One challenge many nonprofit organizations face is competing against for-profit businesses to attract key employees and administrators to run their operations. More often than not, nonprofits just do not have the funds to match their for-profit counterparts. Fortunately, there are plenty of qualified administrators out there who are willing to take a lower salary from a nonprofit because they believe in that organization’s mission. However, there is another incentive that most nonprofits have that is not available to for-profit businesses: Section 457 Deferred Compensation Plans (“457 Plans”).
As the name suggests, 457 Plans are authorized by Section 457 of the Internal Revenue Code. This section allows tax-exempt organizations and government agencies to establish a deferred compensation plan for key employees. Each year the nonprofit can divert a portion of the employee's salary (up to $17,500 in 2013) into the 457 Plan instead of paying it directly to the employee. Because those funds go into the Plan the employee is not taxed at that time. Instead, taxes on the amount diverted into the Plan are postponed until the Plan is authorized to dispense funds from the 457 Plan to the employee.
The Plan then acts similarly to a pension or 401K plan in that the money accumulates from year to year in the Plan and generates income on investments. As a result, these Plans are extremely helpful in helping a nonprofit’s key employees plan and save for retirement. Another advantage of a 457 Plan is that the tax on the income on those investments is also postponed until the employee actually starts receiving benefits from the Plan.
Section 457 is clear that the employee cannot begin receiving benefits until the employee reaches the age of 70 ½, the employment relationship with the nonprofit ends or the employee faces an unforeseeable emergency, whichever is earlier. In addition, the employee can designate beneficiaries to receive benefits upon the employee’s death. Taxes are then paid on the funds as they are disbursed to the employee.
Another advantage of 457 Plans is that they are fairly flexible. They can be funded with direct payments of cash, but also by life insurance premiums and annuities. Moreover, the funds in the Plan can be used as collateral by a nonprofit organization seeking a loan.
Of course setting up a 457 Plan requires care because there are several technical requirements that need to be met. As a result, I strongly suggest that a nonprofit organization considering establishing a 457 Plan consult with a tax law professional. For more information also see the Internal Revenue Service website.