A “403(b) plan” is a tax-favored retirement plan that is available to churches and other tax-exempt organizations. Such plans provide the following benefits:
- Employee participants do not pay tax on allowable contributions in the year they are made. Instead, their contributions are taxed when then begin making withdrawals from the plan, usually after retirement.
- Earnings and gains on amounts in an employee’s 403(b) account are not taxed until they are withdrawn, usually after retirement.
- Employees may be eligible to take a credit for elective deferrals contributed to their 403(b) account.
- The Regulations. The provisions in the final regulations of most relevance to churches are summarized below.
- 1. Written Plan Requirement
- In general
- The final regulations require all 403(b) providers, including churches, to have a plan document in place no later than December 31, 2008. But merely having a plan document is not enough. The plan document, in both form and operation, must satisfy the requirements of section 403(b) and the regulations. This means that a plan document must address several issues, including the following:
- employee eligibility
- contribution limits
- distributions?
- benefits
- salary reductions
- investments (fund providers available under the plan)
- loans
- hardship withdrawals
- allocate compliance responsibilities to employers and fund providers (vendors)
- What is the purpose of the written plan requirement? The IRS summary that accompanied the final regulations explains:
- The existence of a written plan facilitates the allocation of plan responsibilities among the employer, the issuer of the contract, and any other parties involved in implementing the plan. Without such a central document for a comprehensive summary of responsibilities, there is a risk that many of the important responsibilities required under the statute and final regulations may not be allocated to any party …. The maintenance of a written plan also benefits participants by providing a central document setting forth their rights and enables government agencies to determine whether the arrangements satisfy applicable law and, in particular, for determining which employees are eligible to participate in the plan.
- Effect of failure to adopt a plan document before January 1, 2009
The final regulations warn that a failure to adopt a written plan document before January 1, 2009, will render all subsequent contributions to the plan fully taxable. - Allocation of responsibilities
The final regulations note that a 403(b) plan is permitted to allocate to the employer, or to one or more third parties (i.e., investment companies), the responsibility for compliance with section 403(b) and the regulations. Any such allocation must identify who is responsible for compliance with the requirements of section 403(b) including loans and hardship withdrawals. However, the final regulations assert that it is generally inappropriate to allocate these responsibilities to employees. - The final regulations generally take effect in 2009. However, the effective date is delayed to January 1, 2010, for 403(b) plans maintained by a church-related organization for which the authority to amend the plan is held by a church convention. The IRS special website for 403(b) compliance clarifies this special rule as follows: “Churches that sponsor 403(b)s where the obligation to either establish the 403(b) or amend the 403(b) plan itself is an outcome of a church convention [are subject to the delayed effective date]. So merely because a 403(b) is sponsored by a church does not, in and of itself, mean that it’s going to experience a delayed effective date but rather, where the authority to amend or establish the plan would be with the church convention.”
- Drafting a plan document
What help is available to churches in complying with the written plan requirement? Consider the following options: - The IRS has made a sample plan document available to public schools, and in 2009 will be releasing a more generic plan document that can be used by other tax-exempt organizations. While neither document could be used by a church without modifications, they will be helpful in the drafting of an adequate church plan document.
- Many churches use 403(b) plans established by a denominational retirement plan. Most of these denominational plans have created plan documents that can be used by affiliated churches, with minor changes.
- Some churches have established 403(b) plans directly through a mutual fund or other investment company. Most of these third party vendors have created generic plan documents for use by their clients. However, these documents are not designed for churches, and as a result will require far more modification than the sample documents provided by a denominational plan.
- The final regulations clarify the requirement that the plan document include all of the material provisions by permitting the plan to incorporate by reference other documents (including salary reduction agreements, contracts, and policies) which as a result of such reference would become part of the plan. As a result, a plan may include a wide variety of documents, but it is important for the employer that adopts the plan to ensure that there is no conflict with other documents that are incorporated by reference. If a plan does incorporate other documents by reference, then, in the event of a conflict with another document, except in rare and unusual cases, the plan would govern.
- 2. Active and Inactive Vendors
- Since one of the purposes of a written plan document is the allocation of compliance responsibilities between the employer and fund providers, it is important for the document to identify these parties. However, “frozen” vendors that have not received elective deferrals since January 1, 2005, do not have to be identified in the plan document. Frozen vendors that have received elective deferrals after January 1, 2005 generally must be accounted for in the plan document, pursuant to the following two options: First, the employer can direct the vendor to “freeze” employee accounts, thereby cutting off access to loans and hardship distributions. Second, the employer can allow the vendor to continue making loans and hardship distributions to employees, but this will require an information sharing agreement that requires the vendor to share data with the employer that will enable it to approve such transactions and monitor compliance with section 403(b).
- Tip. Churches that offer a 403(b) plan to their employees should consult with an attorney to ensure full compliance with the final regulations. Churches that use a denominational plan should contact their denomination for assistance with compliance.
- 3. Nontaxable Exchanges and Transfers
- The final regulations provide employees with two options for transferring funds out of an existing 403(b) account while the employee is still working for the same employer, without any of the funds being currently taxable: (1) contract exchanges (a change of investment within the same plan), and (2) fund transfers (a plan-to-plan transfer, so that another employer plan receives the exchange). Contract exchanges and fund transfers are explained below.
- Contract exchanges
The final regulations allow an exchange of one contract for another to constitute a nontaxable change of investment within the same plan, but only if certain conditions are satisfied in order to facilitate compliance with tax requirements. The IRS summary that accompanies the final regulations explains: - Specifically, the other contract must include distribution restrictions that are not less stringent than those imposed on the contract being exchanged and the employer must enter into an agreement with the issuer of the other contract under which the employer and the issuer will from time to time in the future provide each other with certain information. This includes information concerning the participant’s employment and information that takes into account other section 403(b) contracts or qualified employer plans, such as whether a severance from employment has occurred for purposes of the distribution restrictions and whether the hardship withdrawal rules in the regulations are satisfied. Additional information that is required is information necessary for the resulting contract or any other contract to which contributions have been made by the employer to satisfy other tax requirements, such as whether a plan loan constitutes a deemed distribution under section 72(p) ….
- Clearly, churches that allow employees to invest their 403(b) contract with more than one authorized vendor will be incurring significant additional paperwork and administrative responsibilities. The same is true for any tax-exempt entity that offers multiple investment providers to its employees. An “information sharing agreement” (ISA) will need to be executed with each investment provider to ensure that it is sharing enough information with the employer to enable it to ensure compliance with section 403(b). To illustrate, some of the issues that each ISA must address include loans and hardship distributions to employees. In the past, employees could “self-certify” their eligibility for loans and hardship distributions. The final regulations prohibit this practice. The employer or plan administrator must approve each employee’s loan or hardship distribution and ensure compliance with the law.
- A recent survey of 403(b) providers revealed that most plan on minimizing the administrative burdens associated with the final regulations in the following ways: (1) Permitting employees to invest their 403(b) funds with only one employer-approved vendor (for many religious organizations this will be a denominational plan). Employees can no longer bypass employer approval by engaging in 90-24 transfers, as in the past. (2) Permitting employees to invest their 403(b) funds with multiple vendors, but inserting a provision in the plan document that prohibits loans and hardship distributions.
- 5. Plan-to-Plan Transfers
- Under the final regulations, plan-to-plan transfers are permitted if the participant whose assets are being transferred is an employee or former employee of the employer that maintains the receiving plan and certain additional requirements are met. However, the regulations prohibit a plan-to-plan transfer to a qualified plan, a plan under section 457(b), or any other type of plan that is not a section 403(b) plan. Similarly, a section 403(b) plan is not permitted to accept a transfer from a qualified plan, an eligible plan under section 457(b), or any other type of plan that is not a section 403(b) plan.
- 6. Limitations on Contributions
- The final regulations provide that the section 403(b) exclusion applies only to the extent that all amounts contributed by the employer for the purchase of an annuity contract for the participant do not exceed the applicable limits under section 415 of the tax code (generally, for 2008, the lesser of $46,000 or 100 percent of an employee’s includible compensation for the most recent year of service).
- If an employer’s excess annual addition is made to a contract that otherwise satisfies the requirements of section 403(b), then the portion of the contract that includes the excess will fail to be a section 403(b) contract and the remaining portion of the contract that includes the contribution that is not in excess of the section 415 limitations is a section 403(b) contract.
- With respect to section 403(b) elective deferrals (contributions by means of salary reduction agreements), section 403(b) applies only if the contract is purchased under a plan that includes the elective deferral limits under section 402(g) of the tax code, including aggregation of all plans, contracts, or arrangements of the employer that are subject to the limits of section 402(g). In general, the elective deferral limit for 2008 was $15,500 (some exceptions may apply).
- Any contribution made for a participant to a section 403(b) contract for a taxable year that exceeds either the section 415 maximum annual contribution limits or the section 402(g) elective deferral limit constitutes an excess contribution that is included in gross income for that taxable year.
- 7. Special Rules for Church Plans
- The final regulations include a number of special rules for church plans. Under section 403(b)(9), a retirement income account for employees of a church-related organization is treated as an annuity contract for purposes of section 403(b). The regulations define a retirement income account as a defined contribution program established or maintained by a church-related organization under which (i) there is separate accounting for the retirement income account’s interest in the underlying assets (namely, it must be possible at all times to determine the retirement income account’s interest in the underlying assets and to distinguish that interest from any interest that is not part of the retirement income account), (ii) investment performance is based on gains and losses on those assets, and (iii) the assets held in the account cannot be used for, or diverted to, purposes other than for the exclusive benefit of plan participants or their beneficiaries. For this purpose, assets are treated as diverted to the employer if the employer borrows assets from the account.
- A retirement income account must be maintained pursuant to a program which is a plan and the plan document must state (or otherwise evidence in a similarly clear manner) the intent to constitute a retirement income account.
- 8. Effect of a Failure to Satisfy Section 403(b)
- Section 403(b)(5) of the tax code provides for all of the contracts purchased for an employee by an employer to be treated as a single contract for purposes of section 403(b). As a result, if a contract fails to satisfy any of the section 403(b) requirements, then not only that contract but also any other contract purchased for that individual by that employer would fail to be a contract that qualifies for tax-deferral under section 403(b).
- If a contract includes any amount that fails to satisfy the requirements of the regulations, then, except for special rules relating to vesting conditions and excess contributions (under section 415 or section 402(g)), that contract and any other contract purchased for that individual by that employer does not constitute a section 403(b) contract.
- In addition, if a contract is not established pursuant to a written plan, then the contract does not satisfy section 403(b). To illustrate, if an employer fails to have a written plan, any contract purchased by that employer would not be a section 403(b) contract. Similarly, if an employer is not an eligible employer for purposes of section 403(b), none of the contracts purchased by that employer is a section 403(b) contract.
- Any operational failure, other than those described in this section, that is solely within a specific contract generally will not adversely affect the contracts issued to other employees that comply with section 403(b). For example, if an employee’s elective deferrals under a contract, when aggregated with any other contract, plan, or arrangement of the employer for that employee during a calendar year, exceed the maximum deferral amount permitted under section 403(b), the failure would adversely affect the contracts issued to the employee by that employer, but would not adversely affect any other employee’s contracts.
- 9. Former Employees
- The final regulations permit employers to make nonelective employer contributions on behalf of a former employee through the fifth year following his or her termination of employment. Nonelective employer contributions for a former employee cannot exceed certain limitations spelled out in the regulations. However, note that nondiscrimination rules that apply to some church affiliated entities prohibit nonelective employer contributions to discriminate in favor of highly compensated former employees (for 2008, those with annual income of $105,000 or more).
- 10. What Churches Need to Do Now
- Churches that have adopted a 403(b) plan for their employees should do the following:
- First, adopt a written plan document that complies with the final regulations. Churches that utilize a denominational 403(b) plan should contact their denomination for assistance with compliance issues. Many denominational 403(b) plans have drafted plan documents that affiliated churches can use. Churches that have adopted a 403(b) plan through a commercial vendor (mutual fund or investment company) should contact the outside vendor for assistance. Note that most of these vendors have relatively little experience with churches, and so their sample documents likely will need to be modified.
- Second, decide what investment choices you will approve for employee participants. Remember, if you authorize multiple vendors, you will be incurring significant administrative burdens. It is for this reason that many 403(b) plans are moving to one vendor.
- Third, contact your denominational plan, outside investment provider, or an attorney, for assistance with any questions or compliance issues.
- Fourth, be alert to future developments. These will be reported in future editions of this newsletter. You also can visit the specialized IRS website that is devoted to 403(b) compliance issues.
- For Further Assistance
Churches that are affiliated with a denomination that offers a 403(b) plan should check with their denominational plan for compliance related questions. Churches that offer 403(b) plans through one or more commercial mutual fund or investment firms should check with those vendors for assistance. In addition, the IRS website contains a section that is devoted to compliance with the new regulations. - The author of the new regulations is IRS employee Bob Architect. Questions regarding the application of the regulations to your church can be directed to him at 202-283-9634.
- This article first appeared in Church Finance Today, December 2008.