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Part 4. Examining Process

Chapter 72. Employee Plans Technical Guidelines

Section 13. 403(b) Plans

4.72.13  403(b) Plans

4.72.13.1  (03-01-2005)
Overview

  1. Guidance is provided on how to examine a plan described in Internal Revenue Code section (403(b) plan).

    1. 4.72.13.1 defines a 403(b) plan and provides a technical overview and historical background of 403(b) plans.

    2. 4.72.13.2 discusses the types of employers eligible to maintain a 403(b) plan.

    3. 4.72.13.3 describes the various funding vehicles for 403(b) plans.

    4. 4.72.13.4 addresses the requirements of salary reduction contributions.

    5. 4.72.13.5 addresses the contribution limits applicable to 403(b) plans.

    6. 4.72.13.6 discusses the applicable nondiscrimination rules.

    7. 4.72.13.7 - 4.72.13.9 address distributions from a 403(b) plan.

    8. 4.72.13.10 provides a list of possible defects in a 403(b) plan or annuity contract and resulting tax consequences.

    9. 4.72.13.11 is a glossary of terms.

  2. These guidelines address only employee plans issues and are intended to assist the employee plans specialist in examining a plan.

    1. The agent may need to consult the Code and federal Income Tax Regulations for further development of a particular issue. Accordingly, cites are provided where appropriate.

    2. These guidelines are designed to help the examiner key in on the issues that should be raised in a particular plan. It is not expected that every issue raised in the guidelines will be relevant or should be raised in every examination.

    3. The techniques identified may be modified based on the actual examination issues encountered.

    4. Given the purpose of these guidelines, they cannot be, nor are they intended to be, a precedential or comprehensive statement of the legal position of the Service on the issues covered.

    5. These guidelines are not to be relied on or cited as authority by taxpayers.

    6. These guidelines reflect changes to the Code made by the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA" ) and the technical corrections made thereto. For examinations of years beginning prior to January 1, 2002, please consult prior examination guidelines for enforcement of laws then in effect.

    7. These guidelines are subject to change in accordance with future developments in the law.

4.72.13.1.1  (03-01-2005)
Technical Overview

  1. Historical background and regulatory framework of 403(b) plans.

    1. IRC section 403(b) was first added to the Code in 1958.

    2. In 1964, pre-ERISA regulations were issued detailing some of the basic statutory provisions of IRC section 403(b). These regulations were later amended as new provisions were added to IRC section 403(b).

    3. Final regulations were issued under IRC section 415 in 1980.

    4. In addition, there are proposed, temporary, and final regulations pertaining to the minimum distribution requirements and final regulations regarding direct rollovers. (Bold font indicates the term or phrase is defined in the Glossary). Currently, there are no nondiscrimination regulations under IRC section 403(b).

4.72.13.1.1.1  (03-01-2005)
General Requirements

  1. Dating back to 1958, a 403(b) plan was less in the nature of a plan than an arrangement under which an employer purchased an individual annuity contract on behalf of an employee from an insurance company. With the enactment of the Tax Reform Act of 1986 (TRA '86) and subsequent legislation, 403(b) plans became more like qualified retirement plans. Presently, 403(b) plans or the annuity contracts thereunder must:

    1. Comply with certain nondiscrimination and coverage rules (including IRC sections 401(a)(4), 401(m) and 410(b)),

    2. Ensure that elective deferrals do not exceed the IRC section 402(g) limit,

    3. Conform to the minimum distribution rules of IRC section 403(b)(10), and

    4. Provide a participant with a meaningful opportunity to elect a direct rollover to another eligible retirement plan.

  2. 403(b) plans take a wide variety of forms. Even where a 403(b) plan takes the form of an arrangement rather than a plan, it is nevertheless subject to all of the requirements of IRC section 403(b).

    Example 1: The employees of Public School District Y participate in a 403(b) plan (Plan). Employer's involvement in the Plan is strictly limited to providing a list of insurance carriers to employees and executing salary reduction agreements. The Plan is not described in a basic or summary plan description (SPD).

    Example 2: Employer is an organization described in IRC section 501(c)(3) and exempt from tax under IRC section 501(a).Employer maintains a 403(b) plan for its employees. The 403(b) plan consists of a lengthy plan document, and employees are informed of plan features through annual SPDs.

  3. The plans in Examples (1) and (2) above are subject to the requirements of 403(b). A 403(b) plan is always subject to Title II (relating to the Code) but may not be subject to Title I, the Labor Title of ERISA.

    Example 3: Assume the same facts as in Example 1. While the Plan may not be an employee benefit plan under Department of Labor (DOL) Reg. section 2510.3-2(f), the Plan is nevertheless subject to Code requirements.

4.72.13.1.1.2  (03-01-2005)
General Characteristics

  1. A 403(b) plan is a retirement plan under which a public school or an organization described under IRC section 501(c)(3) and exempt from tax under section 501(a) purchases annuity contracts or contributes to custodial accounts for its employees. It also includes a retirement income account under which contributions are made by or on behalf of certain ministers. Section 403(b) plans are exempt from the requirements applicable to qualified annuity plans under IRC section 403(a) and are governed by their own separate requirements under IRC section 403(b) . Section 403(b) plans are also known as:

    • 403(b) arrangements

    • tax-sheltered annuities

    • tax-deferred annuities

    • annuity contracts

      Note:

      Throughout these Guidelines, the term annuity contracts encompasses custodial accounts and retirement income accounts unless otherwise specified.

  2. Contributions to a 403(b) plan may consist of

    • salary reduction,

    • non-salary reduction,

    • after-tax employee contributions, or

    • some combination of the above.

  3. In a salary reduction 403(b) plan, an employer gives participants a choice between receiving an amount in cash or having the employer contribute that amount to the 403(b) plan.

  4. Contributions made to a 403(b) plan are generally not includible for income tax purposes in participants' gross income until distributed, even if participants had the ability to receive the contributions as taxable wages in the year of the contributions.

  5. Earnings on contributions are also tax-deferred until distributed.

  6. Distributions from a 403(b) plan are taxable under IRC section 72, relating to annuities.

  7. Generally, participants are required to pay FICA tax on salary reduction contributions at the time of contribution. Although there is no deduction for the employer because it is exempt from income tax, the employer is responsible for FICA, and income and FICA tax withholding, if applicable. Keep in mind that certain governmental and church employers and employees may be exempt from FICA. See IRC sections 3121(b)(7) and 3121(b)(8).

  8. The following examples illustrate that 403(b) plans may involve both employer and individual tax matters.

    Example 4: Hospital M maintains an annuity plan intended to be a 403(b) plan (Plan). The Plan provides for non-salary reduction contributions and is funded through annuity contracts. It is discovered on examination that the Plan is not a 403(b) plan, with the result that, for all open years under the statute: (i) the contributions made to the Plan are includible in the employees' gross income to the extent they are or become vested, (ii) the employees are responsible for FICA taxes, (iii) the employer may be responsible for income tax and FICA withholding, and (iv) Hospital M must pay FICA employment taxes.

    Example 5: The same facts as in Example 4, except that the Plan is a 403(b) plan and it provides both non-salary reduction and salary reduction contributions. The salary reduction contributions are subject to FICA tax at the time of contribution. Hospital M is generally responsible for FICA withholding, and FICA employment taxes.

4.72.13.1.1.3  (03-01-2005)
Aggregated Annuity Contracts

  1. All annuity contracts (including custodial accounts and retirement income accounts) purchased by an employer on behalf of an employee are treated as a single annuity contract for purposes of applying the requirements of IRC section 403(b). See IRC section 403(b)(5) .

4.72.13.1.1.4  (03-01-2005)
403(b) and Qualified Plans

  1. Although there are many similarities, 403(b) plans differ from qualified plans in some important respects.

    1. Only certain types of tax-exempt employers, governments and ministers may contribute to a 403(b) plan.

    2. Suitable funding vehicles for a 403(b) plan are limited to annuity contracts and custodial accounts (and retirement income accounts for churches).

    3. Salary reduction contributions to a 403(b) plan are subject to their own special nondiscrimination rules and not the average deferral percentage (ADP) test under IRC section 401(k)(3).

    4. There is no special averaging for lump sum distributions from 403(b) plans.

    5. Section 402(g) provides an increased limit on elective deferrals for certain participants in a 403(b) plan.

    6. Compensation under 415 is defined as includible compensation under 403(b)(3).

  2. Unlike qualified plans, 403(b) plans are not subject to the requirement of a definite written program (although Title I requires a written plan document for certain 403(b) plans). Accordingly, there is no Title II requirement that a 403(b) plan operate in accordance with its terms. However, certain IRC requirements must be reflected in the underlying annuity contracts or custodial account agreements. These include the:

    1. nontransferability requirement for 403(b)(1) annuity contracts under IRC section 401(g)

    2. direct rollover requirements under Reg. 1.403(b)-2, Q&A 4, (see 4.72.13.9)

    3. 402(g) limit (see 4.72.13.5).

4.72.13.1.2  (03-01-2005)
Correction Programs

  1. Three of the Service's correction programs apply to 403(b) plans. These include the:

    • Self-Correction Procedure (SCP)

    • Voluntary Correction of Tax-Sheltered Annuity Failures (VCP) program

    • Audit CAP for 403(b) Plans

  2. These programs are set forth and described in the following revenue procedures (see also, IRM 7.2.2, Employee Plans Compliance Resolution System):

    • Rev. Proc. 2003-44, 2003 –25 I.R.B. 1051

4.72.13.1.2.1  (03-01-2005)
SCP

  1. SCP is designed to further the Service's voluntary compliance initiatives by providing a self-correction procedure that applies to 403(b) plans. In general, under SCP, an employer (either directly or through the insurer or custodian) that has established compliance practices and procedures which are reasonably designed to facilitate overall plan compliance may correct Operational Failures (as defined in Section 5.02a of Rev. Proc. 2003-44) in its 403(b) plan within two plan years following the plan year of the failure.

    1. Eligible employers may also correct insignificant Operational Failures at any time.

    2. SCP permits correction of Operational Failures relating to contributions in excess of the limitation under IRC section 415.

    3. In general, SCP is not available to correct significant Operational Failures if either the plan or the employer is Under Examination (within the meaning of Section 5.03 of Rev. Proc. 2003-44).

  2. In examining a 403(b) plan, it is important to consider whether an employer has properly self-corrected an Operational Failure.

4.72.13.1.2.2  (03-01-2005)
VCP

  1. The VCP Program generally allows an employer to correct any Operational, Demographic, or Eligibility Failure (as defined in Section 5.02 of Rev. Proc. 2003-44) in its 403(b) plan that is within the jurisdiction of the Area Offices.

  2. Through VCP, an employer enters into a compliance statement with the Service which specifies the types of failures, the agreed method of correction, the applicable fee, and the effect the agreement has on potential tax liability of participants and the employer.

  3. VCP is not available if the plan or employer is Under Examination.

4.72.13.1.2.3  (03-01-2005)
Audit CAP

  1. Audit CAP for 403(b) Plans is available to correct Operational, Demographic, or Eligibility Failures other than a failure that has been corrected under SCP or VCP or is eligible for correction under SCP. Under Audit CAP, an employer and the Service enter into a closing agreement specifying the form of correction and the sanction amount.

4.72.13.1.2.4  (03-01-2005)
Effect of Correction under EPCRS; Reliance

  1. Although excise, FICA taxes, and FUTA taxes (and corresponding withholding) are not waived under the agreement, the Service will not pursue the income tax liability of participants or income tax withholding obligations of the employer due to the failures corrected under VCP, Audit CAP, or SCP. However, correction of failures may result in income tax and withholding for income tax (e.g., a distribution of excess deferrals).

  2. Excise taxes required to be filed on Form 5330, Return of Initial Excise Taxes Related to Pension and Profit-Sharing Plans, (other than those arising under IRC section 4974) should not be resolved as part of the Compliance Statement under VCP or Audit CAP for 403(b) Plans.

  3. In general, excise tax issues should be resolved by securing a Form 5330 providing for 100% of the tax and interest outstanding (although recommendation to the Service Center to waive the failure to file and/or failure to pay penalty under IRC section 6651 is at the discretion of the EP specialist).

4.72.13.1.3  (03-01-2005)
403(b) Filing Requirements

  1. With some exceptions, 403(b) plans are required to file the Form 5500, Annual Return/Report of Employee Benefit Plan. The following types of plans are exempt from filing (see instructions to Form 5500):

    • governmental plans

    • church plans and

    • 403(b) plans that are not employee benefit plans under Title I of ERISA

  2. In general, a 403(b) plan that provides only salary reduction contributions and under which the employer is minimally involved in selecting the funding vehicles is not an employee benefit plan under Title I. See DOL Reg. 2510.3-2(f).

4.72.13.1.4  (03-01-2005)
Examination Steps

  1. Request all documents pertaining to the 403(b) plan, including, to the extent applicable:

    1. the determination of tax exemption,

    2. basic plan document and amendments thereto,

    3. SPDs,

    4. annuity contracts,

    5. custodial account agreements,

    6. salary reduction agreements,

    7. employment contracts and

    8. other communications with employees.

      Note:

      The plan may not have nor does the Code require it to have a basic plan document. However, faulty plan language may indicate operational defects. Furthermore, the annuity contract or custodial account must provide for direct rollovers under section 403(b)(10) and the limit on elective deferrals under section 401(a)(30). Only annuity contracts are required to be nontransferable under section 401(g).

  2. Regarding SCP, verify that the method of correction was appropriate and timely.

  3. If the employer has a compliance statement through VCP:

    1. verify that the employer complied with the terms of the agreement and that correction was properly and timely completed. Because VCP does not cover the accuracy of specific numbers, verify their accuracy.

    2. check to see if there are any failures or years that fall outside of the scope of the agreement.

4.72.13.2  (03-01-2005)
Eligibility

  1. Unlike a qualified plan, only certain tax-exempt employers and certain ministers are eligible to maintain a 403(b) plan on behalf of eligible employees. The three key issues here are whether the:

    1. employer is eligible to maintain a 403(b) plan for participating employees,

    2. participants in a 403(b) plan perform services for the employer as employees, and

    3. self-employed and certain other ministers are described in IRC section 414(e)(5)(A).

4.72.13.2.1  (03-01-2005)
Eligible Employers

  1. Not all non-profit or tax-exempt organizations are eligible to maintain a 403(b) plan. There are only four types of tax-exempt employers eligible to maintain a 403(b) plan:

    1. A State, a political subdivision of a State, or an agency or instrumentality of any one or more of these for employees who perform services for a public education organization described inIRC section 170(b)(1)(A)(ii) ;

    2. A non-profit organization described in IRC section 501(c)(3) and exempt from federal income tax under IRC section 501(a), or an organization treated as described in IRC section 501(c)(3);

    3. A grandfathered Indian tribal government; and

    4. Beginning in years after December 31, 1996, a minister described in IRC section 414(e)(5)(A).

  2. A trade association described in IRC section 501(c)(6) and exempt from tax under IRC section 501(a) is not eligible to maintain a 403(b) plan.

    1. If an employer maintains an annuity plan and is not eligible, the plan is not a 403(b) plan. For resulting tax consequences, seeIRC sections 403(c) and 72.

    2. An ineligible employer may enter into a closing agreement with the Service pursuant to Rev. Proc. 2003-44.

    3. Situations in which an employer's eligibility varies among taxable years are discussed in 4.72.13.5.

4.72.13.2.1.1  (03-01-2005)
Public Education Organizations

  1. A state or local government or any agency or instrumentality of one or more of these is an eligible employer only with respect to employees who perform services directly or indirectly for an educational organization.

  2. To be an educational organization, the organization must normally maintain a regular faculty and curriculum, and normally have a regularly enrolled body of students in attendance at the place where it regularly carries on educational activities. Included in this category are:

    1. public schools

    2. state colleges

    3. universities

  3. Both non-academic staff (e.g., a custodial employee) and faculty may be covered but elected or appointed officials holding positions in which persons who are not education professionals may serve are not eligible (e.g., a member of the school board, university regent or trustee may not be eligible).

    Example 6: Public High School Y maintains a 403(b) plan (Plan) for its employees. Employee A performs timekeeping and payroll services for High School Y. A may participate in the Plan because A performs services for a public educational organization. See Rev. Rul. 72-390, 1972-2 C.B. 227.

    Example 7: A, a state employee, provides in-home teaching services. A may be covered by a 403(b) plan maintained by A's employer because A performs services for a public educational organization.

4.72.13.2.1.2  (03-01-2005)
Organizations Described in IRC section 501(c)(3)

  1. Another type of eligible employer is an organization described in IRC section 501(c)(3) and exempt from federal income tax under IRC section 501(a) (501(c)(3) organization). A 501(c)(3) organization is defined generally as one organized and operated exclusively for the following purposes:

    • religious

    • charitable

    • scientific

    • public safety testing

    • literary or educational

    • to encourage national or international amateur sports competition

    • for the prevention of cruelty to children or animals

  2. These organizations include:

    1. charities,

    2. social welfare agencies,

    3. private hospitals and

    4. health care organizations,

    5. private schools,

    6. religious institutions and

    7. research facilities.

  3. In order to be recognized as a 501(c)(3) organization, all organizations except church and related organizations, and other organizations excepted under section 508, must apply to the Service for a determination letter by filing Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. See Publication 557, Tax-Exempt Status of Your Organization; and also IRM 4.76.3 , Exempt Organizations Examination Guidelines.

4.72.13.2.1.3  (03-01-2005)
Grandfathered Indian Tribe

  1. A designated Indian Tribal Government is treated as a State for purposes of IRC section 403(b), so an educational organization or a 501(c)(3) organization associated with a tribal government is always eligible to maintain a 403(b).

  2. In addition, an Indian tribal government, a subdivision, agency or instrumentality of an Indian tribal government, or a corporation chartered under federal, State, or tribal law which is owned in whole or in part by any of the foregoing is treated as an employer described in section 501(c)(3) with respect to any annuity contract purchased in a plan year beginning before January 1, 1995.

4.72.13.2.1.4  (03-01-2005)
IRC section 414(e)(5)(A) Minister

  1. A self-employed minister may deduct, within the limits of IRC section 404(a)(10), contributions to a retirement income account described in IRC section 403(b)(9).

  2. Similar deductions may be taken by a minister employed by a non-501(c)(3) organization, and one with which the minister does not share common religious bonds.

  3. Beginning January 1, 1998, contributions to a 403(b) plan are not includible in the gross income of a minister described in (2) above. See IRC section 414(a)(5)(E).

4.72.13.2.2  (03-01-2005)
Eligible Employees

  1. A 403(b) plan can only cover the employees of an eligible employer (with the exception of ministers described in IRC section 414(e)(5)(A).

  2. Employee status under IRC section 403(b) is generally determined by employee status for federal employment tax purposes under common law principles. Whether an individual is a common law employee or independent contractor is most likely to arise with professionals such as physicians. See the 20 steps for determining employee status in Rev. Rul. 87-41, 1987-1 C.B. 296.

4.72.13.2.3  (03-01-2005)
Contributions for Retired Participants

  1. Section 403(b) allows certain amounts to be excludable from gross income that are contributed to a 403(b) plan for up to five years after the year of termination of employment. Only non-elective contributions may be excluded and the contributions must fall within the section 415 limit.

    Example 8: A school teacher (Teacher) retires from a public school and is entitled to receive $25,000 in accumulated sick leave and annual leave which, under a collective bargaining agreement, may be received in cash. Three days before this amount is to be paid, Teacher requests that the payroll office pay this amount into her 403(b) plan over the next five years. In this example, the contributions would be made pursuant to a salary reduction agreement because the Teacher has the option to have the employer contribute the amount or receive the amount in cash. The Teacher may not utilize the five-year provision because a salary reduction agreement, which is an agreement between an employer and employee, cannot persist after retirement. The five-year provision only applies to non-elective contributions.

    Example 9: The same facts as above, except that in the normal course of collective bargaining, a union has bargained away the right to receive the payment of accumulated sick and annual leave in cash and the amounts are required to be paid directly to the 403(b) plan by the employer. The amounts are non-elective contributions which can be contributed over a period of five years following retirement pursuant to the five-year provision assuming they satisfy the limit under section 415 and the definition of includible compensation. Only that portion of sick and annual leave attributable to the most recent one-year period of service may be included in includible compensation.

    Example 10: As part of an employment contract, Public School District Z agrees to contribute to Superintendent A’s 403(b) account $41,000 each year for five years following her retirement for a total of $205,000 in deferred compensation. Her last year’s salary exceeds $41,000. This is a permissible use of the five-year provision because her includible compensation for her most recent one-year period of service is in excess of $40,000. This benefit does not violate nondiscrimination and coverage requirements which are not applicable to governmental 403(b) plans with respect to non-elective contributions. (Note that elective contributions under a 403(b) plan maintained by a public school or other governmental entity are subject to universal availability). See also Section 4.72.13.6 below.

4.72.13.2.4  (03-01-2005)
Examination Steps

  1. Because the issue of the employer's eligibility is so basic it is easy to overlook. Check to see whether the employer:

    1. is a public educational organization,

    2. has IRC section 501(c)(3) status, or

    3. has a compliance statement with the Service covering the employer's ineligibility.

  2. Be sure to consider the employer's relationship to the participating employees. If the employer is not eligible, consider a closing agreement under Audit CAP for 403(b) Plans as provided in Rev. Proc. 2003-44 .

  3. If the examination is conducted in connection with an Exempt Organizations audit, a loss of 501(c)(3) status will automatically cause the plan to fail the requirements of IRC section 403(b) for any plan year during which the employer was not eligible. Again, consider a closing agreement under Rev. Proc. 2003-44.

  4. If the examination is not initiated by Exempt Organizations, you may want to request assistance on the issue of employer eligibility.

4.72.13.3  (03-01-2005)
Funding Vehicles

  1. Amounts contributed to a 403(b) plan may be invested only in certain funding vehicles. Funding vehicles refer to the type of investment arrangement for the assets of a 403(b) plan.

  2. The funding vehicles for 403(b) plans are generally limited to --

    1. annuity contracts,

    2. custodial accounts for regulated investment company stock,

    3. retirement income accounts for churches, or

    4. any combination of these.

  3. Custodial accounts and retirement income accounts are treated as annuity contracts for purposes of the Code. Thus, custodial accounts and retirement income accounts are generally subject to the rules applicable to 403(b) annuity contracts (in addition to their own special requirements). Custodial and retirement income accounts must satisfy the --

    1. contribution limits (including IRC sections 415 and 402(g)),

    2. nondiscrimination (except those maintained by IRC section 3121(w)(3)churches),

    3. minimum distribution, and

    4. direct rollover rules.

4.72.13.3.1  (03-01-2005)
Annuity Contracts

  1. The most common type of funding vehicle for a 403(b) plan is an annuity contract under IRC section 403(b)(1).

    1. The annuity contract may be offered only by an insurance company.

    2. The contract may be owned by the individual, or, in the case of a group annuity contract, by the employer.

    3. The annuity may be either variable or guaranteed.

    4. An annuity contract may contain a vesting schedule for non-salary reduction contributions, but the vesting schedule must comply with Title I, the Labor Title of ERISA, if applicable.

  2. Regulations extend the non-transferability requirement of IRC section 401(g) to 403(b) annuity contracts. Thus, a 403(b) annuity contract must provide that it is nontransferable. This means that the contract cannot be sold, assigned, or pledged as security for collateral.

    1. However, loans may be made from an annuity contract and amounts held under the contract may be transferred or rolled over to another 403(b) plan under certain conditions.

    2. Salary reduction contributions to an annuity contract and their earnings are subject to certain early distribution restrictions to ensure that they are used for retirement purposes. See IRC sections 403(b)(7) and 403(b)(11).

    3. Excess contributions to an annuity contract are not subject to the excise tax under IRC section 4973. See 4.72.13.5 and 4.72.13.8.
      Caution: For contracts purchased on or after 2/14/05, see section 1.403(b)-8(c)(2) of the Proposed 403(b) regulations, 2004-49 I.R.B. 925.

  3. An annuity contract may provide life insurance protection as long as the death benefit is merely incidental to the primary purpose of providing retirement benefits. The rules for determining whether life insurance is incidental in qualified plans apply also to 403(b) plans.

    1. Life insurance is incidental if less than 50% of total employer contributions made on behalf of a participant are used to purchase an ordinary life insurance contract, or in the case of term or universal life insurance, no more than 25% of total contributions are used to purchase the life insurance contract.

    2. As in qualified plans, the portion of each year's premium representing the cost of life insurance protection (referred to as P.S. 58 costs) is includible in gross income and counts toward the employee's basis in the annuity contract on distribution.

    3. In addition, a contract on a participant's life must be converted to cash or an annuity or distributed to the participant at retirement. See Rev. Rul. 60-84, 1960-1 C.B. 159; Rev. Rul. 66-143, 1966-1 C.B. 79; and Rev. Rul. 68-31, 1968-1 C.B. 151.

  4. If a plan is structured so that contributions are placed in an employer's savings account to purchase annuity contracts for employees at retirement, the plan is not a 403(b) plan. SeeRev. Rul. 68-87, 1968-2 C.B. 187, and Rev. Rul. 68-488, 1968-2 C.B. 188.

    Example 11: Foundation, a 501(c)(3) organization, maintains an annuity plan intended to be a 403(b) plan (Plan). Foundation makes both salary reduction and non-salary reduction contributions to individual investment accounts (not mutual funds) for each of its employees. Foundation purchases annuity contracts for employees at their retirement. The arrangement is not a 403(b) plan.

    Example 12: Employer is a public education organization maintaining a plan intended to be a 403(b) plan (Plan). All contributions under the Plan are invested in life insurance policies for its employees. Because life insurance must be incidental to the primary purpose of providing retirement benefits, the Plan is not a 403(b) plan.

4.72.13.3.2  (03-01-2005)
Custodial Accounts

  1. A custodial account under IRC section 403(b)(7) is treated as an annuity contract and must satisfy the various requirements of IRC section 403(b). In addition,

    1. the assets of a custodial account must be held by a bank or an approved non-bank trustee or custodian under IRC section 401(f).

    2. the assets must be invested exclusively in regulated investment company stock (e.g., mutual funds) and consequently, a custodial account may not provide life insurance.

    3. a custodial account may permit loans to participants.

  2. Both salary and non-salary reduction contributions to a custodial account are subject to certain early distribution restrictions.

  3. Unlike contributions to annuity contracts, excess contributions to a custodial account are subject to the excise tax under IRC section 4973. See 4.72.13.5.3.

4.72.13.3.3  (03-01-2005)
Retirement Income Accounts

  1. A retirement income account is defined under IRC section 403(b)(9) as a defined contribution program established and maintained by a church or related organization.

  2. A retirement income account may take the form of a defined benefit plan if it is grandfathered. A defined benefit plan which is established by a church or a convention or association of churches and is in effect on August 13, 1982, is not treated as failing to satisfy the requirements of IRC section 403(b) merely because it is a defined benefit arrangement.

  3. Retirement income accounts are generally subject to the rules and requirements for annuity contracts.

  4. The funding vehicles for these accounts are varied, and include annuity contracts and custodial accounts.

4.72.13.4  (03-01-2005)
Salary Reduction Contributions

  1. 403(b) plans are very commonly funded in whole or in part through salary reduction contributions. The requirements for salary reduction and non-salary reduction contributions differ under IRC section 403(b). This section focuses on requirements applicable only to salary reduction contributions.

  2. Salary reduction contributions under a 403(b) plan are also subject to specific requirements such as annual contribution limits, nondiscrimination rules, and withdrawal restrictions. These requirements are discussed in text 4.72.13.5, 4.72.13.6, and 4.72.13.7.

  3. Salary reduction contributions are defined as contributions made by an employer as a result of an agreement with an employee to take a reduction in salary or forego an increase in salary, bonuses or other wages. Salary reduction contributions are made pursuant to a salary reduction agreement.

  4. Salary reduction contributions made to a 403(b) plan are similar to voluntary deferrals under a cash or deferred arrangement described in IRC section 401(k) (CODA). Many of the same rules applicable to cash or deferred elections under IRC section 401(k) apply to salary reduction contributions under a 403(b) plan, including the --

    1. frequency that an employee is permitted to enter into or modify a salary reduction agreement,

    2. compensation to which an agreement may apply, and

    3. ability to revoke the agreement.

  5. A 403(b) plan is neither required to permit, nor precluded from permitting, an employee to make multiple salary reduction agreements in a single taxable year. A 403(b) salary reduction agreement applies to compensation that is not yet paid or currently available to the employee at the effective date of the agreement. The salary reduction agreement must be legally binding.

  6. An automatic reduction of an employee’s salary by a certain amount may be treated as a salary reduction agreement if the employee has an effective opportunity to elect to receive the amounts in cash. See Rev. Rul. 2000-35.

  7. The salary reduction contributions must be in the nature of compensation.

  8. Salary reduction contributions are generally treated as employer contributions (notably for purposes of IRC sections 403(b), 402(g) and 415) but are treated as employee contributions for other purposes, including FICA.

4.72.13.4.1  (03-01-2005)
Examination Step

  1. Check sample salary reduction election forms to determine whether the agreement applies to amounts not yet currently available to the employee at the time the agreement is effective.

4.72.13.5  (03-01-2005)
Contribution Limits

  1. For years beginning on or after January 1, 2002, there are two separate limitations on the amount of contributions to a 403(b) plan which are excludable from gross income. These limitations are found in:

    • IRC section 402(g), and

    • IRC section 415.

  2. Section 402(g) imposes a limit on the annual dollar amount of elective deferrals made by a participant during the year. Section 402(g) limits the elective deferrals in a 403(b) plan.

  3. All elective deferrals made by a participant to a SEP, CODA, 403(b) plan, 501(c)(18) plan, and simple retirement account are included in applying the limit. The limit is designed to restrict the total amount that may be deferred by a participant on a salary reduction basis.

  4. Section 415 places an overall limit on the amount of elective and non-elective contributions that may be made annually on an employee's behalf to a 403(b) plan during a single limitation year. Section 415 imposes a limit of the lesser of $ 41,000 or 100% of includible compensation on the maximum amount that may be contributed to a 403(b) plan for the year.

  5. Under IRC section 414(u), contributions by an employer or employee pursuant to veterans' re-employment rights under the Uniform Services Employment and Reemployment Rights Act of 1994 (USERRA) , are not treated as contributions made in the year the contributions are made, but in the year to which they relate, for purposes of IRC section 402(g) and IRC section 415.

  6. The exclusion allowance, which limited contributions to a 403(b) plan, was repealed for years beginning after December 31, 2001. For exam years prior to that date, please refer to prior examination guidelines.

4.72.13.5.1  (03-01-2005)
IRC section 402(g) Limit on Elective Deferrals

  1. For plan years beginning after December 31, 1987, elective deferrals under a 403(b) plan are subject to the limitation under IRC section 402(g).

  2. For purposes of IRC section 403(b), an elective contribution is any contribution that arises because of an employee's election between current cash compensation or deferral under the plan.

  3. An elective deferral is any elective contribution by a participant made to the following types of plans:

    1. qualified CODA

    2. salary reduction simplified employee pension plan

    3. 403(b) plan

    4. simple retirement account.

  4. Elective deferrals are subject to FICA.

  5. Elective deferrals under a 403(b) plan are employer contributions which are used to purchase an annuity contract (or made to a custodial account) under a salary reduction agreement.

  6. In addition to the 415 limit, there are two limits restricting the amount of elective deferrals that may be made on behalf of a participant:

    1. a participant limit under IRC section 402(g) and

    2. a contract limit under IRC section 403(b)(1)(E). The contract limit has two components, a form and an operational requirement.

  7. The IRC section 402(g) participant limit applies to all the elective deferrals made on behalf of a participant.

    Example 13: An employee participating in two salary reduction 403(b) plans with separate employers must count the elective deferrals made under both plans in applying the limit. If this employee also participated in a CODA underIRC section 401(k), or a simple retirement account under IRC section 408(p), these elective deferrals would also be counted. See IRC section 402(g)(3).

  8. The contract requirement under IRC section 403(b)(1)(E) applies only to limit elective deferrals under annuity contracts purchased by a single employer. See 4.72.13.5.1.3.

  9. The coordination limit under IRC section 457(c)(2) was repealed for years beginning after December 31, 2001.

4.72.13.5.1.1  (03-01-2005)
One-Time Irrevocable Election

  1. Elective deferrals for income tax purposes do not include elective contributions made pursuant to a one-time irrevocable election that is made at:

    1. initial eligibility to participate in the salary reduction agreement, or

    2. pre-tax contributions made as a condition of employment.
      Caution: For FICA application, see T.D. 9159, 2004-49 I.R.B. 895

  2. If a participant has the right or ability to terminate or modify an election, the contributions are elective deferrals even if the participant never exercises this right. The IRC section 402(g) limit affects only elective deferrals, it does not apply to other kinds of contributions. Consequently, it is critical to determine which (if any) contributions are elective deferrals.

    Example 14: X participates in a 403(b) plan (Plan). In order to receive employer contributions under the Plan, X is required to elect to defer 3% of salary in the form of Mandatory Contributions. X has the option of revoking this election at any time, although X never terminates his election. The Mandatory Contributions are elective deferrals because X's election is revocable. These contributions are therefore included in applying the IRC section 402(g) limit. They are also subject to FICA (if applicable).

    Example 15: Assume the same facts as in Example 14, except that the Plan further provides that an election to terminate participation in the Plan is irrevocable. Thus, an employee who terminates his election will be permanently excluded from participating in the Plan. Even so, since the election to participate is revocable, the Mandatory Contributions are elective deferrals under IRC section 402(g). The contributions are subject to FICA (if applicable).

    Note:

    Example 15 points out that if an employee may terminate his election to participate in a plan, the election is not considered to be irrevocable. Irrevocability relates to the election to participate rather than an election to terminate participation in a plan.

4.72.13.5.1.2  (03-01-2005)
Catch-Up Election

  1. Section 402(g)(7) provides a special election for certain long-term employees. Under the rule, they may catch up on the funding of their retirement benefit by increasing their elective deferrals over the $12,000 (for 2003) limit.

  2. The election is available only to an employee who has completed at least 15 years of service (defined in IRC section 403(b)) with an employer that is either a(n):

    1. educational organization

    2. hospital

    3. home health service agency

    4. health and welfare service agency

    5. church

    6. related church organizations.

  3. With the exception of churches, years with different employers cannot be added together for purposes of satisfying the 15-year requirement.

  4. Under the election, the annual limitation is increased by the smallest of:

    1. $3,000,

    2. $15,000 minus any elective deferrals made by the organization and previously excluded under the catch-up election, or

    3. $5,000 times the employee's years of service minus the elective deferrals made to plans of the organization in prior taxable years.

  5. As can be seen from this election, there is a limit on increases under the election of $15,000, and the annual limit cannot exceed $15,000 for 2003. The catch-up applies to elective deferrals made by the qualified organization on behalf of the employee. The catch-up election is per employer and not per employee.

  6. For an individual who attains age 50 prior to the end of the year, there is an additional catch-up of $1,000 in 2002, $2,000 in 2003, and increasing $1,000 each year through 2006.

4.72.13.5.1.3  (03-01-2005)
Contract Limit

  1. As indicated in text 13.5.1.2, IRC section 402(g) limits all elective deferrals of a participant, even if the elective deferrals are made with respect to plans of separate employers. Section 403(b)(1)(E) imposes a contract requirement which limits the amount of elective deferrals under annuity contracts purchased by a single employer. A failure to satisfy this requirement results in the loss of 403(b) status of the annuity contracts.

4.72.13.5.1.3.1  (03-01-2005)
Contract Terms

  1. Under IRC section 403(b)(1)(E), a contract purchased by an employer must comply with the requirements of IRC section 401(a)(30).

  2. Section 401(a)(30) requires a qualified plan to provide that the amount of elective deferrals under plans of the employer not exceed the limit under IRC section 402(g). Thus, in order to be a valid contract under IRC section 403(b), the contract by its terms must preclude the making of excess deferrals.

  3. Section 403(b) contracts must reflect the 402(g) limit.

4.72.13.5.1.3.2  (03-01-2005)
Operational Requirement

  1. Excess deferrals are elective deferrals in excess of the 402(g) limit. If 403(b) contracts purchased by a single employer accept excess deferrals, 403(b) status is lost for affected contracts unless the excess deferrals are timely corrected.

    1. Under Reg. 1.402(g)-1(e), a contract may avoid the loss of 403(b) status by distributing the excess deferrals plus the earnings thereon by April 15 of the following taxable year, if the contract so permits.

    2. The distribution may be made notwithstanding any other provision of law.

    3. The portion of the distribution attributable to excess deferrals is taxable in the year of contribution, while the earnings are taxable in the year of receipt. The issuer must file a Form 1099 indicating the distribution.

  2. If a contract loses its status as a 403(b) because of paragraph (1) above, the affected annuity contract (or custodial account) loses its status under section 403(b) for the taxable year of the violation. Thus, all amounts contributed to the affected annuity contract or contracts for the year of the violation are includible in gross income.

    1. The excess deferrals are taxable again on distribution.

    2. The employer is responsible for applicable employment taxes and income tax withholding.

  3. If excess deferrals are made by the employee to contracts of two unrelated employers and they are not timely corrected, there is no loss of 403(b) status of the annuity contracts but the excess is taxed both in the year contributed and again on distribution.

    Example 16: Association, a 501(c)(3) organization, maintains a 403(b) plan (Plan) with a calendar plan year. In 2003, each of Association's highly compensated employees (HCEs) elects to make contributions of $40,000 on the mistaken assumption that the contributions are not elective deferrals limited by IRC section 402(g). The excess deferrals of $28,000 ($40,000 - $12,000) are not timely corrected. All contributions made to the affected annuity contracts are includible in the employees' gross income for taxable year 2003 and are subject to FICA. In addition, Association is responsible for employment taxes and withholding. The excess deferrals are taxable again on distribution.

    Example 17: The same facts as Example 16, except that $ 15,000 of the $40,000 contributed to the Plan in 2003 consists of non-elective contributions. The $25,000 in elective deferrals are in excess of the IRC section 402(g) limit for the year, and thus all contributions made to the affected annuity contracts are includible in gross income for tax year 2003.

4.72.13.5.1.4  (03-01-2005)
Examination Steps

  1. The first step is to identify the elective deferrals under the plan(s) of the employer. Consider all contributions made to the plan(s).

  2. In determining whether contributions are elective deferrals, examine the substance of the arrangement. Do not be misled by the labels an employer attaches to the contributions, such as employer, employee or mandatory contributions.

  3. In determining whether deferrals are elective or non-elective, you may want to consider the following, if applicable:

    1. The operation of the plan -- have any participants revoked their elections?

    2. Employment contracts -- is participation in the plan a condition of employment? If so, the contributions are not elective deferrals.

    3. All plan documents, including SPDs, funding vehicles, and any memoranda or other communications to employees, if any.

  4. In certain cases, it may be appropriate to check for any inconsistencies in the various documents.

  5. If there are elective deferrals under the plan, see if the underlying annuity contracts (including custodial account agreements) specifically limit elective deferrals. Also check for excess deferrals by requesting annual contributions records and/or salary reduction agreements.

  6. If the employer has another plan covering the same employees (including a 403(b) plan with elective deferrals), make sure that the combined amount of elective deferrals are within the 402(g) limit.

  7. Check to see if the elective deferrals were reported on the Form W-2, and on Form 1099-R if distributed.

  8. If a participant had excess deferrals, determine whether the excesses were timely and properly corrected.

4.72.13.5.2  (03-01-2005)
Section 415 Limit

  1. Section 415 limits on contributions (hereinafter referred to as 415 limits or 415 contribution limits) that apply to qualified plans also generally apply to 403(b) plans. A 403(b) plan is treated as a defined contribution plan for purposes of the 415 contribution limits. Consequently, contributions to a 403(b) plan (including salary reduction contributions and after-tax employee contributions) may not exceed the lesser of 100% of includible compensation or $40,000 in the limitation year (although IRC section 402(g) further limits elective deferrals to $12,000, as indexed for 2003).

  2. The 415 limit applies to contributions made to a 403(b) plan with respect to the limitation year regardless of whether they are vested.


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