Many state and local governments are aware that the Internal Revenue Code was changed in 1986 to prohibit most of them from maintaining a 401(k) plan. Instead, these entities can and — for the most part, do — maintain eligible deferred compensation plans, also referred to as 457(b) plans. Because the special rules for governmental 457(b) plans make them very similar to 401(k) plans, public agencies don’t seem to mind being excluded from the world of 401(k)s. But, what if your agency could have both a 457(b) plan and a 401(k) plan?
One of the lesser-known (and used) provisions of the Code allows a state or local government or instrumentality that is a “rural cooperative” to set up and maintain a governmental 401(k) plan in addition to a 457(b) plan. Some of the more common types of rural cooperatives are:
- Governmental entities providing electrical services on a mutual, cooperative or public utility basis;
- Municipal irrigation, water conservation or drainage districts; and
- Mutual irrigation or ditch companies that are governmental.
If you are (or think you might be) a rural cooperative, it could be well worth it to analyze and consider your ability to establish a new 401(k) plan. Why?
- Your employees will be able to defer twice as much into the combination of a 457(b) and a 401(k) — that is, a total of $36,000 (2 x $18,000) in regular pre-tax deferrals for 2017, plus an additional $12,000 (2 x $6,000) if they are at least 50 years old.
- The 401(k) plan, being governmental, is not subject to the regular testing rules that apply to most private sector 401(k) plans.
- Unlike a 457(b) plan, which generally has an overall employer/employee contribution limit of $18,000 (not including age-50 catch-up), the employer can match or contribute additional amounts to an employee’s account up to a combined employer/employee maximum of $53,000 ($18,000 + $35,000) for 2017. Some of these amounts will increase slightly for 2018. Once again, the employer contributions are not subject to normal, private-sector discrimination testing.
- Governmental 401(k) plans, like their 457(b) counterparts, can be distributed in the form of tax-free rollovers, which provide terminated or retired employees with considerable financial planning flexibility.
- The higher pre-tax deferral limits of two plans may allow you and your employees to arrange for more flexible and individualized forms of manager compensation and retirement planning. However, as with any defined contribution arrangement, years of participation are needed to maximize its utility and value.
- Like your 457(b) plan, your new 401(k) plan also can have participant-directed investments. This gives participants more control while taking most of the investment risk off the shoulders of the employer.