403(b) Plan Fix-It Guide - You didn’t give all employees of the organization the opportunity to make a salary deferral
|Mistake||Find the Mistake||Fix the Mistake||Avoid the Mistake|
|4) You didn’t give all employees of the organization the opportunity to make a salary deferral.||Perform a review of the plan and its operation. Review employees who received a W-2 but didn’t participate. Determine if you excluded any class of employees, such as janitors, cafeteria workers, bus drivers or union employees.||Provide improperly excluded employees the opportunity to participate in the plan in current and future years. Make a corrective contribution to the plan for the employees that compensates for their missed deferral opportunity.||Understand which employees you may exclude from the 403(b) plan. Provide proper notification to employees of their eligibility to participate in the 403(b) plan at least annually.|
This universal availability rule means that if one employee is permitted to make 403(b) elective deferrals (including designated Roth contributions, if allowed by the plan), the employer must extend this option to all its employees. However, an employer may choose to include a plan provision to exclude the following employees from participating in the plan:
- Employees who will contribute $200 annually or less
- Employees who are eligible to participate in a 401(k), 457(b) or other 403(b) plan of the same employer
- Non-resident aliens
- Employees who normally work less than 20 hours per week (meaning they don’t accumulate at least 1,000 hours in at least one year)
- Students performing services described in IRC Section 3121(b)(10)
Note: Prior to 2009, a written plan provision was not necessary to exclude the above groups of employees. In addition, prior to 2009, Notice 89-23 allowed plan sponsors to exclude other groups of employees from the plan.
It’s easy to assume certain employees who only have a support role with the organization or work in what is typically considered a part-time position aren’t eligible to participate in the plan. However, under the universal availability rule, the plan may decline to cover only the employees who meet the above specific exclusions.
A mistake in this area can be disastrous. For instance, if a plan includes an employee it could have excluded, it may have to include all employees in that class. Another example is the failure to include an otherwise eligible employee in the plan. This may lead to the entire 403(b) plan losing its tax-deferred status.
The second part of universal availability is effective opportunity. This is a facts and circumstances test. A 403(b) plan satisfies the effective opportunity requirement if, at least once each plan year, the plan provides an employee with an effective opportunity to make or change a cash or deferred election.
How to find the mistake:
Employers should develop a strategy based on their organization’s structure. For example, you could discover this potential mistake by making a list of employees who received a W-2 but did not participate in the 403(b) plan. For employees on that list, determine if you properly notified them of their eligibility to participate in the plan or if you improperly excluded them from participation. For each employee you improperly excluded, you may have an issue that you need to correct.
Next, look at employees who received a W-2 and participated in the 403(b) plan. In this second sample, look for employees who should have been excluded from participation. If you improperly included an employee, you may have a universal availability issue to correct.
Although you can’t base exclusions on job classifications or groups, you may also have an issue if you note that participation by certain groups of employees is significantly less than other groups. For example, if bus drivers, cafeteria workers or maintenance workers are participating significantly less than another group, it may signal a problem that you haven’t properly notified those groups of their right to participate - or, at the very least, you may need to reach out to those employees to re-educate them on their plan rights.
In addition, before 2009, the law allowed certain administrative exclusions, such as union employees, visiting professors and employees affiliated with a religious order who have taken a vow of poverty. Beginning in 2009, under transitional rules, those exclusions are no longer allowed. Ensure that your plan no longer excludes these types of employees.
How to fix the mistake:
To correct a universal availability failure, you should provide each improperly excluded eligible employee with the opportunity to participate in the plan in current and future years. In addition, you may be required to make a contribution to the plan for each eligible employee for the time that the employee was improperly excluded from the 403(b) plan.
The amount necessary to correct mistakes involving the failure to allow plan participants to defer salary uses the concept of “lost opportunity cost,” which generally represents the loss of the ability of the salary deferral to grow tax-free in the 403(b) plan. The IRS has determined that this lost opportunity cost is equal to 50% of the amount of the elective salary deferral the employee could have made to the 403(b) plan.
In accordance with the IRS safe harbor in Revenue Procedure 2013-12 Appendix A.05(6), you may deem the lost salary deferral amount to be the greater of:
- 3% of compensation, or
- the maximum deferral percentage for which the plan sponsor provides a matching contribution rate that is at least as favorable as100% of the elective deferral made by the employee.
Therefore, the corrective contribution you need to pay to the plan for the improperly excluded employees would generally be 1.5% of their compensation for each year you excluded them, adjusted for any lost earnings through the date of correction. If you provided matching contributions to the plan for the affected year, you would need to pay additional corrective contributions to the plan to restore matching contributions you would have provided on the missed deferral amounts for the improperly excluded employees.
DEF Independent School District maintains a 403(b) plan for its teachers and staff. At the end of 2015, 350 employees were eligible to participate in the plan. Three part-time teacher’s aides worked more than 20 hours per week during 2012, 2013, 2014 and the first eight months in 2015; however, they were not included in the 403(b) plan. Assume each teacher’s aide earned $20,000 annually during 2012 through 2015. The school district discovered the failure on September 1, 2015 and allowed each of the three teacher’s aides to participate in the plan as of that date. Assume that the 403(b) plan provides for a 100% match up to 3% of participant compensation.
To correct this mistake, the school district should provide each eligible employee the opportunity to participate in the plan for the current and subsequent years. The plan sponsor must make a contribution to the plan for each of the three employees improperly excluded from participating in the plan in prior years. This contribution should be equal to 50% of the amount of elective deferral the employee could have made to the plan, adjusted for any lost earnings through the date of correction. The corrective contribution associated with the lost elective deferrals must be 100% vested and be subject to the distribution restrictions in IRC Section 403(b)(11). The corrective contribution for lost matching contributions, if applicable, can be subject to the plan’s regular vesting schedule and distribution restrictions in effect during the years the employees were excluded.
The school district can determine the amount it must contribute for each teacher’s aide that it improperly excluded in 2012, 2013, 2014 and part of 2015 as follows:
The school district can apply the IRS safe harbor correction method and deem the lost elective deferral amount to be 3% of compensation. In that case, the corrective contribution for each aide would be:
- The total corrective contribution owed to each aide for the lost deferrals is $1,100 (($20,000 x 3%) x 50%=$300, $300 x 3 years 8 months).
- Considering the lost deferral amount of $600 that the excluded employees could have made to the plan ($20,000 x 3%), the matching contribution owed per year is equal to $600. Total matching contributions owed to each teacher’s aide is $2,200 ($600 x 3 years 8 months).
- Total corrective contribution owed to each teacher’s aide is $3,300 ($1,100 + $2,200), adjusted for earnings through the date of correction.
Other correction methods may be acceptable to fix this mistake. Any correction method used that is not described in Appendix A or B would need to satisfy the correction principles of Revenue Procedure 2013-12, section 6 and would be outside of the IRS safe harbor. For example, a 403(b) plan sponsor might determine the missed deferral for excluded rank and file employees using a percentage based on the average deferrals for all non-highly compensated employees in the plan.
For failures found and fixed promptly, plan sponsors have the option to reduce the corrective contribution for the lost opportunity cost from 50% of the missed deferral to 25% under certain conditions:
- The excluded employee must be currently employed by the employer at the time of correction
- The period of failure exceeds three months
- Correct deferrals finally begin by the first payment of compensation made on or after the earlier of: the last day of the second plan year after the plan year in which the failure first began for the affected employee; or the last day of the month after the month the affected eligible employee first notified the plan sponsor.
- Within 45 days of being given the opportunity to make salary reduction contributions, the affected participant must receive a special notice. See Appendix A.05(9) discussed in Rev. Proc. 2015–28 for details as to the specific content that must be in this notice. If the participant terminates employment before the notice is provided, then this requirement has not been met.
If the period of failure is less than three months, the corrective contribution for the missed deferral opportunity is reduced to zero if the commencement of deferrals occurs within the three-month period from the start of the failure and issuance of the special notice occurs within the 45-day timeframe.
All other corrective contributions must be paid to the 403(b) plan before the end of the second plan year beginning after the initial year of the failure.
For 403(b) plans with automatic contribution features (in other words, auto-enrollment and auto-escalation), the corrective contribution for the missed deferral opportunity is reduced to zero if correct deferrals begin by the first payment of compensation made on or after the earlier of:
- 9½ months after the end of the plan year in which the failure first occurred; or
- the last day of the month after the month the affected employee first notified the plan sponsor of the error.
The special notice to the affected employee must be provided within the applicable 45-day timeframe. (See Appendix A.05(8) for additional details.) This special 0% rule only applies to failures occurring before 2021. The plan sponsor is still responsible for providing correcting matching contributions or missed employer contributions to the 403(b) plan within the two-year timeframe used to correct significant operational failures under Revenue Procedure 2013-12.
In the above Example1, DEF School District would not be able to use the safe harbors in Rev. Proc. 2015-28. The correction of the failures for the affected employees did not satisfy the conditions of the safe harbor because the failures began in 2012 and were not corrected until 2015 and because no special notice was issued to the affected participants.
Hospital T maintains a calendar year written 403(b) plan that contains automatic contribution features. In this case, all employees in the 403(b) plan automatically have salary reduction contributions of 3% of compensation withheld from their pay. Participants may decrease or increase this amount by filing an affirmative, written election. In 2016, Hospital T realized four part-time nurses, hired in June of 2015, were improperly excluded from the plan due to an administrative error. Hospital T discovered the failure in 2016 and auto-enrolled the four nurses in the 403(b) plan as of April 1, 2016 and began withholding 3% of their compensation as salary reduction contributions to the 403(b). On May 1, 2016, Hospital T issued a special notice to each nurse that satisfied the content requirement specified in Rev. Proc. 2015-28. Hospital T does not have to provide a corrective contribution for the missed opportunity to make salary reduction contributions due to the nurses’ improper exclusion from the plan in 2015 and first three months of 2016. The conditions of the Appendix .05(8) safe harbor were met when:
- Improperly excluded employees were enrolled; special notice provided within the applicable 45 day period: and
- The above actions occurred within 9 ½ months after end of the plan year which the failure first occurred (i.e. before October 15, 2016).
Note: Hospital T is still responsible to pay corrective contributions to the 403(b) for any 2015 or 2016 matching contributions or employer contributions, if applicable to which the nurses would have been entitled to per the written 403(b) plan.
Assume the same set of facts, except that Hospital’s T 403(b) plan terms did not provide for automatic contribution features. Assume excluded nurses become plan participants on April 1, 2016, and were given the opportunity to participate in the 403(b) plan. Hospital T issued the the special notice on May 1, 2016. Under these facts, the lost opportunity cost for the missed deferrals would be 25% of the missed deferral amount for 2015 and first three months of 2016. Adjust this amount for earnings through the date of correction. This is permitted because Hospital T complied with the special safe harbor requirements in the Appendix A.05(9) safe harbor discussed in Rev. Proc. 2015-28. Hospital T would still owe 100% of any owed corrective contributions associated with matching or non-elective employer contributions, if applicable and all corrective contributions would have to be paid to the plan before the end of the second plan year beginning after the initial year of the failure.
Assume the same set of facts, except that one of the Hospital T’s excluded employees terminated in March, 2016. Then none of the special safe harbors in Appendix A.05(8) or .05(9) would be applicable to the terminated employee as the conditions of Rev. Proc. 2015-28 can’t be met as the employee is no longer employed by Hospital T at the time of correction. Therefore, the lost opportunity cost for the missed deferrals would be 50% of the missed deferral amounts for this employee. Adjust for earnings through the date of correction.
Correction programs available:
Operational mistakes may be corrected under the Self-Correction Program. Under SCP, there are no applications or reporting requirements. To use SCP to correct this universal availability issue, the school district needs to make two determinations:
- First, it must determine if it has sufficient compliance practices and procedures in place to correct under SCP.
- If it’s determined that sufficient compliance practices and procedures exist, it may correct under SCP.
- If sufficient compliance practices don’t exist, it must correct under the Voluntary Correction Program.
- Second, it must determine if this error is significant or insignificant.
- If it’s determined the error is insignificant,
- DEF Independent School District from Example 1may fully correct the mistake for 2012, 2013, 2014 and 2015 under SCP at any time.
- DEF Independent School District from Example 1may fully correct the mistake for 2012, 2013, 2014 and 2015 under SCP at any time.
- If it’s determined the error is significant,
- The school district wouldn’t be able to correct this failure under SCP because it needed to correct the oldest affected plan years within 2 years of the error. In this example, the deadline for taking corrective action for 2012 would’ve been the last day of the 2014 plan year.
- The school district may not be able to use SCP to fix this error, however it could be resolved on a voluntary basis if it makes a submission to the IRS under VCP.
- If it’s determined the error is insignificant,
Voluntary Correction Program:
If the school district determined it didn’t have the proper practices and procedures or that the error was significant, this mistake is correctible under VCP if the district or plan is not under audit. Correction would be the same, except that the district must make a VCP submission according to Revenue Procedure 2013-12. The user fee for the school district’s VCP submission (based on 350 eligible participants) is $5,000. The school district should make its VCP submission using the model document, Form 14568, Model VCP Compliance Statement, and must include Forms 8950 and 8951.
Audit Closing Agreement Program:
Under Audit CAP, correction of this mistake is the same as described under SCP. The school district and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount.
How to avoid the mistake:
Universal availability mistakes can be very expensive to correct, so avoiding this mistake is important. You must have a good understanding of which employees you may exclude from your organization’s 403(b) plan. Many organizations assume they can exclude part-time or certain classes of employees, but that’s not how it works.
A common mistake is to improperly exclude employees who work more than 20 hours per week, or 1,000 hours per year, for example substitute teachers or adjunct professors. Many governmental plan sponsors avoid this mistake by making these types of employees eligible for a 457(b) plan. If each employee is either eligible for the 403(b) or 457(b) plan (or both), a governmental plan sponsor may be able to avoid the expensive fix associated with a universal availability failure.
Another important feature is to provide proper notification to employees of their right to participate in the 403(b) plan. You should provide proper notification to each employee of their eligibility to participate in the 403(b) plan at least annually.