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EP Team Audit (EPTA) Program - EPTA Compliance Trends & Tips - 403(b) Tax-Sheltered Annuity Plan, 457 Plan and Governmental Plan Trends

Failure to properly apply universal availability to participants

Elective deferrals, that is salary reduction contributions, under a 403(b) plan are not governed by a mathematical test as there is under a 401(k) plan, but rather are subject to a standard called “Universal Availability”. This requires that participants who are not among one of the permissively excludable groups must have the right to make elective deferrals. Universal availability has many, factors, and it applies to each common-law entity separately rather than grouping controlled groups together. A prominent issue in the conduct of exams is confirming that all employees who technically have the right to make elective deferrals are actually offered that right in practice, are given a meaningful notice of that right and the timing requirements for making and changing elections.

A central issue in examining the universal availability requirement is confirming that all individuals who are common-law employees and not members of a permissively excludable group are eligible to make elective deferrals. Employees eligible under other deferral plans (such as 401(k) plan or 457(b) governmental eligible plans that also provides for salary deferrals), nonresident aliens, and employees who ordinarily work less than 20 hours per week can be excluded without violating the universal availability requirement. Among these permissive exclusions, determining when employees ordinarily work less than 20 hours per week and ensuring that the written plan spells out the details of this exclusion present the most problems. For example, how are hours tracked and monitored? Exams discover 403(b) plans that improperly exclude groups such as collectively bargained employees, visiting professors, employees who have taken vows of poverty, employees who make a one-time election to participate in a governmental non-403(b) plan, and specified categories of employees, such as substitute teachers, janitors, cafeteria workers, and nurses. These groups are not permissive exclusions.

More information on finding, fixing, and avoiding this error can be found in Issue #2 of the 403(b) Checklist and Section III of the 403(b) FAQ page.

Failure to properly track and limit 15 year rule contributions and combine with age 50 Catch-up Feature

Employee elective deferrals can have different classifications depending on the circumstances of a particular participant and, in the case of the permissive 15-year rule contributions and the permissive age 50 catch-up contributions, the ordering rules required for classifying these contributions are a potential source of errors. Each employee of certain public schools, hospitals, health services, churches, and similar organizations who has 15 years of service with that same employer, must have their previous elective deferrals and catch up contributions for all prior years tracked and used in the calculation below to determine the employee’s level of permitted catch-up contribution. Elective deferrals, including catch-ups, are limited to the lesser of the following amounts:

(a) $3,000;

(b) $15,000 less previously excluded special 15-year rule catch-ups, and designated Roth contributions for prior tax years; and

(c) $5,000 multiplied by years of service minus previously excluded elective deferrals throughout the employment period.

The failure to track and properly limit contributions made under this 15-year rule is a common error and usually occurs either because weak internal controls prevent the plan sponsor from maintaining records of the employee’s elective deferrals in all prior years throughout the employment period or the employee is not employed by an eligible employer.

Catch-up ordering is another aspect that causes errors. A 403(b) plan may permit participants who are age 50 or over by the end of the calendar year to make additional salary deferral contributions that are classified as catch-up contributions. These catch-up contributions receive favorable treatment because they are not subject to the general limits that apply to 403(b) contributions, but properly identifying and classifying these contributions is a frequent compliance issue. Contributions can only be considered age 50 catch-up contributions after the employee elective deferral limits and the 15-year rule amounts are met for the tax year. Therefore, properly designating employee elective deferrals as age 50 catch-up contributions requires precision in classifying and limiting the overall employee elective deferral and the 15-year rule contribution limits as well.

More information on finding, fixing, and avoiding this error can be found in Issues #3, 5, 6, and 8 of the 403(b) Checklist.

Failure to have a written plan document (effective 1-1-2010)

The regulations require that the written 403(b) plan document include all of the material provisions regarding eligibility, benefits, applicable limitations, the contracts available under the plan, and the time and form under which benefits distributions would be made.

For the very first time, non ERISA governed 403(b) programs are required to be maintained pursuant to written defined contribution plans for taxable years beginning after December 31, 2009. These written plans must satisfy the 403(b) requirements in form and contain all the terms and conditions for eligibility, limitations, and benefits under the plan, although there is no requirement that all of the materials that make up a plan must be in a single document or form. This essentially means that all provisions concerning the way the plan works have to be spelled out in a plan and the plan has to operate in accordance with these written terms.

Although this is a new requirement that all 403(b) plan sponsors should take special care to comply with, many organizations may already have the detail of these types of programs spelled out though a number of items that are stapled or paper clipped together. To help organizations meet this written plan requirement, a revenue procedure was released that contains model plan language that may be used by public schools to comply with the written plan requirement. Although the model plan language is provided specifically for use by public schools, it could be used as a starting point for an 403(b) plan sponsor to help adopt or amend a very simple basic 403(b) program to comply with the new written plan requirement.

More information on the written plan requirement can be found in the Final Regulations Regarding Written Plan Requirement, Section II of the 403(b) FAQ page, and the Model Plan Language for Public Schools for 403(b).

Failure to follow controlled group rules

The controlled group rules generally apply to tax-exempt sponsors of 403(b) and 457 plans and this can significantly affect compliance with contribution limitations as well as several other requirements. In the tax-exempt context, the controlled group rules utilize an 80% director or trustee common control test.  Employers will most commonly be members of a controlled group under IRC sections 414(b), (c), (m), (n) or (o) where a tax-exempt entity controls at least 80% of the board members of another tax-exempt entity. These affiliated entities must pay careful attention to plan language and tax rules referencing employers because affiliated entities will be aggregated and considered together for most of these purposes.

Failure to follow unforeseeable emergency 457 plan distribution rules

Improper administration of distributions made on account of an unforeseeable emergency is a frequent source of errors for sponsors of 457(b) plans. Hardship distributions from a 457(b) plan are only permitted when the participant is faced with an unforeseeable emergency and where the amount of these distributions does not exceed the amount reasonably necessary to satisfy the emergency need. Although determining whether a participant or beneficiary is faced with an unforeseeable emergency is based on the facts and circumstances of each situation, rules and examples defining “unforeseeable emergency” must be applied. Errors made in administering these distributions include mistaken determinations, inadequate documentation, and distributions that exceed the amount needed for the unforeseeable emergency. 

Failure to limit contributions under IRC Section 415

Generally, the sum of elective deferrals and employer contributions made on behalf of any participant cannot exceed the $51,000 (for 2013; $52,000 for 2014) or 100% of includible compensation for the participant’s most recent year of service, plus any age 50 catch-up contributions. Employee elective deferrals include the 15 year catch-up discussed above, but if an eligible employer also sponsors a 457 plan for its employees, employee elective deferrals do not include contributions under the 457 plan for these purposes. Also, contributions to multiple 403(b) accounts, or other qualified plans or simplified employee pensions of certain related entities, must be combined in testing this limitation for each participant. Errors made in determining includible compensation, the most recent year of service, whether contributions from other plans are included, or how the IRC Section 415 limit applies to contributions after retirement can cause 403(b) plans to fail to comply with the required limitations under IRC Section 415. 

More information on finding, fixing, and avoiding this error can be found in Issue #4 of the 403(b) Checklist.

Failure to comply with the IRC Section 403(b) post severance contribution requirements

No employee elective deferrals can be made from compensation payable from any payroll period that begins after severance from employment unless the compensation meets the 2½ month rule described below, the total and permanent disability rule, or the qualifying military service rule. The 2½ month rule allows employee elective deferrals to be made from certain compensation paid by the later of 2½ months after severance from employment or the end of the limitation year (usually a calendar year) that includes the date of severance from employment. Regular compensation, overtime, shift differential, commissions, bonuses, and other similar payments are eligible for the 2½ month rule as well as certain leave cash-outs and deferred compensation payments. Employees may also be eligible to make elective deferrals from post severance compensation paid to them when they are permanently and totally disabled or when they end employment to perform qualified military service if specific requirements of the total and permanent disability or qualifying military service rules are satisfied.

More information on finding, fixing, and avoiding this error can be found in Issue #8 of the 403(b) Checklist and Section IV of the 403(b) FAQ page.

Failure to comply with IRC Section 457(b) catch-up limitations

Generally, 457(b) plans can allow for two types of catch-up provisions. The first is the age 50 catch-up contributions for governmental employers only.  This is the same age 50 catch-up as used in 403(b) and other defined contribution plans and amounts to an additional $5,500 (in 2013 and 2014) that can be contributed by participants who are over age 50 by the end of the calendar year.

The second (available to all eligible employers) is much more complicated and is available to 457(b) plan participants who are within 3 years of normal retirement age. This second catch-up feature can be equal to the annual employee deferral limit for the year ($17,500 for 2013 and 2014) so it can effectively double this limit in a given year, but the IRC Section 457(b)(3) catch-up increase is limited to unused deferral limits from previous years under a formula that is affected by several factors. This formula essentially means that participants who had previously deferred the maximum amount of money into a 457(b) plan every year they were eligible for that plan would not be able to utilize this extra IRC Section 457(b)(3) catch-up.  Participants in eligible 457(b) plans may only use it in the last 3 tax years prior to the tax year in which the participant reaches normal retirement age under the terms of the 457(b) plan. For a governmental 457(b) plan the IRC Section 457(b)(3) catch-up contributions cannot be combined with age 50 catch-up contributions in any year, so eligible participants are limited to contributing the higher of their age 50 catch-up increase or their IRC Section 457(b)(3) catch up increase.

Model amendments for this catch-up provision can be found in Sections 3.3 and 3.4 of Revenue Procedure 2004-56.

Failure to comply with IRC Section 457(b) permissive service credit transfer rules

An eligible governmental 457(b) plan may permit participants and beneficiaries to transfer deferred amounts to defined benefit governmental plans for the purpose of purchasing permissive past service credit under the receiving defined benefit governmental plan. Permissive past service credit is credit for a period of past service recognized by a governmental defined benefit plan. Both the transferee and receiving plans must permit the transfers and the receiving plan must also prevent the amount transferred from exceeding the amount necessary to fund the benefit resulting from the past service credit on an actuarial basis. The participant and beneficiary must voluntary contribute the transferred amount to the defined benefit governmental plan in addition to any regular employee contribution required under the plan. These transfers are not treated as distributions for purposes of the IRC Section 457(b) distribution restrictions, so the transfers may be made before the severance from employment of the participant or beneficiary. 

Model amendments for this catch-up provision can be found in Section 6.04 of Revenue Procedure 2004-56 and Final Regulations Regarding Purchase of Permissive Service Credit by Plan– to–Plan Transfer.

Page Last Reviewed or Updated: 04-Aug-2014