The sponsor of a 457 plan has been approached with a new program that includes a "supplemental disability" element. Essentially, if a participant becomes disabled, he/she receives disability benefits under a group contract offered by the insurance company that is providing the investments for the 457 plan. The employer (i.e., the sponsor of the 457 plan) reports the disability payments on a W-2, as compensation to the disabled employee. And under the disability policy, the insurer pays a certain amount to the 457 plan (pre-tax) on behalf of the disabled employee. It strikes me as suspect, because the 457 plan contributions are tied to a percentage of "includible compensation," and it doesn't seem appropriate ot label the disability insurance proceeds as "includible compensation." Anyone have any experience with this type of arrangement?

Is the employer a governmental or nongovernmental entity?

If the employer is nongovernmental, the 457 plan cannot be funded. Thus, the payments from the disability plan would go to the employer, and would be treated the same as if the employer had made further deferrals under the 457 plan. Then the question was whether the disability payments themselves would be treated as Form W-2 compensation from the employer (which is part of includible compensation). I haven't looked at this lately, but my recollection is that sick pay paid directly from a third party insurer to an employee is treated as income to the employee but not as W-2 compensation from the employer. Rather, it would fall under separate "sick pay" withholding rules. This could cause difficulties in treating it as part of includible compensation.

However, if the employer is governmental, the plan would be required to be funded. In that case, the disability insurance would be a plan asset. PLR 200031060 held that disability insurance was an appropriate investment of a 401(k) plan, subject to the incidental benefit rule, so I would assume that a 457 plan could also hold it. It also treated disability insurance payments as not being additional contributions to the plan, but rather as an investment return, which would mean that the employee's absence of includible compensation would not be an issue.