Millions of state and local government employees are supplementing their future retirement benefits by contributing to salary reduction plans called salary reduction or defined contribution arrangements. Such plans enable participants to defer part of their current salary for future use. The goal of these plans is to postpone federal income tax until the amounts deferred from an employee’s salary and any earnings or losses thereon are received by the participant at separation or retirement. All salary reduction plans pose some risk of financial loss from poor investment performance. However, amounts in plans organized under Internal Revenue Code (IRC) section 457(b) (hereinafter referred to as 457 plans) bear additional risk because salary deferrals to 457 plans are assets of the sponsoring employer that may be used for nonplan purposes and which are subject in the event of bankruptcy to the claims of general creditors. For example, one municipality’s recent bankruptcy could cause financial losses to employees who participated in its 457 plans. In addition, amounts earmarked to pay another county’s 457 plan obligations could have been at risk when the county intended to use those amounts to meet payroll expenses. In that case, the county might not have had the funds available when the time came to pay out the amounts due the 457 plan participants. In both cases, county officials were entitled to use the money saved to pay 457 plan obligations for nonplan purposes. As a result, concerns have been raised about the security of deferrals that participants make from their salary under 457 plans. A state or local government may elect to offer its employees, among other retirement plans, a deferred compensation arrangement under IRC sections 403(b), 401(k), and 457(b). In all three types of plans, employees may voluntarily defer compensation through payroll deductions. Federal income tax is postponed until employees begin to receive their account balances, usually at retirement or when they are no longer employed by the plan’s sponsor. These three salary reduction plans typically are intended to supplement an employer-sponsored qualified pension plan under IRC section 401(a). In general, 401(k) plans, sometimes referred to as cash or deferred arrangements, are qualified plans that allow employees to choose between receiving current compensation or having part of their compensation contributed to a qualified profit-sharing or stock bonus plan. A 403(b) plan, a qualified-type plan sometimes referred to as a tax-sheltered annuity, is a deferred compensation arrangement that may be sponsored only on behalf of employees of public educational systems and other specific tax-exempt organizations. Section 457(b) plans are nonqualified, unfunded deferred compensation plans that may cover all employees of a state or local government and certain highly compensated employees of a tax-exempt organization. Such plans permit these employees to defer limited amounts of compensation so that, under the principles of constructive receipt and economic benefit, tax will also be deferred on the amounts plus their earnings until some future event. Eligibility and the security of deferred amounts vary among the three plan types. Employees of public schools, colleges and universities, and some private institutions exempt from tax under IRC section 501(c)(3), such as hospitals, typically participate in 403(b) plans. Contributions to these plans are generally maintained as an annuity contract or custodial account, both of which are reserved for the sole benefit of the participant and his or her beneficiaries. Employee deferrals under section 401(k) plans are held in trust for the sole benefit of the participants and their beneficiaries. These participants are primarily employed in the private sector. However, some state and local governments established these plans in the late 1970s and early 1980s for their employees. With the enactment of the Tax Reform Act of 1986,state and local government employers who had not previously established 401(k) plans were prohibited from establishing new 401(k) plans, but existing plans could continue. Despite concerns raised by representatives of state and local governments, among others, the rationale for this exclusion was that allowing public employees to have access to both 401(k) plans and 457 plans would be “inappropriately duplicative.” Only employees of and independent contractors providing service to state and local government and tax-exempt organizations may participate in 457 plans. Unlike 401(k) and 403(b) plans that are funded and must comply with the nondiscrimination and minimum participation rules, section 457 plans are unsecured promises of the employer to pay amounts in the future. A section 457 eligible, salary reduction plan requires that all deferred compensation and income shall remain solely the property of the employer and be subject to the claims of the employer’s general creditors. In 1999, 401(k) and certain 403(b) plans must begin testing for nondiscrimination and minimum participation rules. Generally, the nondiscrimination rule requires that benefits or contributions provided under the plan do not discriminate in favor of highly compensated employees. The minimum participation rule requires that the plan benefit at least the lesser of 50 employees or 40 percent of all employees. The minimum coverage rule requires that the percentage of nonhighly compensated employees who benefit under the plan must be at least 70 percent of the highly compensated employees who benefit under the plan, or the nonhighly compensated employees in the workforce must receive benefits that on average are at least 70 percent of the benefits received by highly compensated employees. State and local government sponsors of these plans have expressed concern that required compliance with these rules will be burdensome and costly. Two tax principles, constructive receipt and economic benefit, are often intertwined in matters regarding nonqualified, unfunded deferred compensation. Under the principle of constructive receipt, income is taxable even when an employee has not actually received current compensation, if the compensation is credited to the employee’s account, set apart for the employee, or otherwise made available to the employee. The principle of economic benefit, on the other hand, taxes assets that have been unconditionally and irrevocably transferred into a fund for the employee’s sole benefit because he or she has received a benefit (that is, some deferred salary) that, although not readily convertible to cash, has an immediate value (that is, a fund for his or her benefit) that is secured from the employer’s creditors. Section 401(k) and 403(b) plans are funded, qualified or qualified-type arrangements where the deferred amounts are placed in trust; that is, set aside for the exclusive benefit of the employees who participate in the plans, secured from an employer’s creditors. So that such arrangements would not cause the participants to be taxed under the basic principles of constructive receipt and economic benefit, the Congress overrode these two principles by providing for income to be taxed only when it is distributed. Section 457 plans, on the other hand, are nonqualified, unfunded deferred compensation plans that follow the basic principles of constructive receipt and economic benefit. Participants are not in constructive receipt of their deferrals because the amounts are not set apart for or otherwise available to them at any time. Participants do not derive the economic benefit of their deferred compensation because the deferred amounts are the property of their employers and subject to the employers’ general creditors. Instead, participants have bookkeeping accounts with balances that represent the amount that the employers promise to pay at some future time. These account balances are comprised of amounts deferred under the plan and any earnings or losses that would have accrued to those amounts if the account balances had been invested as stated under the plan. Although most employers sponsoring 457 plans invest amounts as necessary so that they will be able to provide the promised benefit when due, there is no requirement for them to do so. In 1972, IRS issued the first of a number of private letter rulings holding that tax may be deferred on employee contributions from salary to a nonqualified, unfunded deferred compensation plan where a state or local government was the employer. Nonqualified, unfunded deferred compensation plans of state and local governments and tax-exempt organizations were not subject at that time to certain restrictions placed on qualified plans: (1) they did not need to comply with nondiscrimination rules applicable to qualified plans; (2) there was no limit on the amount participants could contribute; and (3) participants in nonqualified, unfunded plans, unlike participants in qualified plans, could make tax-deductible contributions to individual retirement accounts (IRA). In 1977, however, IRS stopped issuing private letter rulings on the income tax treatment of amounts deferred under nonqualified, unfunded deferred compensation plans, pending formal review of its position. In 1978, IRS changed its position and published proposed regulations that would have subjected participants in nonqualified, unfunded deferred compensation arrangements to immediate taxation on deferred amounts. “cannot have any secured interest in the assets purchased with their deferred compensation and the assets may not be segregated for their benefit in any manner which would put them beyond the reach of the general creditors of the sponsoring entity.” Section 401(k) plans must meet three federal requirements for employee participation to be considered qualified. First, the value of the benefits that highly compensated employees as a group may receive is limited by the value of the benefits the less well paid employees collectively receive; this is the nondiscrimination rule. Second, at least the lesser of 50 employees or 40 percent of all eligible employees must participate in the plan; this is the minimum participation rule. Third, the plan must benefit a percentage of nonhighly compensated employees that is at least 70 percent of the percentage of highly compensated employees benefiting under the plan or the nonhighly compensated employees in the workforce must receive benefits that, on average, are at least 70 percent of the benefits received by highly compensated employees; this is the minimum coverage requirement. Additionally, among many other requirements, sponsoring employers must meet certain nondiscrimination tests and report their annual levels of participation, current assets, and current liabilities. Tax-sheltered annuities under section 403(b) must meet nondiscrimination rules.