
neither an eligible nor an ineligible plan.
    (i) Nonelective employer contribution. A nonelective employer 
contribution is a contribution made by an eligible employer for the 
participant with respect to which the participant does not have the 
choice to receive the contribution in cash or property. Solely for 
purposes of section 457 and Secs. 1.457-2 through 1.457-11, the term 
nonelective employer contribution includes employer contributions that 
would be described in section 401(m) if they were contributions to a 
qualified plan.
    (j) Participant. Participant in an eligible plan means an 
individual who is currently deferring compensation, or who has 
previously deferred compensation under the plan by salary reduction or 
by nonelective employer contribution and who has not received a 
distribution of his or her entire benefit under the eligible plan. Only 
individuals who perform services for

[[Page 30833]]

the eligible employer, either as an employee or as an independent 
contractor, may defer compensation under the eligible plan.
    (k) Plan. Plan includes any agreement or arrangement between an 
eligible employer and a participant or participants under which the 
payment of compensation is deferred (whether by salary reduction or by 
nonelective employer contribution). The following types of plan are not 
treated as agreements or arrangement under which compensation is 
deferred: a bona fide vacation leave, sick leave, compensatory time, 
severance pay, disability pay, or death benefit plan described in 
section 457(e)(11)(A)(i) and any plan paying length of service awards 
to bona fide volunteers (and their beneficiaries) on account of 
qualified services performed by such volunteers as described in section 
457(e)(11)(A)(ii). Further, the term plan does not include any of the 
following (and section 457 and Secs. 1.457-2 through 1.457-11 do not 
apply to any of the following)--
    (1) Any nonelective deferred compensation under which all 
individuals (other than those who have not satisfied any applicable 
initial service requirement) with the same relationship with the 
eligible employer are covered under the same plan with no individual 
variations or options under the plan as described in section 
457(e)(12), but only to the extent the compensation is attributable to 
services performed as an independent contractor;
    (2) An agreement or arrangement described in Sec. 1.457-11(b);
    (3) Any plan satisfying the conditions in section 1107(c)(4) of the 
Tax Reform Act of 1986 (TRA `86) (relating to certain plans for state 
judges); and
    (4) Any of the following plans or arrangements (to which specific 
transitional statutory exclusions apply)--
    (i) A plan or arrangement of a tax-exempt entity in existence prior 
to January 1, 1987, if the conditions of section 1107(c)(3)(B) of the 
TRA `86, as amended by section 1011(e)(6) of Technical and 
Miscellaneous Revenue Act of 1988 (TAMRA), are satisfied;
    (ii) A collectively bargained nonelective deferred compensation 
plan in effect on December 31, 1987, if the conditions of section 
6064(d)(2) of TAMRA are satisfied;
    (iii) Amounts described in section 6064(d)(3) of TAMRA (relating to 
certain nonelective deferred compensation arrangements in effect before 
1989); and
    (iv) Any plan satisfying the conditions in section 1107(c)(4) or 
(5) of TRA `86 (relating to certain plans for certain individuals with 
respect to which the Service issued guidance before 1977).
    (l) State. State includes the 50 States of the United States, the 
District of Columbia, a political subdivision of a state or the 
District of Columbia, or any agency or instrumentality of a state or 
the District of Columbia.
    (m) Tax-exempt entity. Tax-exempt entity includes any organization 
(other than a governmental unit) exempt from tax under subtitle A of 
the Internal Revenue Code.
    (n) Trust. Trust means a trust described under section 457(g) and 
Sec. 1.457-8. Custodial accounts and contracts described in section 
401(f) are treated as trusts under the rules described in Sec. 1.457-
8(a)(2).


Sec. 1.457-3  General introduction to eligible plans.

    (a) Compliance in form and operation. An eligible plan is a written 
plan established and maintained by an eligible employer that is 
maintained, in both form and operation, in accordance with the 
requirements of Secs. 1.457-4 through 1.457-10. An eligible plan must 
contain all the material terms and conditions for benefits under the 
plan. An eligible plan may contain certain optional features not 
required for plan eligibility under section 457(b), such as 
distributions for unforeseeable emergencies, loans, plan-to-plan 
transfers, additional deferral elections, acceptance of rollovers to 
the plan, and distributions of smaller accounts to eligible 
participants. However, except as otherwise specifically provided in 
Secs. 1.457-4 through 1.457-10, if an eligible plan contains any 
optional provisions, the optional provisions must meet, in both form 
and operation, the relevant requirements under section 457 and 
Secs. 1.457-2 through 1.457-10.
    (b) Treatment as single plan. In any case in which multiple plans 
are used to avoid or evade the requirements of Secs. 1.457-4 through 
1.457-10, the Commissioner may apply the rules under Secs. 1.457-4 
through 1.457-10 as if the plans were a single plan.


Sec. 1.457-4  Annual deferrals, deferral limitations, and deferral 
agreements under eligible plans.

    (a) Taxation of annual deferrals. Annual deferrals that satisfy the 
requirements of paragraphs (b) and (c) of this section are excluded 
from the gross income of a participant in the year deferred or 
contributed and are not includible in gross income until paid to the 
participant in the case of an eligible governmental plan, or until paid 
or otherwise made available to the participant in the case of an 
eligible plan of a tax-exempt entity. See Sec. 1.457-7.
    (b) Agreement for deferral. In order to be an eligible plan, the 
plan must provide that compensation may be deferred for any calendar 
month by salary reduction only if an agreement providing for the 
deferral has been entered into before the first day of the month in 
which the compensation is paid or made available. A new employee may 
defer compensation payable in the calendar month during which the 
participant first becomes an employee if an agreement providing for the 
deferral is entered into on or before the first day on which the 
participant performs services for the eligible employer. An eligible 
plan may provide that if a participant enters into an agreement 
providing for deferral by salary reduction under the plan, the 
agreement will remain in effect until the participant revokes or alters 
the terms of the agreement. Nonelective employer contributions are 
treated as being made under an agreement entered into before the first 
day of the calendar month.
    (c) Maximum deferral limitations--(1) Basic annual limitation. (i) 
Except as described in paragraphs (c)(2) and (3) of this section, in 
order to be an eligible plan, the plan must provide that the annual 
deferral amount for a taxable year (the plan ceiling) may not exceed 
the lesser of--
    (A) The applicable annual dollar amount specified in section 
457(e)(15): $11,000 for 2002; $12,000 for 2003; $13,000 for 2004; 
$14,000 for 2005; and $15,000 for 2006 and thereafter. After 2006, the 
$15,000 amount is adjusted for cost-of-living in the manner described 
in paragraph (c)(4) of this section; or
    (B) 100 percent of the participant's includible compensation for 
the taxable year.
    (ii) The amount of annual deferrals permitted by the 100 percent of 
includible compensation limitation under paragraph (c)(1)(i)(B) of this 
section is determined under section 457(e)(5) and Sec. 1.457-2(g).
    (iii) For purposes of determining the plan ceiling under this 
paragraph (c), the annual deferral amount does not include any rollover 
amounts received by the eligible plan under Sec. 1.457-10(e).
    (iv) The provisions of this paragraph (c)(1) are illustrated by the 
following examples:

    Example 1. (i) Facts. Participant A, who earns $14,000 a year, 
enters into a salary reduction agreement in 2006 with A's eligible 
employer and elects to defer $13,000 of A's compensation for that 
year. Participant A is not eligible for the catch-up described in 
paragraph (c)(2) or (3) of this section,

[[Page 30834]]

participates in no other retirement plan, and has no other income 
exclusions taken into account in computing includible compensation.
    (ii) Conclusion. The annual deferral limit for A in 2006 is the 
lesser of $15,000 or 100 percent of includible compensation, 
$14,000. A's annual deferral of $13,000 is permitted under the plan 
because it is not in excess of $14,000 and thus does not exceed 100 
percent of A's includible compensation.
    Example 2. (i) Facts. Assume the same facts as in Example 1, 
except that A's eligible employer provides an immediately vested, 
matching employer contribution under the plan for participants who 
make salary reduction deferrals under A's eligible plan. The 
matching contribution is equal to 100 percent of elective 
contributions, but not in excess of 10 percent of compensation (in 
A's case, $1,400).
    (ii) Conclusion. Participant A's annual deferral exceeds the 
limitations of this paragraph (c)(1). A's maximum deferral 
limitation in 2006 is $14,000. A's salary reduction deferral of 
$13,000 combined with A's eligible employer's nonelective employer 
contribution of $1,400 exceeds the basic annual limitation of this 
paragraph (c)(1) because A's annual deferrals total $14,400. A has 
an excess deferral for the taxable year of $400, the amount 
exceeding A's permitted annual deferral limitation. The $400 excess 
deferral is treated as described in paragraph (e) of this section.
    Example 3. (i) Facts. Beginning in year 2002, Eligible Employer 
X contributes $3,000 per year for five years to Participant B's 
eligible plan account. B's interest in the account vests in 2006. B 
has annual compensation of $50,000 in each of the five years 2002 
through 2006. Participant B is 41 years old. B is not eligible for 
the catch-up described in paragraph (c)(2) or (3) of this section, 
participates in no other retirement plan, and has no other income 
exclusions taken into account in computing includible compensation. 
Adjusted for gain or loss, the value of B's benefit when B's 
interest in the account vests in 2006 is $17,000.
    (ii) Conclusion. Under this vesting schedule, $17,000 is taken 
into account as an annual deferral in 2006. B's annual deferrals 
under the plan are limited to a maximum of $15,000 in 2006. Thus, 
the aggregate of the amounts deferred, $17,000, is in excess of the 
B's maximum deferral limitation by $2,000. The $2,000 is treated as 
an excess deferral described in paragraph (e) of this section.

    (2) Age 50 catch-up--(i) In general. In accordance with section 
414(v) and the regulations thereunder, an eligible governmental plan 
may provide for catch-up contributions for a participant who is age 50 
by the end of the year, provided that such age 50 catch-up 
contributions do not exceed the catch-up limit under section 414(v)(2) 
for the taxable year. The maximum amount of age 50 catch-up 
contributions for a taxable year under section 414(v) is as follows: 
$1,000 for 2002; $2,000 for 2003; $3,000 for 2004; $4,000 for 2005; and 
$5,000 for 2006 and thereafter. After 2006, the $5,000 amount is 
adjusted for cost-of-living. For additional guidance, see regulations 
under section 414(v).
    (ii) Coordination with special section 457 catch-up. In accordance 
with sections 414(v)(6)(C) and 457(e)(18), the age 50 catch-up 
described in this paragraph (c)(2) does not apply for any taxable year 
for which a higher limitation applies under the special section 457 
catch-up under paragraph (c)(3) of this section. Thus, for purposes of 
this paragraph (c)(2)(ii) and paragraph (c)(3) of this section, the 
special section 457 catch-up under paragraph (c)(3) of this section 
applies for any taxable year if and only if the plan ceiling taking 
into account paragraphs (c)(1) and (3) of this section (and 
disregarding the age 50 catch-up described in this paragraph (c)(2)) is 
larger than the plan ceiling taking into account paragraph (c)(1) of 
this section and the age 50 catch-up described in this paragraph (c)(2) 
(and disregarding paragraph (c)(3) of this section). Thus, a 
participant who is eligible for the age 50 catch-up for a year and for 
whom the year is also one of the participant's last three taxable years 
ending before the participant attains normal retirement age is entitled 
to the larger of--
    (A) The plan ceiling under paragraph (c)(1) of this section and the 
age 50 catch-up described in this paragraph (c)(2) (and disregarding 
paragraph (c)(3) of this section) or
    (B) The plan ceiling under paragraphs (c)(1) and (3) of this 
section (and disregarding the age 50 catch-up described in this 
paragraph (c)(2)).
    (iii) Examples. The provisions of this paragraph (c)(2) are 
illustrated by the following examples:

    Example 1. (i) Facts. Participant C, who is 55, is eligible to 
participate in an eligible governmental plan in 2006. The plan 
provides a normal retirement age of 65. The plan provides 
limitations on annual deferrals up to the maximum permitted under 
paragraphs (c)(1) and (3) of this section and the age 50 catch-up 
described in this paragraph (c)(2). For 2006, C will receive 
compensation of $40,000 from the eligible employer. C desires to 
defer the maximum amount possible in 2006. The applicable basic 
dollar limit of paragraph (c)(1)(i)(A) of this section is $15,000 
for 2006 and the additional dollar amount permitted under the age 50 
catch-up is $5,000 for 2006.
    (ii) Conclusion. C is eligible for the age 50 catch-up in 2006 
because C is 55 in 2006. However, C is not eligible for the special 
section 457 catch-up under paragraph (c)(3) of this section in 2006 
because 2006 is not one of the last three taxable years ending 
before C attains normal retirement age. Accordingly, the maximum 
that C may defer for 2006 is $20,000.
    Example 2. (i) Facts. The facts are the same as in Example 1, 
except that, in 2006, C will attain age 62. The maximum amount that 
C can elect under the special section 457 catch-up under paragraph 
(c)(3) of this section is $2,000 for 2006.
    (ii) Conclusion. The maximum that C may defer for 2006 is 
$20,000. This is the sum of the basic plan ceiling under paragraph 
(c)(1) of this section equal to $15,000 and the age 50 catch-up 
equal to $5,000. The special section 457 catch-up under paragraph 
(c)(3) of this section is not applicable since it provides a smaller 
plan ceiling.

    Example 3. (i) Facts. The facts are the same as in Example 2, 
except that the maximum additional amount that C can elect under the 
special section 457 catch-up under paragraph (c)(3) of this section 
is $7,000 for 2006.
    (ii) Conclusion. The maximum that C may defer for 2006 is 
$22,000. This is the sum of the basic plan ceiling under paragraph 
(c)(1) of this section equal to $15,000, plus the additional special 
section 457 catch-up under paragraph (c)(3) of this section equal to 
$7,000. The additional dollar amount permitted under the age 50 
catch-up is not applicable to C for 2006 because it provides a 
smaller plan ceiling.

    (3) Special section 457 catch-up--(i) In general. Except as 
provided in paragraph (c)(2)(ii) of this section, an eligible plan may 
provide that, for one or more of the participant's last three taxable 
years ending before the participant attains ``normal retirement age,'' 
the plan ceiling is an amount not in excess of the lesser of--
    (A) Twice the dollar amount in effect under paragraph (c)(1)(i)(A) 
of this section; or
    (B) The underutilized limitation determined under paragraph 
(c)(3)(ii) of this section.
    (ii) Underutilized limitation. The underutilized amount determined 
under this paragraph (c)(3)(ii) is the sum of--
    (A) The plan ceiling established under paragraph (c)(1) of this 
section for the taxable year; plus
    (B) The plan ceiling established under paragraph (c)(1) of this 
section (or under section 457(b)(2) for any year before the 
applicability date of this section) for any prior taxable year or 
years, less the amount of annual deferrals under the plan for such 
prior taxable year or years (disregarding any annual deferrals under 
the plan permitted under the age 50 catch-up under paragraph (c)(2) of 
this section).
    (iii) Determining underutilized limitation under paragraph 
(c)(3)(ii)(B) of this section. In determining the includible 
compensation of a participant under Sec. 1.457-2(g) for purposes of 
calculating the amount described in paragraph (c)(3)(ii)(A) of this 
section, includible compensation is not reduced by contributions of 
amounts described in paragraph (c)(3)(ii)(B) of this section. In 
addition, a prior taxable year is taken into account

[[Page 30835]]

under paragraph (c)(3)(ii)(B) of this section only if it is a year 
beginning after December 31, 1978, in which the participant was 
eligible to participate in the plan, and in which compensation deferred 
(if any) under the plan during the year was subject to a plan ceiling 
established under paragraph (c)(1) of this section.
    (iv) Special rules concerning application of the coordination limit 
for years prior to 2002 for purposes of determining the underutilized 
limitation--(A) General rule. For purposes of determining the 
underutilized limitation for years prior to 2002, participants remain 
subject to the rules in effect prior to the repeal of the coordination 
limitation under section 457(c)(2). Thus, the applicable basic annual 
limitation under paragraph (c)(1) of this section and the special 
section 457 catch-up under this paragraph (c)(3) for years in effect 
prior to 2002 are reduced, for purposes of determining a participant's 
underutilized amount under a plan, by amounts excluded from the 
participant's income for any prior taxable year by reason of a salary 
reduction or elective contribution under any other eligible section 
457(b) plan, section 401(k) qualified cash or deferred arrangement, 
section 402(h)(1)(B) simplified employee pension (SARSEP), section 
403(b) annuity contract, and section 408(p) simple retirement account, 
or under any plan for which a deduction is allowed because of a 
contribution to an organization described in section 501(c)(18) (pre-
2002 coordination plans). Similarly, in applying the section 
457(b)(2)(B) limitation for includible compensation for years prior to 
2002, the limitation is 33\1/3\ percent of the participant's 
compensation includible in gross income.
    (B) Coordination limitation applied to participant. For purposes of 
determining the underutilized limitation for years prior to 2002, the 
coordination limitation applies to pre-2002 coordination plans of all 
employers for whom a participant has performed services, not only to 
those of the eligible employer. Thus, for purposes of determining the 
amount excluded from a participant's gross income in any prior taxable 
year under paragraph (c)(3)(ii)(B) of this section, the participant's 
annual deferral under an eligible plan, and salary reduction or 
elective deferrals under all other pre-2002 coordination plans, must be 
determined on an aggregate basis. To the extent that the combined 
deferral for years prior to 2002 exceeded the maximum deferral 
limitations, the amount is treated as an excess deferral under 
paragraph (e) of this section for those prior years.
    (C) Special rule where no annual deferrals under the eligible plan. 
A participant who, although eligible, did not defer any compensation 
under the eligible plan in any given year before 2002 is not subject to 
the coordinated deferral limit, even though the participant may have 
deferred compensation under one of the other pre-2002 coordination 
plans. An individual is treated as not having deferred compensation 
under an eligible plan for a prior taxable year if all annual deferrals 
under the plan are distributed in accordance with paragraph (e) of this 
section. Thus, to the extent that a participant participated solely in 
one or more of the other pre-2002 coordination plans during a prior 
taxable year (and not the eligible plan), the participant is not 
subject to the coordinated limitation for that prior taxable year. 
However, the participant is treated as having deferred amounts in a 
prior taxable year for purposes of determining the underutilized 
limitation for that prior taxable year under this paragraph 
(c)(3)(iv)(C), but only to the extent that the participant's salary 
reduction contributions or elective deferrals under all pre-2002 
coordination plans have not exceeded the maximum deferral limitations 
in effect under section 457(b) for that prior taxable year. To the 
extent an employer did not offer an eligible plan to an individual in a 
prior given year, no underutilized limitation is available to the 
individual for that prior year, even if the employee subsequently 
becomes eligible to participate in an eligible plan of the employer.
    (D) Examples. The provisions of this paragraph (c)(3)(iv) are 
illustrated by the following examples:

    Example 1. (i) Facts. In 2001 and in years prior to 2001, 
Participant D earned $50,000 a year and was eligible to participate 
in both an eligible plan and a section 401(k) plan. However, D had 
always participated only in the section 401(k) plan and had always 
deferred the maximum amount possible. For each year before 2002, the 
maximum amount permitted under section 401(k) exceeded the 
limitation of paragraph (c)(3)(i) of this section. In 2002, D is in 
the 3-year period prior to D's attainment of the eligible plan's 
normal retirement age of 65, and D now wants to participate in the 
eligible plan and make annual deferrals of up to $30,000 under the 
plan's special section 457 catch-up provisions.
    (ii) Conclusion. Participant D is treated as having no 
underutilized amount under paragraph (c)(3)(ii)(B) of this section 
for 2002 for purposes of the catch-up limitation under section 
457(b)(3) and paragraph (c)(3) of this section because, in each of 
the years before 2002, D has deferred an amount in excess of the 
limitation of paragraph (c)(3)(i) of this section.
    Example 2. (i) Facts. Assume the same facts as in Example 1, 
except that D only deferred $2,500 per year under the section 401(k) 
plan for one year before 2002.
    (ii) Conclusion. D is treated as having an underutilized amount 
under paragraph (c)(3)(ii)(B) of this section for 2002 for purposes 
of the special section 457 catch-up limitation. This is because D 
has deferred an amount for prior years that is less than the 
limitation of paragraph (c)(1)(i) of this section.
    Example 3. (i) Facts. Participant E, who earned $15,000 for 
2000, entered into a salary reduction agreement in 2000 with E's 
eligible employer and elected to defer $3,000 for that year. For 
2000, E's eligible employer provided an immediately vested, matching 
employer contribution under the plan for participants who make 
salary reduction deferrals under E's eligible plan. The matching 
contribution was equal to 100 percent of elective contributions, but 
not in excess of 10 percent of compensation before salary reduction 
deferrals (in E's case, $1,500). For 2000, E was not eligible for 
any catch-up contribution, participated in no other retirement plan, 
and had no other income exclusions taken into account in computing 
taxable compensation.
    (ii) Conclusion. Participant E's annual deferral exceeded the 
limitations of section 457(b) for 2000. E's maximum deferral 
limitation in 2000 was $4,000 because E's includible compensation 
was $12,000 ($15,000 minus the deferral of $3,000) and the 
applicable limitation for 2000 was one-third of the individual's 
includible compensation (one-third of $12,000 equals $4,000). E's 
salary reduction deferral of $3,000 combined with E's eligible 
employer's matching contribution of $1,500 exceeded the limitation 
of section 457(b) for 2000 because E's annual deferrals totaled 
$4,500. E had an excess deferral for 2000 of $500, the amount 
exceeding E's permitted annual deferral limitation, and E's 
underutilized amount for 2000 is zero.

    (v) Normal retirement age--(A) General rule. For purposes of the 
special section 457 catch-up in this paragraph (c)(3), a plan must 
specify the normal retirement age under the plan. A plan may define 
normal retirement age as any age that is on or after the earlier of age 
65 or the age at which participants have the right to retire and 
receive, under the basic defined benefit pension plan of the state or 
tax-exempt entity, immediate retirement benefits without actuarial or 
similar reduction because of retirement before some later specified 
age, and that is not later than age 70\1/2\. Alternatively, a plan may 
provide that a participant is allowed to designate a normal retirement 
age within these ages. For purposes of the special section 457 catch-up 
in this paragraph (c)(3), an entity sponsoring more than one eligible 
plan may not permit a participant to have more than one normal 
retirement age under the eligible plans it sponsors.

[[Page 30836]]

    (B) Special rule for eligible plans of qualified police or 
firefighters. An eligible plan with participants that include qualified 
police or firefighters as defined under section 415(b)(2)(H)(ii)(I) may 
designate a normal retirement age for such qualified police or 
firefighters that is earlier than the earliest normal retirement age 
designated under the general rule of paragraph (c)(3)(i)(A) of this 
section, but in no event may the normal retirement age be earlier than 
age 40. Alternatively, a plan may allow a qualified police or 
firefighter participant to designate a normal retirement age that is 
between age 40 and age 70\1/2\.
    (vi) Examples. The provisions of this paragraph (c)(3) are 
illustrated by the following examples:

    Example 1. (i) Facts. Participant F, who will turn 61 on April 
1, 2006, becomes eligible to participate in an eligible plan on 
January 1, 2006. The plan provides a normal retirement age of 65. 
The plan provides limitations on annual deferrals up to the maximum 
permitted under paragraphs (c)(1) through (3) of this section. For 
2006, F will receive compensation of $40,000 from the eligible 
employer. F desires to defer the maximum amount possible in 2006. 
The applicable basic dollar limit of paragraph (c)(1)(i)(A) of this 
section is $15,000 for 2006 and the additional dollar amount 
permitted under the age 50 catch-up in paragraph (c)(2) of this 
section for an individual who is at least age 50 is $5,000 for 2006.
    (ii) Conclusion. F is not eligible for the special section 457 
catch-up under paragraph (c)(3) of this section in 2006 because 2006 
is not one of the last three taxable years ending before F attains 
normal retirement age. Accordingly, the maximum that F may defer for 
2006 is $20,000. See also paragraph (c)(2)(iii) Example 1 of this 
section.
    Example 2. (i) Facts. The facts are the same as in Example 1 
except that, in 2006, F elects to defer only $2,000 under the plan 
(rather than the maximum permitted amount of $20,000). In addition, 
assume that the applicable basic dollar limit of paragraph 
(c)(1)(i)(A) of this section continues to be $15,000 for 2007 and 
the additional dollar amount permitted under the age 50 catch-up in 
paragraph (c)(2) of this section for an individual who is at least 
age 50 continues to be $5,000 for 2007. In F's taxable year 2007, 
which is one of the last three taxable years ending before F attains 
the plan's normal retirement age of 65, F again receives a salary of 
$40,000 and elects to defer the maximum amount permissible under the 
plan's catch-up provisions prescribed under paragraph (c) of this 
section.
    (ii) Conclusion. For 2007, which is one of the last three 
taxable years ending before F attains the plan's normal retirement 
age of 65, the applicable limit on deferrals for F is the larger of 
the amount under the special section 457 catch-up or $20,000, which 
is the basic annual limitation ($15,000) and the age 50 catch-up 
limit of section 414(v) ($5,000). For 2007, F's special section 457 
catch-up amount is the lesser of two times the basic annual 
limitation ($30,000) or the sum of the basic annual limitation 
($15,000) plus the $13,000 underutilized limitation under paragraph 
(c)(3)(ii) of this section (the $15,000 plan ceiling in 2006, minus 
the $2,000 contributed for F in 2006), or $28,000. Thus, the maximum 
amount that F may defer in 2007 is $28,000.
    Example 3. (i) Facts. The facts are the same as in Examples 1 
and 2, except that F does not make any contributions to the plan 
before 2010. In addition, assume that the applicable basic dollar 
limitation of paragraph (c)(1)(i)(A) of this section continues to be 
$15,000 for 2010 and the additional dollar amount permitted under 
the age 50 catch-up in paragraph (c)(2) of this section for an 
individual who is at least age 50 continues to be $5,000 for 2010. 
In F's taxable year 2010, the year in which F attains age 65 (which 
is the normal retirement age under the plan), F desires to defer the 
maximum amount possible under the plan. F's compensation for 2010 is 
again $40,000.
    (ii) Conclusion. For 2010, the maximum amount that F may defer 
is $20,000. The special section 457 catch-up provisions under 
paragraph (c)(3) of this section are not applicable because 2010 is 
not a taxable year ending before the year in which F attains normal 
retirement age.
    (4) Cost-of-living adjustment. For years beginning after December 
31, 2006, the $15,000 dollar limitation in paragraph (c)(1)(i)(A) of 
this section will be adjusted to take into account increases in the 
cost-of-living. The adjustment in the dollar limitation is made at the 
same time and in the same manner as under section 415(d) (relating to 
qualified plans under section 401(a)), except that the base period is 
the calendar quarter beginning July 1, 2005 and any increase which is 
not a multiple of $500 will be rounded to the next lowest multiple of 
$500.
    (d) Deferral of sick, vacation, and back pay under an eligible 
plan--(1) In general. An eligible plan may provide that a participant 
may elect to defer accumulated sick pay, accumulated vacation pay, and 
back pay under an eligible plan if certain conditions are satisfied. 
The plan must provide, in accordance with paragraph (b) of this 
section, that these amounts may be deferred for any calendar month only 
if an agreement providing for the deferral is entered into before the 
beginning of the month in which the amounts would otherwise be paid or 
made available and the participant is an employee in that month. Any 
deferrals made under this paragraph (d)(1) under an eligible plan are 
subject to the maximum deferral limitations of paragraph (c) of this 
section.
    (2) Examples. The provisions of this paragraph (d) are illustrated 
by the following examples:

    Example 1. (i) Facts. Participant G, age 62, is a participant in 
an eligible plan providing a normal retirement age of 65. Under the 
terms of G's employer's eligible plan and G's sick leave plan, G 
may, during November of 2003 (which is one of the three years prior 
to normal retirement age), make a one-time election to contribute 
amounts representing accumulated sick pay to the eligible plan in 
December of 2003 (within the maximum deferral limitations). 
Alternatively, such amounts may remain in the ``bank'' under the 
sick leave plan. No cash out of the sick pay is available at any 
time prior to termination of employment. The total value of G's 
accumulated sick pay (determined, in accordance with the terms of 
the sick leave plan, by reference to G's current salary) is $4,000 
in December of 2003.
    (ii) Conclusion. Under the terms of the eligible plan and sick 
leave plan, G may elect before December of 2003 to defer the $4,000 
value of accumulated sick pay under the eligible plan, provided that 
G's other annual deferrals to the eligible plan for 2003, when added 
to the $4,000, do not exceed G's maximum deferral limitation for the 
year.
    Example 2. (i) Facts. Employer X maintains an eligible plan and 
a vacation leave plan. Under the terms of the vacation leave plan, 
employees generally accrue three weeks of vacation per year. Up to 
one week's unused vacation may be carried over from one year to the 
next, so that in any single year an employee may have a maximum of 
four weeks vacation time. At the beginning of each calendar year, 
under the terms of the eligible plan (which constitutes an agreement 
providing for the deferral), the value of any unused vacation time 
from the prior year in excess of one week is automatically 
contributed to the eligible plan, to the extent of the employee's 
maximum deferral limitations. Amounts in excess of the maximum 
deferral limitations are forfeited.
    (ii) Conclusion. The value of the unused vacation pay 
contributed to X's eligible plan pursuant to the terms of the plan 
and the terms of the vacation leave plan is treated as an annual 
deferral to the eligible plan in the calendar year the contribution 
is made. No amounts contributed to the eligible plan will be 
considered made available to a participant in X's eligible plan.

    (e) Excess deferrals under an eligible plan--(1) In general. Any 
amount deferred under an eligible plan for the taxable year of a 
participant that exceeds the maximum deferral limitations set forth in 
paragraphs (c)(1) through (3) of this section, and any amount that 
exceeds the individual limitation under Sec. 1.457-5, constitutes an 
excess deferral taxable in accordance with Sec. 1.457-11 for that 
taxable year. Thus, an excess deferral is includible in gross income in 
the taxable year deferred or, if later, the first taxable year in which 
there is no substantial risk of forfeiture.
    (2) Excess deferrals under an eligible governmental plan other than 
as a result of the individual limitation. In order to be an eligible 
governmental plan, the plan must provide that any excess deferrals 
resulting from a failure of a

[[Page 30837]]

plan to apply the limitations of paragraphs (c)(1) through (3) of this 
section to amounts deferred under the eligible plan (computed without 
regard to the individual limitation under Sec. 1.457-5) will be 
distributed to the participant, with allocable net income, as soon as 
administratively practicable after the plan determines that the amount 
is an excess deferral. For purposes of determining whether there is an 
excess deferral resulting from a failure of a plan to apply the 
limitations of paragraphs (c)(1) through (3) of this section, all plans 
under which an individual participates by virtue of his or her 
relationship with a single employer are treated as a single plan. An 
eligible governmental plan does not fail to satisfy the requirements of 
paragraphs (a) through (d) of this section or Secs. 1.457-6 through 
1.457-10 (including the distribution rules under Sec. 1.457-6 and the 
funding rules under Sec. 1.457-8) solely by reason of a distribution 
made under this paragraph (e)(2). If such excess deferrals are not 
corrected by distribution under this paragraph (e)(2), the plan will be 
an ineligible plan under which benefits are taxable in accordance with 
Sec. 1.457-11.
    (3) Excess deferrals under an eligible plan of a tax-exempt 
employer other than as a result of the individual limitation. If a plan 
of a tax-exempt employer fails to comply with the limitations of 
paragraphs (c)(1) through (3) of this section, the plan will be an 
ineligible plan under which benefits are taxable in accordance with 
Sec. 1.457-11. For purposes of determining whether there is an excess 
deferral resulting from a failure of a plan to apply the limitations of 
paragraphs (c)(1) through (3) of this section, all plans under which an 
individual participates by virtue of his or her relationship with a 
single employer are treated as a single plan.
    (4) Excess deferrals arising from application of the individual 
limitation. An eligible plan may provide that an excess deferral as a 
result of a failure to comply with the individual limitation under 
Sec. 1.457-5 for a taxable year may be distributed to the participant, 
with allocable net income, as soon as administratively practicable 
after the plan determines that the amount is an excess deferral. An 
eligible plan does not fail to satisfy the requirements of paragraphs 
(a) through (d) of this section or Secs. 1.457-6 through 1.457-10 
(including the distribution rules under Sec. 1.457-6 and the funding 
rules under Sec. 1.457-8) solely by reason of a distribution made under 
this paragraph (e)(4). Although a plan will still maintain eligible 
status if excess deferrals are not distributed under this paragraph 
(e)(4), a participant must include the excess amounts in income as 
provided in paragraph (e)(1) of this section.
    (5) Examples. The provisions of this paragraph (e) are illustrated 
by the following examples:

    Example 1.  (i) Facts. In 2006, the eligible plan of State 
Employer X in which Participant H participates permits a maximum 
deferral of the lesser of $15,000 or 100 percent of includible 
compensation. In 2006, H, who has compensation of $28,000, 
nevertheless defers $16,000 under the eligible plan. Participant H 
is age 45 and normal retirement age under the plan is age 65. For 
2006, the applicable dollar limit under paragraph (c)(1)(i)(A) of 
this section is $15,000.
    (ii) Conclusion. Participant H has deferred $1,000 in excess of 
the $15,000 limitation provided for under the plan for 2006. The 
$1,000 excess must be included by H into H's income for 2006. In 
order to correct the failure and still be an eligible plan, the plan 
must distribute the excess deferral, with allocable net income, as 
soon as administratively practicable after determining that the 
amount exceeds the plan deferral limitations. If the excess deferral 
is not distributed, the plan will be an ineligible plan with respect 
to which benefits are taxable in accordance with Sec. 1.457-11.
    Example 2. (i) Facts. The facts are the same as in Example 1, 
except that H's deferral under the eligible plan is limited to 
$11,000 and H also makes a salary reduction contribution of $5,000 
to an annuity contract under section 403(b) with the same Employer 
X.
    (ii) Conclusion. H's deferrals are within the plan deferral 
limitations of Employer X. Because of the repeal of the application 
of the coordination limitation under former paragraph (2) of section 
457(c), H's salary reduction deferrals under the annuity contract 
are no longer considered in determining H's applicable deferral 
limits under paragraphs (c)(1) through (3) of this section.
    Example 3. (i) Facts. The facts are the same as in Example 1, 
except that H's deferral under the eligible governmental plan is 
limited to $14,000 and H also makes a deferral of $4,000 to an 
eligible governmental plan of a different employer. Participant H is 
age 45 and normal retirement age under both eligible plans is age 
65.
    (ii) Conclusion. Because of the application of the individual 
limitation under Sec. 1.457-5, H has an excess deferral of $3,000 
(the sum of $14,000 plus $4,000 equals $18,000, which is $3,000 in 
excess of the dollar limitation of $15,000). The $3,000 excess 
deferral, with allocable net income, may be distributed from either 
plan as soon as administratively practicable after determining that 
the combined amount exceeds the deferral limitations. If the $3,000 
excess deferral is not distributed to H, each plan will continue to 
be an eligible plan, but the $3,000 must be included by H into H's 
income for 2006.
    Example 4. (i) Facts. Assume the same facts as in Example 3, 
except that H's deferral under the eligible governmental plan is 
limited to $14,000 and H also makes a deferral of $4,000 to an 
eligible plan of Employer Y, a tax-exempt entity.
    (ii) Conclusion. The results are the same as in Example 3, i.e., 
because of the application of the individual limitation under 
Sec. 1.457-5, H has an excess deferral of $3,000. If the $3,000 
excess deferral is not distributed to H, each plan will continue to 
be an eligible plan, but the $3,000 must be included by H into H's 
income for 2006.

    Par. 3. Sections 1.457-5 through 1.457-12 are added to read as 
follows:


Sec. 1.457-5  Individual limitation for combined annual deferrals under 
multiple eligible plans

    (a) General rule. The individual limitation under section 457(c) 
and this section equals the basic annual deferral limitation under 
Sec. 1.457-4(c)(1)(i)(A), the age 50 catch-up amount under Sec. 1.457-
4(c)(2), and the special section 457 catch-up amount under Sec. 1.457-
4(c)(3), applied by taking into account the combined annual deferral 
for the participant for any taxable year under all eligible plans. 
While an eligible plan may include provisions under which it will meet 
the individual limitation under section 457(c) and this section, annual 
deferrals by a participant that exceed the individual limit under 
section 457(c) and this section will not cause a plan to lose its 
eligible status. However, to the extent the combined annual deferrals 
for a participant for any taxable year exceed the individual limitation 
under section 457(c) and this section for that year, the amounts are 
treated as excess deferrals as described in Sec. 1.457-4(e).
    (b) Limitation applied to participant. The individual limitation in 
this section applies to eligible plans of all employers for whom a 
participant has performed services, including both eligible 
governmental plans and eligible plans of a tax-exempt entity and both 
eligible plans of the employer and eligible plans of other employers. 
Thus, for purposes of determining the amount excluded from a 
participant's gross income in any taxable year (including the 
underutilized limitation under Sec. 1.457-4(c)(3)(ii)(B)), the 
participant's annual deferral under an eligible plan, and the 
participant's annual deferrals under all other eligible plans, must be 
determined on an aggregate basis. To the extent that the combined 
annual deferral amount exceeds the maximum deferral limitation 
applicable under Sec. 1.457-4(c)(1)(i)(A), (c)(2), or (c)(3), the 
amount is treated as an excess deferral under Sec. 1.457-4(e).
    (c) Special rules for catch-up amounts under multiple eligible 
plans. For purposes of applying section 457(c) and

[[Page 30838]]

this section, the special section 457 catch-up under Sec. 1.457-4(c)(3) 
is taken into account only to the extent that an annual deferral is 
made for a participant under an eligible plan as a result of plan 
provisions permitted under Sec. 1.457-4(c)(3). In addition, if a 
participant has annual deferrals under more than one eligible plan and 
the applicable catch-up amount under Sec. 1.457-4(c)(2) or (3) is not 
the same for each such eligible plan for the taxable year, section 
457(c) and this section are applied using the catch-up amount under 
whichever plan has the largest catch-up amount applicable to the 
participant.
    (d) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. (i) Facts. Participant F is age 62 in 2006 and 
participates in two eligible plans during 2006, Plans J and K, which 
are each eligible plans of two different governmental entities. Each 
plan includes provisions allowing the maximum annual deferral 
permitted under Sec. 1.457-4(c)(1) through (3). For 2006, the 
underutilized amount under Sec. 1.457-4(c)(3)(ii)(B) is $20,000 
under Plan J and is $40,000 under Plan K. Normal retirement age is 
age 65 under both plans. Participant F defers $15,000 under each 
plan. Participant F's includible compensation is in each case in 
excess of the deferral. Neither plan designates the $15,000 
contribution as a catch-up permitted under each plan's special 
section 457 catch-up provisions.
    (ii) Conclusion. For purposes of applying this section to 
Participant F for 2006, the maximum exclusion is $20,000. This is 
equal to the sum of $15,000 plus $5,000, which is the age 50 catch-
up amount. Thus, F has an excess amount of $10,000 which is treated 
as an excess deferral for Participant F for 2006 under Sec. 1.457-
4(e).
    Example 2. (i) Facts. Participant E, who will turn 63 on April 
1, 2006, participates in four eligible plans during 2006: Plan W 
which is an eligible governmental plan; and Plans X, Y, and Z which 
are each eligible plans of three different tax-exempt entities. For 
2006, the limitation under these plans that apply to Participant E 
under all four plans under Sec. 1.457-4(c)(1)(i)(A) is $15,000. For 
2006, the additional age 50 catch-up limitation that applies to 
Participant E under Plan W under Sec. 1.457-4(c)(2) is $5,000. 
Further, for 2006, different limitations under Secs. 1.457-4(c)(3) 
and (c)(3)(ii)(B) apply to Participant E under each of these plans, 
as follows: Under Plan W, the underutilized limitation under 
Sec. 1.457-4(c)(3)(ii)(B) is $7,000; under Plan X, the underutilized 
limitation under Sec. 1.457-4(c)(3)(ii)(B) is $2,000; under Plan Y, 
the underutilized limitation under Sec. 1.457-4(c)(3)(ii)(B) is 
$8,000; and under Plan Z, Sec. 1.457-4(c)(3) is not applicable since 
normal retirement age is age 62 under Plan Z. Participant E's 
includible compensation is in each case in excess of any applicable 
deferral.
    (ii) Conclusion. For purposes of applying this section to 
Participant E for 2006, Participant E could elect to defer $23,000 
under Plan Y, which is the maximum deferral limitation under 
Secs. 1.457-4(c)(1) through (3), and to defer no amount under Plans 
W, X, and Z. The $23,000 maximum amount is equal to the sum of 
$15,000 plus $8,000, which is the catch-up amount applicable to 
Participant E under Plan Y and which is the largest catch-up amount 
applicable to Participant E under any of the four plans for 2006. 
Alternatively, Participant E could instead elect to defer the 
following combination of amounts: $5,000 to Plan W and an aggregate 
total of $15,000 to Plans X, Y, and Z; $22,000 to Plan W and none to 
any of the other three plans; $17,000 to Plan X and none to any of 
the other three plans; or $15,000 to Plan Z and none to any of the 
other three plans.
    (iii) If the underutilized amount under Plans W, X, and Y for 
2006 were in each case zero (because E had always contributed the 
maximum amount or E was a new participant) or an amount not in 
excess of $5,000, the maximum exclusion under this section would be 
$20,000 for Participant E for 2006 ($15,000 plus the $5,000 age 50 
catch-up amount), which Participant E could contribute to Plan W.


Sec. 1.457-6  Timing of distributions under eligible plans.

    (a) In general. Except as provided in paragraph (c) of this section 
(relating to distributions on account of an unforeseeable emergency), 
paragraph (e) of this section (relating to distributions of small 
accounts), Sec. 1.457-10(a) (relating to plan terminations), or 
Sec. 1.457-10(c) (relating to domestic relations orders), amounts 
deferred under an eligible governmental plan may not be paid to a 
participant or beneficiary before the participant has a severance from 
employment with the eligible employer. For rules relating to loans, see 
paragraph (f) of this section.
    (b) Severance from employment--(1) Employees. An employee has a 
severance from employment with the eligible employer if the employee 
dies, retires, or otherwise has a severance from employment with the 
eligible employer.
    (2) Independent contractors--(i) In general. An independent 
contractor is considered to have a severance from employment with the 
eligible employer upon the expiration of the contract (or in the case 
of more than one contract, all contracts) under which services are 
performed for the eligible employer, if the expiration constitutes a 
good-faith and complete termination of the contractual relationship. An 
expiration does not constitute a good faith and complete termination of 
the contractual relationship if the eligible employer anticipates a 
renewal of a contractual relationship or the independent contractor 
becoming an employee. For this purpose, an eligible employer is 
considered to anticipate the renewal of the contractual relationship 
with an independent contractor if it intends to again contract for the 
services provided under the expired contract, and neither the eligible 
employer nor the independent contractor has eliminated the independent 
contractor as a possible provider of services under any such new 
contract. Further, an eligible employer is considered to intend to 
again contract for the services provided under an expired contract if 
the eligible employer's doing so is conditioned only upon incurring a 
need for the services, the availability of funds, or both.
    (ii) Special rule. Notwithstanding paragraph (b)(2)(i) of this 
section, the plan is considered to satisfy the requirement described in 
paragraph (a) of this section that no amounts deferred under the plan 
be paid or made available to the participant before the participant has 
a severance from employment with the eligible employer, if, with 
respect to amounts payable to a participant who is an independent 
contractor, an eligible plan provides that--
    (A) No amount will be paid to the participant before a date at 
least 12 months after the day on which the contract expires under which 
services are performed for the eligible employer (or, in the case of 
more than one contract, all such contracts expire); and
    (B) No amount payable to the participant on that date will be paid 
to the participant if, after the expiration of the contract (or 
contracts) and before that date, the participant performs services for 
the eligible employer as an independent contractor or an employee.
    (c) Rules applicable to distributions for unforeseeable 
emergencies--(1) In general. An eligible plan may permit a distribution 
to a participant or beneficiary faced with an unforeseeable emergency. 
The distribution must satisfy the requirement of paragraph (c)(2) of 
this section.
    (2) Requirements--(i) Unforeseeable emergency defined. An 
unforeseeable emergency must be defined in the plan as a severe 
financial hardship of the participant or beneficiary resulting from an 
illness or accident of the participant or beneficiary, the 
participant's or beneficiary's spouse or the participant's or 
beneficiary's dependent (as defined in section 152(a)); loss of the 
participant's or beneficiary's property due to casualty; or other 
similar extraordinary and unforeseeable circumstances arising as a 
result of events beyond the control of the participant or the 
beneficiary. For example, the imminent foreclosure of or eviction from 
the participant's or beneficiary's primary residence may constitute an 
unforeseeable emergency.

[[Page 30839]]

In addition, the need to pay for medical expenses, including non-
refundable deductibles, as well as for the cost of prescription drug 
medication, may constitute an unforeseeable emergency. Finally, the 
need to pay for the funeral expenses of a family member may also 
constitute an unforeseeable emergency. Except in extraordinary 
circumstances, the purchase of a home and the payment of college 
tuition are not unforeseeable emergencies under this paragraph (c)(2).
    (ii) Unforeseeable emergency distribution standard. Whether a 
participant or beneficiary is faced with an unforeseeable emergency 
permitting a distribution under this paragraph (c) is to be determined 
based on the relevant facts and circumstances of each case, but, in any 
case, a distribution on account of unforeseeable emergency may not be 
made to the extent that such emergency is or may be relieved through 
reimbursement or compensation from insurance or otherwise; by 
liquidation of the participant's assets, to the extent the liquidation 
of such assets would not itself cause severe financial hardship; or by 
cessation of deferrals under the plan.
    (iii) Distribution necessary to satisfy emergency need. 
Distributions because of an unforeseeable emergency must be limited to 
the amount reasonably necessary to satisfy the emergency need (which 
may include any amounts necessary to pay any federal, state, or local 
income taxes or penalties reasonably anticipated to result from the 
distribution).
    (d) Minimum required distributions for eligible plans. In order to 
be an eligible plan, a plan must meet the distribution requirements of 
section 457(d)(1) and (2). Under section 457(d)(2), a plan must meet 
the minimum distribution requirements of section 401(a)(9). See section 
401(a)(9) and the regulations thereunder for these requirements. 
Section 401(a)(9) requires that a plan begin lifetime distributions to 
a participant no later than April 1 of the calendar year following the 
later of the calendar year in which the participant attains age 70\1/2\ 
or the calendar year in which the participant retires.
    (e) Distributions of smaller accounts--(1) In general. An eligible 
plan may provide for a distribution of all or a portion of a dollar 
amount which is not attributable to rollover contributions (as defined 
in section 411(a)(11)(D)). In order to permit such a distribution, an 
eligible plan must provide that the amount of the distribution must not 
exceed the dollar limit under section 411(a)(11)(A) (which is $5,000 
for 2002) and that the distribution is made only if no amount has been 
deferred under the plan by or for the participant during the two-year 
period ending on the date of the distribution and there has been no 
prior distribution under the plan to the participant under this 
paragraph (e). An eligible plan is not required to permit distributions 
under this paragraph (e).
    (2) Alternative provisions possible. Consistent with the provisions 
of paragraph (e)(1) of this section, a plan may provide that the total 
amount deferred for a participant or beneficiary, if not in excess of 
the applicable dollar limit of section 411(a)(11)(A), will be 
distributed automatically to the participant or beneficiary if the 
requirements of paragraph (e)(1) of this section are met. 
Alternatively, the plan may provide for the total amount deferred for a 
participant or beneficiary, if not in excess of the applicable dollar 
limit of section 411(a)(11)(A), to be distributed to the participant or 
beneficiary only if the participant or beneficiary so elects. The plan 
is permitted to substitute a specified dollar amount that is less than 
the applicable dollar limit of section 411(a)(11)(A) under either of 
these alternatives. In addition, these two alternatives can be 
combined; for example, a plan could provide for automatic distributions 
for account balances totaling an amount not in excess of the applicable 
dollar limit of section 411(a)(11)(A) but allow participants or 
beneficiary to elect a distribution if the total account balance is 
above $500 but not above the applicable dollar limit of section 
411(a)(11)(A).
    (f) Loans from eligible plans--(1) Eligible plans of tax-exempt 
entities. If a participant or beneficiary receives (directly or 
indirectly) any amount deferred as a loan from an eligible plan of a 
tax-exempt entity, that amount will be treated as having been paid or 
made available to the individual as a distribution under the plan, in 
violation of the distribution requirements of section 457(d).
    (2) Eligible governmental plans. The determination of whether the 
availability of a loan, the making of a loan, or a failure to repay a 
loan made from a trustee (or a person treated as a trustee under 
section 457(g)) of an eligible governmental plan to a participant or 
beneficiary is treated as a distribution (directly or indirectly) for 
purposes of this section, and the determination of whether the 
availability of the loan, the making of the loan, or a failure to repay 
the loan is in any other respect a violation of the requirements of 
section 457(b) and the regulations, depends on the facts and 
circumstances. Thus, for example, a loan must bear a reasonable rate of 
interest in order to satisfy the exclusive benefit requirement of 
section 457(g)(1) and Sec. 1.457-8(a)(1). See also Sec. 1.457-7(b)(3) 
relating to the application of section 72(p) with respect to the 
taxation of a loan made under an eligible governmental plan, and 
Sec. 1.72(p)-1 relating to section 72(p)(2).
    (3) Example. The provisions of paragraph (f)(2) of this section are 
illustrated by the following example:
    Example. (i) Facts. Eligible Plan X of State Y is funded through 
Trust Z. Plan X provides for an employee's account balance under 
Plan X to be paid in 5 annual installments (of \1/5\th the account 
balance the first year, \1/4\th the account balance the second year, 
etc.) beginning at severance from employment with State Y. Plan X 
includes a loan program under which any active employee with a 
vested account balance may receive a loan from Trust Z. Loans are 
made pursuant to plan provisions regarding loans that are set forth 
in the plan under which loans bear a reasonable rate of interest and 
are secured by the employee's account balance. In order to avoid 
taxation under Sec. 1.457-7(b)(3) and section 72(p)(1), the plan 
provisions limit the amount of loans and require loans to be repaid 
in level installments as required under section 72(p)(2). 
Participant J's vested account balance under Plan X is $50,000. J 
receives a loan from Trust Z in the amount of $5,000 on December 1, 
2003 to be repaid in level installments made quarterly over the 5-
year period ending on November 30, 2008. Participant J makes the 
required repayments until J has a severance from employment from 
State Y in 2005 and subsequently fails to repay the outstanding loan 
balance of $2,250. The $2,250 loan balance is offset against J's 
$80,000 account balance benefit under Plan X, and J is paid one 
fifth of the remaining $77,750 in 2005.
    (ii) Conclusion. The making of the loan to J will not be treated 
as a violation of the requirements of section 457(b) or the 
regulations. The cancellation of the loan at severance from 
employment does not cause Plan X to fail to satisfy the requirements 
for plan eligibility under section 457. In addition, because the 
loan satisfies the maximum amount and repayment requirements of 
section 72(p)(2), J is not required to include any amount in income 
as a result of the loan until 2005, when J has income of $2,250 as a 
result of the offset (which is a permissible distribution under this 
section) and income of $15,550 (one fifth of $77,750) as a result of 
the first annual installment payment.


Sec. 1.457-7  Taxation of distributions under eligible plans.

    (a) General rules for when amounts are included in gross income. 
The rules for determining when an amount deferred under an eligible 
plan is includible in the gross income of a participant or beneficiary 
depend on whether the plan is an eligible governmental plan or an 
eligible plan of a tax-exempt entity. Paragraph (b) of this

[[Page 30840]]

section sets forth the rules for an eligible governmental plan. 
Paragraph (c) of this section sets forth the rules for an eligible plan 
of a tax-exempt entity.
    (b) Amounts included in gross income under an eligible governmental 
plan--(1) Amounts included in gross income in year paid under an 
eligible governmental plan. Except as provided in paragraphs (b)(2) and 
(3) of this section (or in Sec. 1.457-10(c) relating to payments to a 
spouse or former spouse pursuant to a qualified domestic relations 
order), amounts deferred under an eligible governmental plan are 
includible in the gross income of a participant or beneficiary for the 
taxable year in which paid to the participant or beneficiary under the 
plan.
    (2) Rollovers to individual retirement arrangements and other 
eligible retirement plans. A trustee-to-trustee transfer in accordance 
with section 401(a)(31) (generally referred to as a direct rollover) is 
not includible in gross income of a participant or beneficiary in the 
year transferred. In addition, any payment made in the form of an 
eligible rollover distribution (as defined in section 402(c)(4)) is not 
includible in gross income in the year paid to the extent the payment 
is transferred to an eligible retirement plan (as defined in section 
402(c)(8)(B)) within 60 days, including the transfer to the eligible 
retirement plan of any property distributed from the eligible 
governmental plan. For this purpose, the rules of section 402(c)(2) 
through (7) and (9) apply. Any trustee-to-trustee transfer under this 
paragraph (b)(2) is a distribution that is subject to the distribution 
requirements of Sec. 1.457-6.
    (3) Amounts taxable under section 72(p)(1). In accordance with 
section 72(p), the amount of any loan from an eligible governmental 
plan to a participant or beneficiary (including any pledge or 
assignment treated as a loan under section 72(p)(1)(B)) is treated as 
having been received as a distribution from the plan under section 
72(p)(1), except to the extent set forth in section 72(p)(2) (relating 
to loans that do not exceed a maximum amount and that are repayable in 
accordance with certain terms) and Sec. 1.72(p)-1. Thus, except to the 
extent a loan satisfies section 72(p)(2), any amount loaned from an 
eligible governmental plan to a participant or beneficiary (including 
any pledge or assignment treated as a loan under section 72(p)(1)(B)) 
is includible in the gross income of the participant or beneficiary for 
the taxable year in which the loan is made. See generally Sec. 1.72(p)-
1.
    (4) Examples. The provisions of this paragraph (b) are illustrated 
by the following examples:

    Example 1. (i) Facts. Eligible Plan G of a governmental entity 
permits distribution of benefits in a single sum or in installments 
of up to 20 years, with such benefits to commence at any date that 
is after severance from employment (but not later than the plan's 
normal retirement age of 65). Effective for participants who have a 
severance from employment after December 31, 2001, Plan X allows an 
election--as to both the date on which payments are to begin and the 
form in which payments are to be made--to be made by the participant 
at any time that is before the commencement date selected. However, 
Plan X chooses to require elections to be filed at least 30 days 
before the commencement date selected in order for Plan X to have 
enough time to be able to effectuate the election.
    (ii) Conclusion. No amounts are included in gross income before 
actual payments begin. If installment payments begin (and the 
installment payments are payable over at least 10 years so as not to 
be eligible rollover distributions), the amount included in gross 
income for any year is equal to the amount of the installment 
payment paid during the year.
    Example 2. (i) Facts. Same facts as in Example 1, except that 
the same rules are extended to participants who had a severance from 
employment before January 1, 2002.
    (ii) Conclusion. For all participants (i.e., both those who have 
a severance from employment after December 31, 2001 and those who 
have a severance from employment before January 1, 2002 (including 
those whose benefit payments have commenced before January 1, 
2002)), no amounts are included in gross income before actual 
payments begin. If installment payments begin (and the installment 
payments are payable over at least 10 years so as not to be eligible 
rollover distributions), the amount included in gross income for any 
year is equal to the amount of the installment payment paid during 
the year.

    (c) Amounts included in gross income under an eligible plan of a 
tax-exempt entity--(1) Amounts included in gross income in year paid or 
made available under an eligible plan of a tax-exempt entity. Amounts 
deferred under an eligible plan of a tax-exempt entity are includible 
in the gross income of a participant or beneficiary for the taxable 
year in which paid or otherwise made available to the participant or 
beneficiary under the plan. Thus, amounts deferred under an eligible 
plan of a tax-exempt entity are includible in the gross income of the 
participant or beneficiary in the year the amounts are first made 
available under the terms of the plan, even if the plan has not 
distributed the amounts deferred. Amounts deferred under an eligible 
plan of a tax-exempt entity are not considered made available to the 
participant or beneficiary solely because the participant or 
beneficiary is permitted to choose among various investments under the 
plan.
    (2) When amounts deferred are considered to be made available under 
an eligible plan of a tax-exempt entity--(i) General rule. Except as 
provided in paragraphs (c)(2)(ii) through (iv) of this section, amounts 
deferred under an eligible plan of a tax-exempt entity are considered 
made available (and, thus, are includible in the gross income of the 
participant or beneficiary under this paragraph (c)) at the earliest 
date, on or after severance from employment, on which the plan allows 
distributions to commence, but in no event later than the date on which 
distributions must commence pursuant to section 401(a)(9). For example, 
in the case of a plan that permits distribution to commence on the date 
that is 60 days after the close of the plan year in which the 
participant has a severance from employment with the eligible employer, 
amounts deferred are considered to be made available on that date. 
However, distributions deferred in accordance with paragraphs 
(c)(2)(ii) through (iv) of this section are not considered made 
available prior to the applicable date under paragraphs (c)(2)(ii) 
through (iv) of this section. In addition, no portion of a participant 
or beneficiary's account is treated as made available (and thus 
currently includible in income) under an eligible plan of a tax-exempt 
entity merely because the participant or beneficiary under the plan may 
elect to receive a distribution in any of the following circumstances:
    (A) If the requirements of Sec. 1.457-4(d) are met, a distribution 
of amounts representing accumulated sick and vacation pay solely 
because a participant was entitled to take paid sick or vacation leave 
in lieu of regular compensation or because the participant could have 
deferred these amounts under an eligible plan at an earlier date. 
However, to the extent that the participant is able to receive the 
value of accumulated sick and vacation pay in cash (in addition to 
regular compensation) at the time of the election to defer, these 
amounts are considered made available.
    (B) If the requirements of Sec. 1.457-6(c)(2) are met, a 
distribution in the event of an unforeseeable emergency.
    (C) If the requirements of Sec. 1.457-6(e)(1) are met, a 
distribution not in excess of the dollar limit under section 
411(a)(11)(A) (which is $5,000 for 2002) either before or after the 
participant has a severance from employment with the employer.
    (ii) Initial election to defer commencement of distributions--(A) 
In general. An eligible plan of a tax-exempt

[[Page 30841]]

entity may provide a period for making an initial election during which 
the participant or beneficiary may elect, in accordance with the terms 
of the plan, to defer the payment of some or all of the amounts 
deferred to a fixed or determinable future time. The period for making 
this initial election must expire prior to the first time that any such 
amounts would be considered made available under the plan under 
paragraph (c)(2)(i) of this section.
    (B) Failure to make initial election to defer commencement of 
distributions. Generally, if no initial election is made by a 
participant or beneficiary under this paragraph (c)(2)(ii), then the 
amounts deferred under an eligible plan of a tax-exempt entity are 
considered made available and taxable to the participant or beneficiary 
in accordance with paragraph (c)(2)(i) of this section at the earliest 
time, on or after severance from employment (but in no event later than 
the date on which distributions must commence pursuant to section 
401(a)(9)), that distribution is permitted to commence under the terms 
of the plan. However, the plan may provide for a default payment 
schedule that applies if no election is made. If the plan provides for 
a default payment schedule, the amounts deferred are includible in the 
gross income of the participant or beneficiary in the year the amounts 
deferred are first made available under the terms of the default 
payment schedule.
    (iii) Additional election to defer commencement of distribution. An 
eligible plan of a tax-exempt entity is permitted to provide that a 
participant or beneficiary who has made an initial election under 
paragraph (c)(2)(ii)(A) of this section may make one additional 
election to defer (but not accelerate) commencement of distributions 
under the plan before distributions have commenced in accordance with 
the initial deferral election under paragraph (c)(2)(ii)(A) of this 
section. Amounts payable to a participant or beneficiary under an 
eligible plan of a tax-exempt entity are not treated as made available 
merely because the plan allows the participant to make an additional 
election under this paragraph (c)(2)(iii). A participant or beneficiary 
is not precluded from making an additional election to defer 
commencement of distributions merely because the participant or 
beneficiary has previously received a distribution under Sec. 1.457-
6(c) because of an unforeseeable emergency, has received a distribution 
of smaller amounts under Sec. 1.457-6(e), has made (and revoked) other 
deferral or method of payment elections within the initial election 
period, or is subject to a default payment schedule under which the 
commencement of benefits is deferred (for example, until a participant 
is age 65).
    (iv) Election as to method of payment. An eligible plan of a tax-
exempt entity may provide that the election as to the method of payment 
under the plan may be made at any time prior to the time the amounts 
are distributed in accordance with the participant or beneficiary's 
initial or additional election to defer commencement of distributions 
under paragraph (c)(2)(ii) or (iii) of this section. Where no method of 
payment is elected, the entire amount deferred will be includible in 
the gross income of the participant or beneficiary when the amounts 
first become made available in accordance with a participant's initial 
or additional elections to defer under paragraphs (c)(2)(ii) and (iii) 
of this section, unless the eligible plan provides for a default method 
of payment (in which case amounts are considered made available and 
taxable when paid under the terms of the default payment schedule).
    (3) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. (i) Facts. Eligible Plan X of a tax-exempt entity 
provides that a participant's total account balance, representing 
all amounts deferred under the plan, is payable to a participant in 
a single sum 60 days after severance from employment throughout 
these examples, unless, during a 30-day period immediately following 
the severance, the participant elects to receive the single sum 
payment at a later date (that is not later than the plan's normal 
retirement age of 65) or elects to receive distribution in 10 annual 
installments to begin 60 days after severance from employment (or at 
a later date, if so elected, that is not later than the plan's 
normal retirement age of 65). On November 13, 2002, participant K, a 
calendar year taxpayer, has a severance from employment with the 
eligible employer. K does not, within the 30-day window period, 
elect to postpone distributions to a later date or to receive 
payment in 10 fixed annual installments.
    (ii) Conclusion. The single sum payment is payable to K 60 days 
after the date K has a severance from employment (January 12, 2003), 
and is includible in the gross income of K in 2003 under section 
457(a).
    Example 2. (i) Facts. The terms of eligible Plan X are the same 
as described in Example 1. Participant L participates in eligible 
Plan X. On November 11, 2002, participant L has a severance from the 
employment of the eligible employer. On November 24, 2002, L makes 
an initial deferral election not to receive the single sum payment 
payable 60 days after the severance, and instead elects to receive 
the amounts in 10 annual installments to begin 60 days after 
severance from employment.
    (ii) Conclusion. No portion of L's account is considered made 
available in 2002 or 2003 before a payment is made and no amount is 
includible in the gross income of L until distributions commence. 
The annual installment payable in 2003 will be includible in L's 
gross income in 2003.
    Example 3. (i) Facts. The facts are the same as in Example 1, 
except that eligible Plan X also provides that those participants 
who are receiving distributions in 10 annual installments may, at 
any time and without restriction, elect to receive a cash out of all 
remaining installments. Participant M elects to receive a 
distribution in 10 annual installments commencing in 2003.
    (ii) Conclusion. M's total account balance, representing the 
total of the amounts deferred under the plan, is considered made 
available in, and is includible in M's gross income, in 2003.
    Example 4. (i) Facts. The facts are the same as in Example 3, 
except that, instead of providing for an unrestricted cash out of 
remaining payments, the plan provides that participants or 
beneficiaries who are receiving distributions in 10 annual 
installments may accelerate the payment of the amount remaining 
payable to the participant upon the occurrence of an unforeseeable 
emergency as described in Sec. 1.457-6(c)(1) in an amount not 
exceeding that described in Sec. 1.457-6(c)(2).
    (ii) Conclusion. No amount is considered made available to 
participant M on account of M's right to accelerate payments upon 
the occurrence of an unforeseeable emergency.
    Example 5. (i) Facts. Eligible Plan Y of a tax-exempt entity 
provides that distributions will commence 60 days after a 
participant's severance from employment unless the participant 
elects, within a 30-day window period following severance from 
employment, to defer distributions to a later date (but no later 
than the year following the calendar year the participant attains 
age 70\1/2\). The plan provides that a participant who has elected 
to defer distributions to a later date may make an election as to 
form of distribution at any time prior to the 30th day before 
distributions are to commence.
    (ii) Conclusion. No amount is considered made available prior to 
the date distributions are to commence by reason of a participant's 
right to defer or make an election as to the form of distribution.
    Example 6. (i) Facts. The facts are the same as in Example 1, 
except that the plan also permits participants who have earlier made 
an election to defer distribution to make one additional deferral 
election at any time prior to the date distributions are scheduled 
to commence. Participant N has a severance from employment at age 
50. The next day, during the 30-day period provided in the plan, N 
elects to receive distribution in the form of 10 annual installment 
payments beginning at age 55. Two weeks later, within the 30-day 
window period, N makes a new election permitted under the plan to 
receive 10 annual installment payments beginning at age 60 (instead 
of age 55). When N is age 59, N elects under the additional deferral 
election provisions, to defer distributions until age 65.
    (ii) Conclusion. In this example, N's election to defer 
distributions until age 65 is a valid election. The two elections N 
makes

[[Page 30842]]

during the 30-day window period are not additional deferral 
elections described in paragraph (c)(2)(iii) of this section because 
they are made before the first permissible payout date under the 
plan. Therefore, the plan is not precluded from allowing N to make 
the additional deferral election. However, N can make no further 
election to defer distributions beyond age 65 because this 
additional deferral election can only be made once.


Sec. 1.457-8  Funding rules for eligible plans.

    (a) Eligible governmental plans--(1) In general. In order to be an 
eligible governmental plan, all amounts deferred under the plan, all 
property and rights purchased with such amounts, and all income 
attributable to such amounts, property, or rights, must be held in 
trust for the exclusive benefit of participants and their 
beneficiaries. A trust described in this paragraph (a) that also meets 
the requirements of Secs. 1.457-3 through 1.457-10 is treated as an 
organization exempt from tax under section 501(a), and a participant's 
or beneficiary's interest in amounts in the trust is includible in the 
gross income of the participants and beneficiaries only to the extent, 
and at the time, provided for in section 457(a) and Secs. 1.457-4 
through 1.457-10.
    (2) Trust requirement. (i) A trust described in this paragraph (a) 
must be established pursuant to a written agreement that constitutes a 
valid trust under state law. The terms of the trust must make it 
impossible, prior to the satisfaction of all liabilities with respect 
to participants and their beneficiaries, for any part of the assets and 
income of the trust to be used for, or diverted to, purposes other than 
for the exclusive benefit of participants and their beneficiaries.
    (ii) Amounts deferred under an eligible governmental plan must be 
transferred to a trust within a period that is not longer than is 
reasonable for the proper administration of the participant accounts 
(if any). For purposes of this requirement, the plan may provide for 
amounts deferred for a participant under the plan to be transferred to 
the trust within a specified period after the date the amounts would 
otherwise have been paid to the participant. For example, the plan 
could provide for amounts deferred under the plan to be contributed to 
the trust within 15 business days following the month in which these 
amounts would otherwise have been paid to the participant.
    (3) Custodial accounts and annuity contracts treated as trusts--(i) 
In general. For purposes of the trust requirement of this paragraph 
(a), custodial accounts and annuity contracts described in section 
401(f) that satisfy the requirements of this paragraph (a)(3) are 
treated as trusts under rules similar to the rules of section 401(f). 
Therefore, the provisions of Sec. 1.401(f)-1(b) will generally apply to 
determine whether a custodial account or an annuity contract is treated 
as a trust. The use of a custodial account or annuity contract as part 
of an eligible governmental plan does not preclude the use of a trust 
or another custodial account or annuity contract as part of the same 
plan, provided that all such vehicles satisfy the requirements of 
section 457(g)(1) and (3) and paragraphs (a)(1) and (2) of this section 
and that all assets and income of the plan are held in such vehicles.
    (ii) Custodial accounts--(A) In general. A custodial account is 
treated as a trust, for purposes of section 457(g)(1) and paragraph 
(a)(1) and (2) of this section, if the custodian is a bank, as 
described in section 408(n), or a person who meets the nonbank trustee 
requirements of paragraph (a)(3)(ii)(B) of this section, and the 
account meets the requirements of paragraphs (a)(1) and (2) of this 
section, other than the requirement that it be a trust.
    (B) Nonbank trustee status. The custodian of a custodial account 
may be a person other than a bank only if the person demonstrates to 
the satisfaction of the Commissioner that the manner in which the 
person will administer the custodial account will be consistent with 
the requirements of section 457(g)(1) and (3). To do so, the person 
must demonstrate that the requirements of Sec. 1.408-2(e)(2) through 
(6) (relating to nonbank trustees) are met. The written application 
must be sent to the address prescribed by the Commissioner in the same 
manner as prescribed under Sec. 1.408-2(e). To the extent that a person 
has already demonstrated to the satisfaction of the Commissioner that 
the person satisfies the requirements of Sec. 1.408-2(e) in connection 
with a qualified trust (or custodial account or annuity contract) under 
section 401(a), that person is deemed to satisfy the requirements of 
this paragraph (a)(3)(ii)(B).
    (iii) Annuity contracts. An annuity contract is treated as a trust 
for purposes of section 457(g)(1) and paragraph (a)(1) of this section 
if the contract is an annuity contract, as defined in section 401(g), 
that has been issued by an insurance company qualified to do business 
in the State, and the contract meets the requirements of paragraphs 
(a)(1) and (2) of this section, other than the requirement that it be a 
trust. An annuity contract does not include a life, health or accident, 
property, casualty, or liability insurance contract.
    (4) Combining assets. [Reserved]
    (b) Eligible plans maintained by tax-exempt entity--(1) General 
rule. In order to be an eligible plan of a tax-exempt entity, the plan 
must be unfunded and plan assets must not be set aside for participants 
or their beneficiaries. Under section 457(b)(6) and this paragraph (b), 
an eligible plan of a tax-exempt entity must provide that all amounts 
deferred under the plan, all property and rights to property (including 
rights as a beneficiary of a contract providing life insurance 
protection) purchased with such amounts, and all income attributable to 
such amounts, property, or rights, must remain (until paid or made 
available to the participant or beneficiary) solely the property and 
rights of the eligible employer (without being restricted to the 
provision of benefits under the plan), subject only to the claims of 
the eligible employer's general creditors.
    (2) Additional requirements. For purposes of paragraph (b)(1) of 
this section, the plan must be unfunded regardless of whether or not 
the amounts were deferred pursuant to a salary reduction agreement 
between the eligible employer and the participant. Any funding 
arrangement under an eligible plan of a tax-exempt entity that sets 
aside assets for the exclusive benefit of participants violates this 
requirement, and amounts deferred are generally immediately includible 
in the gross income of plan participants and beneficiaries. Nothing in 
this paragraph (b) prohibits an eligible plan from permitting 
participants and their beneficiaries to make an election among 
different investment options available under the plan, such as an 
election affecting the investment of the amounts described in paragraph 
(b)(1) of this section.


Sec. 1.457-9  Effect on eligible governmental plan when not 
administered in accordance with eligibility requirements.

    A plan of a state ceases to be an eligible governmental plan on the 
first day of the first plan year beginning more than 180 days after the 
date on which the Commissioner notifies the state in writing that the 
plan is being administered in a manner that is inconsistent with one or 
more of the requirements of Secs. 1.457-3 through 1.457-8, or 1.457-10. 
However, the plan may correct the plan inconsistencies specified in the 
written notification before the first day of that plan year and 
continue to maintain plan eligibility. If a plan ceases to be an 
eligible governmental plan, amounts

[[Page 30843]]

subsequently deferred by participants will be includible in income when 
deferred, or, if later, when the amounts deferred cease to be subject 
to a substantial risk of forfeiture, as provided at Sec. 1.457-11. 
Amounts deferred before the date on which the plan ceases to be an 
eligible governmental plan, and any earnings thereon, will be treated 
as if the plan continues to be an eligible governmental plan and will 
not be includible in participant's or beneficiary's gross income until 
paid to the participant or beneficiary.


Sec. 1.457-10  Miscellaneous provisions.

    (a) Plan terminations and frozen plans--(1) In general. An eligible 
employer may amend its plan to eliminate future deferrals for existing 
participants or to limit participation to existing participants and 
employees. An eligible plan may also contain provisions that permit 
plan termination and permit amounts deferred to be distributed on 
termination. In order for a plan to be considered terminated, amounts 
deferred under an eligible plan must be distributed to all plan 
participants and beneficiaries as soon as administratively practicable 
after termination of the eligible plan. The mere provision for, and 
making of, distributions to participants or beneficiaries upon a plan 
termination will not cause an eligible plan to cease to satisfy the 
requirements of section 457(b) of the regulations.
    (2) Employers that cease to be eligible employers--(i) Plan not 
terminated. An eligible employer that ceases to be an eligible employer 
may no longer maintain an eligible plan. If the employer was a tax-
exempt entity and the plan is not terminated as permitted under 
paragraph (a)(2)(ii) of this section, the tax consequences to 
participants and beneficiaries in the previously eligible (unfunded) 
plan of an ineligible employer will be determined in accordance with 
either section 451 if the employer becomes an entity other than a state 
or Sec. 1.457-11 if the employer becomes a state. If the employer was a 
state and the plan is neither terminated as permitted under paragraph 
(a)(2)(ii) of this section nor transferred to another eligible plan of 
that state as permitted under paragraph (b) of this section, the tax 
consequences to participants in the previously eligible governmental 
plan of an ineligible employer, the assets of which are held in trust 
pursuant to Sec. 1.457-8(a), will be determined in accordance with 
section 402(b) (section 403(c) in the case of an annuity contract) and 
the trust will no longer be treated as a trust that is exempt from tax 
under section 501(a).
    (ii) Plan termination. As an alternative to determining the tax 
consequences to the plan and participants under paragraph (a)(2)(i) of 
this section, the employer may terminate the plan and distribute the 
amounts deferred (and all plan assets) to all plan participants as soon 
as administratively practicable in accordance with paragraph (a)(1) of 
this section. Such distribution may include eligible rollover 
distributions in the case of a plan that was an eligible governmental 
plan. In addition, if the employer is a state, another alternative to 
determining the tax consequences under paragraph (a)(2)(i) of this 
section is to transfer the assets of the eligible governmental plan to 
an eligible governmental plan of another eligible employer within the 
same state under the plan-to-plan transfer rules of paragraph (b) of 
this section.
    (3) Examples. The provisions of this paragraph (a) are illustrated 
by the following examples:

    Example 1. (i) Facts. Employer Y, a corporation that owns a 
state hospital, sponsors an eligible governmental plan funded 
through a trust. Employer Y is acquired by a for-profit hospital and 
Employer Y ceases to be an eligible employer under section 457(e)(1) 
or Sec. 1.457-2(e). Employer Y terminates the plan and, during the 
next 6 months, distributes to participants and beneficiaries all 
amounts deferred that were under the plan.
    (ii) Conclusion. The termination and distribution does not cause 
the plan to fail to be an eligible governmental plan. Amounts that 
are distributed as eligible rollover distributions may be rolled 
over to an eligible retirement plan described in section 
402(c)(8)(B).
    Example 2. (i) Facts. The facts are the same as in Example 1, 
except that Employer Y decides to continue to maintain the plan.
    (ii) Conclusion. If Employer Y continues to maintains the plan, 
the tax consequences to participants and beneficiaries with respect 
to compensation deferred thereafter will be determined in accordance 
with either section 402(b) if the compensation deferred is funded 
through a trust, section 403(c) if the compensation deferred is 
funded through annuity contracts, or Sec. 1.457-11 if the 
compensation deferred is not funded through a trust or annuity 
contract. In addition, if Employer Y continues to maintain the plan, 
the trust (including amounts deferred before the date on which the 
plan ceases to be an eligible governmental plan and any earnings 
thereon) will no longer be treated as exempt from tax under section 
501(a).
    Example 3. (i) Facts. Employer Z, a corporation that owns a tax-
exempt hospital, sponsors an unfunded eligible plan. Employer Z is 
acquired by a for-profit hospital and is no longer an eligible 
employer under section 457(e)(1) or Sec. 1.457-2(e). Employer Z 
terminates the plan and distributes all amounts deferred under the 
eligible plan to participants and beneficiaries within a one-year 
period.
    (ii) Conclusion. Distributions under the plan are treated as 
made under an eligible plan of a tax-exempt entity and the 
distributions of the amounts deferred are includible in the gross 
income of the participant or beneficiary in the year distributed.
    Example 4. (i) Facts. The facts are the same as in Example 3, 
except that Employer Z decides to maintain instead of terminate the 
plan.
    (ii) Conclusion. If Employer Z maintains the plan, the tax 
consequences to participants and beneficiaries in the plan will 
thereafter be determined in accordance with section 451.

    (b) Plan-to-plan transfers--(1) General rule. An eligible 
governmental plan may provide for the transfer of amounts deferred by a 
participant or beneficiary to another eligible governmental plan, and 
an eligible plan of a tax-exempt entity may provide for transfers of 
amounts deferred by a participant to another eligible plan of a tax-
exempt entity, if the conditions in paragraph (b)(2) of this section 
are met. An eligible governmental plan may accept transfers from 
another eligible governmental plan as described in the preceding 
sentence, and an eligible plan of a tax-exempt entity may accept 
transfers from another eligible plan of a tax-exempt entity as 
described in the preceding sentence. However, a state may not transfer 
the assets of its eligible governmental plan to a tax-exempt entity's 
eligible plan and the plan of a tax-exempt entity may not accept such a 
transfer. Similarly, a tax-exempt entity may not transfer the assets of 
its eligible plan to an eligible governmental plan and an eligible 
governmental plan may not accept such a transfer. In addition, if the 
conditions in paragraph (b)(4) of this section (relating to permissive 
past service credit and repayments under section 415) are met, an 
eligible governmental plan of a state may provide for the transfer of 
amounts deferred by a participant or beneficiary to a qualified plan 
(under section 401(a)) maintained by a state. However, a qualified plan 
may not transfer assets to an eligible governmental plan or to an 
eligible plan of a tax-exempt entity, and an eligible governmental plan 
or the plan of a tax-exempt entity may not accept such a transfer.
    (2) Requirements for plan-to-plan transfers among eligible plans. A 
transfer under paragraph (b)(1) of this section from an eligible 
governmental plan to another eligible governmental plan is permitted 
only if the following conditions are met--
    (i) The transferor plan provides for transfers;
    (ii) The receiving plan provides for the receipt of transfers;

[[Page 30844]]

    (iii) The participant or beneficiary whose amounts deferred are 
being transferred will have an amount deferred immediately after the 
transfer at least equal to the amount deferred with respect to that 
participant or beneficiary immediately before the transfer; and
    (iv) The participant or beneficiary whose amounts deferred are 
being transferred has had a severance from employment with the 
transferring employer and is performing services for the entity 
maintaining the receiving plan. However, this paragraph (b)(2)(iv) is 
not required to be satisfied if--
    (A) All of the assets held by the eligible governmental plan are 
transferred;
    (B) The transfer is to another eligible governmental plan 
maintained by an eligible employer that is a state entity within the 
same state; and
    (C) The participants whose deferred amounts are being transferred 
are not eligible for additional annual deferrals in the receiving plan 
unless they are performing services for the entity maintaining the 
receiving plan.
    (3) Examples. The provisions of paragraphs (b)(1) and (2) of this 
section are illustrated by the following examples:

    Example 1. (i) Facts. Participant A, the president of City X's 
hospital, has accepted a position with another hospital which is a 
tax-exempt entity. A participates in the eligible governmental plan 
of City X. A would like to transfer the amounts deferred under City 
X's eligible governmental plan to the eligible plan of the tax-
exempt hospital.
    (ii) Conclusion. City X's plan may not transfer A's amounts 
deferred to the tax-exempt employer's eligible plan. In addition, 
because the amounts deferred would no longer be held in trust for 
the exclusive benefit of participants and their beneficiaries, the 
transfer would violate the exclusive benefit rule of section 457(g) 
and Sec. 1.457-8(a).
    Example 2. (i) Facts. County M, located in State S, operates 
several health clinics and maintains an eligible governmental plan 
for employees of those clinics. One of the clinics operated by 
County M is being acquired by a hospital operated by State S, and 
employees of that clinic will become employees of State S. County M 
permits those employees to transfer their balances under County M's 
eligible governmental plan to the eligible governmental plan of 
State S.
    (ii) Conclusion. If the eligible governmental plans of County M 
and State S provide for the transfer and acceptance of the transfer 
(and the other requirements of paragraph (b)(1) of this section are 
satisfied), the transfer will not cause either plan to violate the 
requirements of section 457 or these regulations.
    Example 3. (i) Facts. City Employer Z, a hospital, sponsors an 
eligible governmental plan. City Employer Z is located in State B. 
All of the assets of City Employer Z are being acquired by a tax-
exempt hospital. City Employer Z, in accordance with the plan-to-
plan transfer rules of paragraph (b) of this section, would like to 
transfer the total amount of assets deferred under City Employer Z's 
eligible governmental plan to the acquiring tax-exempt entity's 
eligible plan.
    (ii) Conclusion. City Employer Z may not permit participants to 
transfer the amounts to the eligible plan of the tax-exempt entity. 
In addition, because the amounts deferred would no longer be held in 
trust for the exclusive benefit of participants and their 
beneficiaries, the transfer would violate the exclusive benefit rule 
of section 457(g) and Sec. 1.457-8(a).
    Example 4.  (i) Facts. The facts are the same as in Example 3, 
except that City Employer Z, prior to the transfer of all of its 
assets to the eligible plan of the tax-exempt entity, decides to 
transfer all of the amounts deferred under City Z's eligible 
governmental plan to the eligible governmental plan of the related 
state government entity, State B.
    (ii) Conclusion. If City Employer Z's (transferor) eligible 
governmental plan provides for such transfer and the eligible 
governmental plan of the State B permits the acceptance of such a 
transfer (and the other requirements of paragraph (b)(1) of this 
section are satisfied), City Employer Z may transfer the total 
amounts deferred under its eligible governmental plan, prior to 
termination of that plan, to the eligible governmental plan 
maintained by State B. However, the participants of City Employer Z 
whose deferred amounts are being transferred are not eligible to 
participate in the eligible governmental plan of State B, the 
receiving plan, unless they are performing services for State B.

    (4) Purchase of permissive past service credit by plan-to-plan 
transfers from an eligible governmental plan to a qualified plan--(i) 
General rule. An eligible governmental plan of a state may provide for 
the transfer of amounts deferred by a participant or beneficiary to a 
defined benefit governmental plan (as defined in section 414(d)) of 
that state, and no amount shall be includible in gross income by reason 
of the transfer, if the conditions in paragraph (b)(4)(ii) of this 
section are met. A transfer under this paragraph (b)(4) is not treated 
as a distribution for purposes of Sec. 1.457-6. Therefore, such a 
transfer may be made before severance from employment.
    (ii) Conditions for plan-to-plan transfers from an eligible 
governmental plan to a qualified plan. A transfer may be made under 
this paragraph (b)(4) only if the transfer is either--
    (A) For the purchase of permissive past service credit (as defined 
in section 415(n)(3)(A)) under the receiving defined benefit 
governmental plan; or
    (B) A repayment to which section 415 does not apply by reason of 
section 415(k)(3).
    (iii) Example. The provisions of this paragraph (b)(4) are 
illustrated by the following example:

    Example. (i) Facts. Plan X is an eligible governmental plan 
maintained by County Y for its employees. Plan X provides for 
distributions only in the event of death, an unforeseeable 
emergency, or severance from employment with Y (including retirement 
from Y). Plan S is a qualified defined benefit plan maintained by 
State T for its employees. County Y is within State T. Employee A is 
an employee of Y and is a participant in Plan X. Employee A 
previously was an employee of T and is still entitled to benefits 
under Plan S. Plan S includes provisions allowing participants in 
certain plans, including Plan X, to transfer assets to Plan S for 
the purchase past service credit under Plan S not in excess of the 
credit permitted under section 415(n) and does not permit the amount 
transferred to exceed the amount necessary to fund the benefit 
resulting from the past service credit. Although not required to do 
so, Plan X allows A to transfer assets to Plan T to provide a past 
service benefit under Plan T.
    (ii) Conclusion. Assuming that the special rules at section 
415(n)(3) are satisfied with respect to the transfer, the transfer 
is permitted under this paragraph (b)(4).

    (c) Qualified domestic relations orders under eligible plans--(1) 
General rule. An eligible plan does not become an ineligible plan 
described in section 457(f) solely because its administrator or sponsor 
complies with a qualified domestic relations order as defined in 
section 414(p), including an order requiring the distribution of the 
benefits of a participant to an alternate payee in advance of the 
general rules for eligible plan distributions under Sec. 1.457-6. If a 
distribution or payment is made from an eligible plan to an alternate 
payee pursuant to a qualified domestic relations order, rules similar 
to the rules of section 402(e)(1)(A) shall apply to the distribution or 
payment.
    (2) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. (i) Facts. Participant C and C's spouse D are 
divorcing. C is employed by State S and is a participant in an 
eligible plan maintained by S. C has an account valued at $100,000 
under the plan. Pursuant to the divorce, a court issues a qualified 
domestic relations order on September 1, 2003 that allocates 50 
percent of C's $100,000 plan account to D and specifically provides 
for an immediate distribution to D of D's share within 6 months of 
the order. Payment is made to D in January of 2004.
    (ii) Conclusion. S's eligible plan does not become an ineligible 
plan described in section 457(f) and Sec. 1.457-11 solely because 
its administrator or sponsor complies with the qualified domestic 
relations order requiring the immediate distribution to D in advance 
of the general rules for eligible plan distributions under 
Sec. 1.457-6. In accordance with section 402(e)(1)(A), D (not C) 
must include the distribution in gross income. The

[[Page 30845]]

distribution is includible in D's gross income in 2004. If the 
qualified domestic relations order were to provide for distribution 
to D at a future date, amounts deferred attributable to D's share 
will be includible in D's gross income when paid to D.
    Example 2. (i) Facts. The facts are the same as in Example 1, 
except that S is a tax-exempt entity, instead of a state.
    (ii) Conclusion. S's eligible plan does not become an ineligible 
plan described in section 457(f) and Sec. 1.457-11 solely because 
its administrator or sponsor complies with the qualified domestic 
relations order requiring the immediate distribution to D in advance 
of the general rules for eligible plan distributions under 
Sec. 1.457-6. In accordance with section 402(e)(1)(A), D (not C) 
must include the distribution in gross income. The distribution is 
includible in D's gross income in 2004, assuming that the plan did 
not make the distribution available to D in 2003. If the qualified 
domestic relations order were to provide for distribution to D at a 
future date, amounts deferred attributable to D's share would be 
includible in D's gross income when paid or made available to D.

    (d) Death benefits and life insurance proceeds. A death benefit 
plan under section 457(e)(11) is not an eligible plan. In addition, no 
amount paid or made available under an eligible plan as death benefits 
or life insurance proceeds is excludable from gross income under 
section 101.
    (e) Rollovers to eligible governmental plans--(1) General rule. An 
eligible governmental plan may accept contributions that are eligible 
rollover distributions (as defined in section 402(c)(4)) made from 
another eligible retirement plan (as defined in section 402(c)(8)(B)) 
if the conditions in paragraph (e)(2) of this section are met. Amounts 
contributed to an eligible governmental plan as eligible rollover 
distributions are not taken into account for purposes of the annual 
limit on annual deferrals by a participant in Sec. 1.457-4(c) or 
Sec. 1.457-5, but are otherwise treated in the same manner as amounts 
deferred under section 457 for purposes of Secs. 1.457-3 through 1.457-
9 and this section.
    (2) Conditions for rollovers to an eligible governmental plan. An 
eligible governmental plan that permits eligible rollover distributions 
made from another eligible retirement plan to be paid into the eligible 
governmental plan is required under this paragraph (e)(2) to provide 
that it will separately account for any eligible rollover distributions 
it receives.
    (3) Example. The provisions of this paragraph (e) are illustrated 
by the following example:

    Example. (i) Facts. Plan T is an eligible governmental plan that 
provides that employees who are eligible to participate in Plan T 
may make rollover contributions to Plan T from amounts distributed 
to an employee from an eligible retirement plan. An eligible 
retirement plan is defined in Plan T as another eligible 
governmental plan, a qualified section 401(a) or 403(a) plan, or a 
section 403(b) contract, or an individual retirement arrangement 
(IRA) that holds such amounts. Plan T requires rollover 
contributions to be paid by the eligible retirement plan directly to 
Plan T (a direct rollover) or to be paid by the participant within 
60 days after the date on which the participant received the amount 
from the other eligible retirement plan. Plan T does not take 
rollover contributions into account for purposes of the plan's 
limits on amounts deferred that conform to Sec. 1.457-4(c). Rollover 
contributions paid to Plan T are invested in the trust in the same 
manner as amounts deferred under Plan T and rollover contributions 
(and earnings thereon) are available for distribution to the 
participant at the same time and in the same manner as amounts 
deferred under Plan T. In addition, Plan T provides that, for each 
participant who makes a rollover contribution to Plan T, the Plan T 
recordkeeper is to establish a separate account for the 
participant's rollover contributions. The recordkeeper calculates 
earnings and losses for investments held in the rollover account 
separately from earnings and losses on other amounts held under the 
plan and calculates disbursements from and payments made to the 
rollover account separately from disbursements from and payments 
made to other amounts held under the plan.
    (ii) Conclusion. Plan T does not lose its status as an eligible 
governmental plan as a result of the receipt of rollover 
contributions.

    (f) Deemed IRAs under eligible governmental plans. [Reserved]


Sec. 1.457-11  Tax treatment of participants if plan is not an eligible 
plan.

    (a) In general. Under section 457(f), if an eligible employer 
provides for a deferral of compensation under any agreement or 
arrangement that is an ineligible plan--
    (1) Compensation deferred under the agreement or arrangement is 
includible in the gross income of the participant or beneficiary for 
the first taxable year in which there is no substantial risk of 
forfeiture (within the meaning of section 457(f)(3)(B)) of the rights 
to such compensation;
    (2) If the compensation deferred is subject to a substantial risk 
of forfeiture, the amount includible in gross income for the first 
taxable year in which there is no substantial risk of forfeiture 
includes earnings thereon to the date on which there is no substantial 
risk of forfeiture;
    (3) Earnings credited on the compensation deferred under the 
agreement or arrangement that are not includible in gross income under 
paragraph (a)(2) of this section are includible in the gross income of 
the participant or beneficiary only when paid or made available to the 
participant or beneficiary, provided that the interest of the 
participant or beneficiary in any assets (including amounts deferred 
under the plan) of the entity sponsoring the agreement or arrangement 
is not senior to the entity's general creditors; and
    (4) Amounts paid or made available to a participant or beneficiary 
under the agreement or arrangement are includible in the gross income 
of the participant or beneficiary under section 72, relating to 
annuities.
    (b) Exceptions. Paragraph (a) of this section does not apply with 
respect to--
    (1) A plan described in section 401(a) which includes a trust 
exempt from tax under section 501(a);
    (2) An annuity plan or contract described in section 403;
    (3) That portion of any plan which consists of a transfer of 
property described in section 83;
    (4) That portion of any plan which consists of a trust to which 
section 402(b) applies; or
    (5) A qualified governmental excess benefit arrangement described 
in section 415(m).
    (c) Coordination of section 457(f) with section 83--(1) Transfer of 
property described in section 83. Under paragraph (b)(3) of this 
section, section 457(f) and paragraph (a) of this section do not apply 
to that portion of any plan which consists of a transfer of property 
described in section 83. For this purpose, a transfer of property 
described in section 83 means a transfer of property to which section 
83 applies. Section 457(f) and paragraph (a) of this section do not 
apply if the date on which there is no substantial risk of forfeiture 
with respect to compensation deferred under an agreement or arrangement 
that is not an eligible plan is on or after the date on which there is 
a transfer of property to which section 83 applies. However, section 
457(f) and paragraph (a) of this section apply if the date on which 
there is no substantial risk of forfeiture with respect to compensation 
deferred under an agreement or arrangement that is not an eligible plan 
precedes the date on which there is a transfer of property to which 
section 83 applies. If deferred compensation payable in property is 
includible in gross income under section 457(f), then, as provided in 
section 72, the amount includible in gross income when that property is 
later transferred or made available to the service provider is the 
excess of the value of the property at that time over the amount 
previously included in gross income under section 457(f).

[[Page 30846]]

    (2) Examples. The provisions of this paragraph (c) are illustrated 
in the following examples:

    Example 1.  (i) Facts. As part of an arrangement for the 
deferral of compensation, an eligible employer agrees on December 1, 
2002 to pay an individual rendering services for the eligible 
employer a specified dollar amount on January 15, 2005. The 
arrangement provides for the payment to be made in the form of 
property having a fair market value equal to the specified dollar 
amount. The individual's rights to the payment are not subject to a 
substantial risk of forfeiture (within the meaning of section 
457(f)(3)(B)).
    (ii) Conclusion. In this example, because there is no 
substantial risk of forfeiture with respect to the agreement to 
transfer property in 2005, the present value (as of December 1, 
2002) of the payment is includible in the individual's gross income 
for 2002. Under paragraph (a)(4) of this section, when the payment 
is made on January 15, 2005, the amount includible in the 
individual's gross income is equal to the excess of the fair market 
value of the property when paid, over the amount that was includible 
in gross income for 2002 (which is the basis allocable to that 
payment).
    Example 2.  (i) Facts. As part of an arrangement for the 
deferral of compensation, individuals A and B rendering services for 
a tax-exempt entity each receive in 2010 property that is subject to 
a substantial risk of forfeiture (within the meaning of section 
457(f)(3)(B) and within the meaning of section 83(c)(1)). Individual 
A makes an election to include the fair market value of the property 
in gross income under section 83(b) and individual B does not make 
this election. The substantial risk of forfeiture for the property 
transferred to individual A lapses in 2012 and the substantial risk 
of forfeiture for the property transferred to individual B also 
lapses in 2012. Thus, the property transferred to individual A is 
included in A's gross income for 2010 when A makes a section 83(b) 
election and the property transferred to individual B is included in 
B's gross income for 2012 when the substantial risk of forfeiture 
for the property lapses.
    (ii) Conclusion. In this example 2, in each case, the 
compensation deferred is not subject to section 457(f) or this 
section because section 83 applies to the transfer of property on or 
before the date on which there is no substantial risk of forfeiture 
with respect to compensation deferred under the arrangement.
    Example 3.  (i) Facts. In 2010, X, a tax-exempt entity, agrees 
to pay deferred compensation to employee C. The amount payable is 
$100,000 to be paid 10 years later in 2020. The commitment to make 
the $100,000 payment is not subject to a substantial risk of 
forfeiture. In 2010, the present value of the $100,000 is $50,000. 
In 2018, X transfers to C property having a fair market value (for 
purposes of section 83) equal to $70,000. The transfer is in partial 
settlement of the commitment made in 2010 and, at the time of the 
transfer in 2018, the present value of the commitment is $80,000. In 
2020, X pays C the $12,500 that remains due.
    (ii) Conclusion. In this example 3, C has income of $50,000 in 
2010. In 2018, C has income of $30,000, which is the amount 
transferred in 2018, minus the allocable portion of the basis that 
results from the $50,000 of income in 2010. (Under section 
72(e)(2)(B), income is allocated first. The income is equal to 
$30,000 ($80,000 minus the $50,000 basis), with the result that the 
allocable portion of the basis is equal to $40,000 ($70,000 minus 
the $30,000 of income).) In 2020, C has income of $2,500 ($12,500 
minus $10,000, which is the excess of the original $50,000 basis 
over the $40,000 basis allocated to the transfer made in 2018).


Sec. 1.457-12  Effective dates.

    Sections 1.457-1 through 1.457-11 apply for taxable years beginning 
after December 31, 2001, except that Sec. 1.457-11(c) does not apply 
with respect to an option without a readily ascertainable fair market 
value (within the meaning of section 83(e)(3)) that was granted on or 
before May 8, 2002 and, except that Sec. 1.457-10(c) (relating to 
qualified domestic relations orders) applies for transfers, 
distributions, and payments made afer December 31, 2001.

Robert E. Wenzel,
Deputy Commissioner of the Internal Revenue Service.
[FR Doc. 02-11036 Filed 5-7-02; 8:45 am]
BILLING CODE 4830-01-P