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Part 4. Examining Process

Chapter 72. Employee Plans Technical Guidelines

Section 13. 403(b) Plans (Cont. 1)

4.72.13  403(b) Plans (Cont. 1)

4.72.13.5 
Contribution Limits

4.72.13.5.2 
Section 415 Limit

4.72.13.5.2.1  (03-01-2005)
Alternative Limitations

  1. There are alternative limitations under IRC section 415(c)(7) that are available in the case of employees of a church or related organization.

    1. Such employees may elect to substitute the IRC section 415 limit with an annual limit of $10,000 (even if more than 100% of includible compensation) up to a total lifetime limit of $40,000.

  2. Even if the limitation under IRC section 415 is $41,000, IRC section 402(g) further limits elective deferrals to $13,000 for 2004 (or a maximum of $13,000 plus $3,000 if the full catch-up limit applies). The IRC section 402(g) limit must always be considered in examining a 403(b) plan with elective deferrals.

4.72.13.5.2.2  (03-01-2005)
Plan Aggregation

  1. Under IRC section 415, a participant generally is considered to exclusively control and maintain his own 403(b) plan. Consequently, contributions to a 403(b) plan are not combined or aggregated with contributions to a qualified plan except when a participant controls any employer. In this situation, the 403(b) plan is treated as a defined contribution plan maintained by both the employer and the participant.

  2. Thus, where a participant controls any employer (this may be the employer contributing to the 403(b) plan or another employer) for a limitation year, the contributions to the 403(b) plan are combined with contributions to a qualified plan by the controlled employer or any affiliated employer under IRC section 415. See Reg. IRC section 1.415-8(d) .

  3. The following example illustrates that an employee who is covered by a pension plan of the employer may also participate in a 403(b) plan through the employer without having to aggregate the plans under IRC section 415. Thus, the employer could contribute non-salary reduction contributions of up to $40,000 to the 403(b) plan even though the employee has contributions under the qualified plan which are at the IRC section 415 maximum.

    Example 18: Employee A is employed by a hospital which is a 501(c)(3) organization. The hospital contributes to a 403(b) plan on behalf of A in the limitation year, and A is also a participant in the hospital's defined contribution plan. Employee A is not required to aggregate contributions under the qualified defined contribution plan with those made under the 403(b) plan for purposes of testing under IRC section 415.

    Example 19: The facts are the same as in Example 18, except that A is also a physician maintaining a private practice in which he is more than a 50% owner. A is a participant in a defined contribution plan maintained by A’s private practice. The defined contribution plan of A's private practice must be combined with A's 403(b) plan for purposes of applying the limit under IRC section 415(c) because A controls his private practice.

4.72.13.5.2.3  (03-01-2005)
Limitation Year

  1. The limitation year generally is the calendar year unless a participant elects another 12-month period.

  2. If a participant is in control of an employer, the limitation year is the limitation year of the employer.

  3. Control and affiliation for purposes of this section of the guidelines are defined under IRC sections 414(b), 414(c) and 415(h).

4.72.13.5.2.4  (03-01-2005)
Includible Compensation

  1. Includible compensation is generally all salary from the employer includible in gross income for the employee's most recent one-year period of service ending with or within the taxable year.

    1. Includible compensation also includes a participant's elective deferrals (all elective deferrals as described in section 402(g)(3)), and amounts not included in an employee's gross income by reason of IRC section 125 or 457(b).

  2. Includible compensation does not include:

    1. Contributions (vested or not vested) made by the employer to a qualified plan, including contributions picked up by the employer under IRC section 414(h)(2), because they are not currently includible in compensation. See Rev. Rul. 79-221, 1979-2 C.B. 188.

    2. Except for elective deferrals, any contributions to a 403(b) plan of the employer even if the contributions are includible in gross income.

    3. Compensation earned while the employer was not eligible to maintain the 403(b) plan.

    4. Compensation earned prior to the employee's most recent one-year period of service.

    5. Includible compensation does not include any amount contributed by the employer for a 403(b) annuity contract or any amount received by a former employee after the fifth taxable year following the taxable year in which such employee was terminated.

    6. For 2003, the maximum amount of compensation that may be taken into account is $200,000.

4.72.13.5.2.5  (03-01-2005)
Effect of Contributions in Excess of IRC Section 415 Limit

  1. Contributions to a 403(b) plan in excess of the IRC section 415 limit are includible in the employee's gross income for the tax year ending with or within the limitation year.

    Example 20:Foundation is a 501(c)(3) organization which maintains a 403(b) plan (Plan) for its employees. The gross annual compensation of Employee A equals $60,000. Contributions to the Plan on behalf of Employee A equal $42,500 (all are non-salary reduction) in the limitation year ending December 31, 2003, $2,500 above the allowable 415 limit. The $2,500 excess is includible in A’s gross income for the 2003 taxable year.

4.72.13.5.2.6  (03-01-2005)
Correction

  1. Like qualified plans, excess 415 amounts in 403(b) plans may be corrected under Reg. 1.415-6(b)(6) to the extent the excess amounts are due to one of the following:

    1. the allocation of forfeitures,

    2. a reasonable error in estimating a participant's compensation,

    3. a reasonable error in determining total elective deferrals, or

    4. in certain other limited facts and circumstances as determined by the Commissioner. See Rev. Proc. 92-93, 1992-2 C.B. 505.

  2. In the absence of such correction, excess 415 amounts and earnings thereon are currently includible in the participant’s gross income.

4.72.13.5.2.7  (03-01-2005)
Examination Steps

  1. Check the annual contributions to the 403(b) plan. If the amount deferred for any employee exceeds $40,000, there may be excess 415 amounts.

  2. Determine whether a participant in the 403(b) plan has his or her own practice (such as a medical clinic or consulting firm) which maintains a Keogh plan. Contributions under the qualified plan may have to be aggregated with 403(b) contributions.

  3. Check plan documents, including the basic plan document and SPDs, as well as the funding vehicles, to determine whether contributions are properly limited by IRC section 415. Plan language is not required, however, faulty plan language may indicate an operational defect.

  4. For further details on the contribution limits, see Publication 571 Tax-Sheltered Annuity Plans for Employees of Public Schools and Certain Tax-Exempt Organizations.

    Example 21: Private School, a 501(c)(3) organization, maintains both a 403(b) plan (Plan A) and a matching plan under IRC sections 401(a) and 401(m) (Plan B). The contributions provided under Plan B are matched to elective deferrals under Plan A. In 2001, Private School contributes $3,000 of elective deferrals and $3,000 of matching contributions to Plans A and B on behalf of Employee X. X must exclude the matching contributions in calculating includible compensation for purposes of computing X's 2003 415 limitation.

4.72.13.5.3  (03-01-2005)
Excise Tax

  1. Under IRC section 4973, a 6% cumulative excise tax is imposed on the employee for excess contributions made to a 403(b)(7) custodial account.

  2. Excess contributions are the excess of the amount contributed over the IRC section 415 limit.

  3. To the extent contributions are in excess of the 415 limit, the contributions are taxable.

  4. The excise tax applies only to excess contributions to a custodial account and is not applicable to a 403(b)(1) annuity contract.

  5. Excess contributions are determined at the end of the taxable year.

  6. The excise tax applies only to the excess contributions and not to earnings on the contributions. As illustrated in the following example, the excise tax does not apply to excess contributions (contributions in excess of the 415 limit) invested in annuity contracts. It does not apply to excess deferrals. Contributions are tested on a yearly basis with respect to the applicable 415 limit for the year.

    Example 22: Foundation maintains a 403(b) plan (Plan) on behalf of its employees. The funding vehicles for the Plan include both annuity contracts and custodial accounts. In the limitation year ending December 31, 2003, 50 employees receive contributions in excess of the 415 limit. All of the excess 415 amounts are includible in employees' gross income in taxable year 2003. In addition, the portion of the excess 415 amounts invested in the custodial accounts are subject to the excise tax under IRC section 4973 . Foundation may contribute less in 2004 with respect to affected employees to prevent excess contributions under section 415 and application of the excise tax.

4.72.13.5.3.1  (03-01-2005)
Examination Steps

  1. If a plan has excess contributions, see whether or to what extent the funds of the 403(b) plan are invested in mutual funds through a custodial account.

  2. Ask the employer for the actual amount contributed to the custodial account, and check salary reduction agreements and annual compensation of participants.

4.72.13.6  (03-01-2005)
Nondiscrimination and Coverage

  1. TRA '86 imposed nondiscrimination and coverage rules on 403(b) plans under IRC section 403(b)(12).

    1. These rules generally must be satisfied for plan years beginning after December 31, 1988.

    2. These rules do not apply to churches, including qualified church-controlled organizations, as defined by IRC section 3121(w)(3).

  2. Nondiscrimination and coverage requirements (exceptIRC section 401(a)(17)) with respect to non-salary reduction contributions do not apply to governmental 403(b) plans.

    1. A governmental plan (within the meaning ofIRC section 414(d)) is one maintained by a State or local government or political subdivision, agency or instrumentality thereof.

  3. Currently there are no nondiscrimination regulations under IRC section 403(b)(12). Pending the issuance of regulations or other guidance, Notice 89-23, 1989-1 C.B. 654 (extended by Notice 96-64, 1938-2 C.B. 229), provides guidance for complying with the nondiscrimination rules.

    1. Notice 89-23 deems a 403(b) plan to satisfy nondiscrimination if the employer operates the plan in accordance with a good faith, reasonable interpretation ofIRC section 403(b)(12). One means of satisfying this test is through the safe harbors set forth in Notice 89-23.

    2. Under the notice, salary reduction and non-salary reduction contributions are tested separately for nondiscrimination. Only non-salary reduction contributions (both matching and non-elective) are subject to the coverage requirements of IRC section 410(b). See 4.72.13.6.2.

  4. Under IRC section 414(u), a 403(b) plan is not treated as failing nondiscrimination or coverage requirements by reason of the making of employer or employee contributions (or the right to make such contributions) made pursuant to veterans' reemployment rights under USERRA.

4.72.13.6.1  (03-01-2005)
Salary Reduction Contributions

  1. Salary reduction contributions are tested separately from non-salary reduction contributions for nondiscrimination. See IRC section 403(2)(12)(A)(ii).

    1. The nondiscrimination requirement for salary reduction contributions is satisfied only if the plan in operation allows each employee to elect to defer more than $200 annually. Unlike a qualified CODA, nondiscrimination with respect to salary reduction contributions is not satisfied through compliance with the ADP test.

    2. The test for salary reduction contributions focuses on eligibility and generally requires universal eligibility. However, there is no requirement that the opportunity to make salary reduction contributions be available; but once that opportunity is available to any employee, it must be available to all nonexcludable employees to satisfy nondiscrimination.

    3. Until future guidance is issued, both public education institutions and 501(c)(3) organizations MUST currently operate their 403(b) plans in accordance with a good faith/reasonable interpretation of the nondiscrimination requirement for salary reduction contributions. No plan provisions are currently required, but faulty plan language may indicate an operational violation.

    4. Additional catch-up contributions under IRC section 414(v) must be universally available to employees if these are made available to any employee.

  2. Excludable employees may be disregarded in applying the nondiscrimination test for salary reduction contributions. These include:

    1. nonresident aliens with no U.S. source income,

    2. employees who normally work less than 20 hours per week,

    3. collectively-bargained employees,

    4. students performing certain services,

    5. employees whose maximum salary reduction contributions under the plan would be no greater than $200,

    6. participants in an eligible 457 plan, a qualified CODA, or other salary reduction 403(b) plan, and

    7. certain ministers described in IRC section 414(e)(5)(C) . Note: Unlike a qualified plan, a 403(b) plan is not permitted to have any minimum age and service exclusion for salary reduction contributions.

  3. Like elective deferrals under IRC section 402(g), salary reduction contributions for nondiscrimination testing consist of employer contributions made pursuant to a salary reduction agreement.

  4. Under Notice 89-23, employer means the common law employer (and not the controlled group) for purposes of testing salary reduction contributions for nondiscrimination. A good faith, reasonable interpretation as to the identity of the employer is sufficient for this purpose.

    1. Salary reduction contributions made pursuant to a one-time irrevocable election at initial eligibility to participate in the salary reduction agreement, or pursuant to certain other one-time irrevocable elections specified in the regulations, and pre-tax contributions made as a condition of employment are treated and tested as non-salary reduction contributions. See text 4.72.13.5 for a discussion of a similar definition for elective deferrals under IRC section 402(g).

  5. Examples 23-26 illustrate that salary reduction contributions are tested separately from other contributions for nondiscrimination and that these contributions must be offered universally to non-excludable employees. The effect of violating nondiscrimination is the loss of 403(b) status. Contributions to the Plans are therefore subject to income tax, employment tax and withholding.

    Example 23: Employer is a large public university located in City Y. Employer maintains an annuity plan (Plan) intended to be a 403(b) plan. Both non-elective, non-matching contributions and salary reduction contributions are provided under the Plan. Under the Plan, only senior administrative staff and faculty are eligible to elect to defer a portion of their salary pursuant to salary reduction agreements with Employer. Employer also maintains a defined benefit plan for remaining employees. Employer maintains no other plans of deferred compensation. The salary reduction contributions are discriminatory. The Plan does not satisfy the requirements of IRC section 403(b).

    Example 24: Same as Example 23, except that all full-time employees are eligible to participate in the Plan. There are 40 part-time clerical employees who are not students and who normally work 29 hours per week (or 1,508 hours per year). Since the part-time employees in this example are not excludable, the salary reduction contributions are discriminatory. The Plan is not a 403(b) plan.

    Example 25: Employer is a small private school which maintains an annuity plan intended to be a 403(b) plan. All eligible employees may elect to defer at least 4% of compensation. An eligible employee, A, has compensation of $25,000 for 2000 and elects prior to 2000 to defer 1.5% of compensation. The plan administrator declines to process the election and informs A that the minimum deferral is 4% of compensation. The salary reduction contributions are discriminatory, and the Plan fails to satisfy 403(b).

    Example 26: Employer is a private hospital maintaining an annuity plan (Plan) intended to be a 403(b) plan. The Plan provides only a salary reduction arrangement. Under the Plan, all medical doctors and senior administrative staff are eligible to participate in the Plan immediately upon hire. Remaining employees, including nurses and other support staff, are eligible only after two years of service and attainment of age 21. Employer maintains no other plans of deferred compensation. The salary reduction contributions are discriminatory, and the Plan loses its status as a 403(b).

4.72.13.6.2  (03-01-2005)
Non-Salary Reduction Contributions

  1. Non-salary reduction contributions are:

    1. all contributions that are not salary reduction contributions

    2. basically all non-elective and matching contributions

    3. tested separately from salary reduction contributions for nondiscrimination.

  2. Non-elective (non-matching) contributions, and matching and after-tax employee contributions, are also tested separately for nondiscrimination.IRC section 403(b)(12)(A)(i) requires compliance with the following provisions:

    1. IRC section 401(a)(4)(nondiscrimination)

    2. IRC section 401(a)(5) (permitted disparity)

    3. IRC section 401(a)(17) (the $200,000 ceiling on compensation, as indexed for 2003)

    4. IRC section 401(a)(26) (minimum participation)

    5. IRC section 401(m) (matching and after-tax employee contributions)

    6. IRC section 410(b) (minimum coverage) for non-salary reduction contributions

  3. Non-salary reduction contributions of 403(b) plans maintained by public education institutions, or governmental entities which qualify as 501(c)(3) organizations, are not subject to the nondiscrimination or coverage requirements (other than IRC section 401(a)(17)) beginning in tax years on or after August 5, 1997 (prior to that date, governmental plans are deemed to satisfy these requirements, except IRC section 401(a)(17) ).

  4. For 501(c)(3) organizations, under Notice 89-23, nondiscrimination requirements for non-salary reduction contributions are deemed satisfied if the employer operates the plan in accordance with a good faith reasonable interpretation of the above Code sections. The safe harbors in the notice are one means of satisfying the good faith/reasonable interpretation test.

  5. Excludable employees are those employees who have not satisfied any permissible age and service requirements of the plan, in addition to those listed above in 4.72.13.6.1 (2).

  6. Employer is generally defined for purposes of nondiscrimination with respect to non-salary reduction contributions under the following provisions of IRC section 414:

    • (b) (controlled groups)

    • (c) (groups under common control)

    • (m) (affiliated service groups)

    • (o) (other organizations or arrangements described by regulations). Note: Until further guidance is issued, a good faith, reasonable interpretation applies in defining the employer for this purpose. See Notice 89-23 for more detail.

4.72.13.6.3  (03-01-2005)
Highly Compensated Employee

  1. For years beginning after December 31, 2003, the definition of an HCE means any employee who:

    1. was a 5% owner at any time during the year or the preceding year, or

    2. for the preceding year has compensation from the employer in excess of $90,000 (as indexed for COLAs), and if the employer so elects for the preceding year, was in the top paid group of employees for such preceding year.

4.72.13.6.4  (03-01-2005)
Examination Steps

  1. Ask the employer for the number of HCEs and NHCEs, which of these participate or are eligible to participate in the 403(b) plan or other plans of the employer, and annual compensation and contributions records.

  2. ) Using employment records, check to see --

    1. who can make salary reduction contributions and when they can be made.

    2. whether salary reduction contributions are in fact available to all nonexcludable employees. Note: Because the definition of salary reduction contribution and elective deferral are similar, refer to 4.72.13.5.1.4 (Examination Steps) concerning whether contributions are elective or non-elective. Nondiscrimination requirements may be violated if the employer fails to properly characterize the contributions.

  3. Ask the employer which employees were excluded from participation and the basis on which they were excluded.

  4. Find out whether the employer aggregates plans to pass coverage under IRC sections 403(b)(12) and 410(b). Ask which test the employer uses to pass coverage, ratio percentage or average benefits.

  5. Consider whether employer contributions satisfy the safe harbors. If not, see if there is another basis on which employer contributions satisfy good faith/reasonable interpretation.

  6. See whether matching contributions satisfy the ACP test.

4.72.13.7  (03-01-2005)
Minimum Distribution Requirements

  1. IRC section 403(b)(10) imposes minimum distribution requirements on 403(b) annuity contracts. These requirements relate to the latest date at which distributions of a minimum amount must commence.

  2. In applying the minimum distribution rules, 403(b) plans generally are treated as IRAs under IRC section 408.

    1. The rules applicable to individual retirement arrangements (IRAs) are generally the same as those applicable to qualified plans under IRC section 401(a)(9).

    2. The minimum distribution requirements under IRC section 401(a)(9) relate to the form and timing of both before-and after-death distributions.

    3. Final regulations were issued in April, 2002, generally effective January 1, 2003. Governmental plans may be subject to a later effective date. See Rev. Proc. 2003-10.

4.72.13.7.1  (03-01-2005)
Required Beginning Date

  1. The required beginning date (the RBD) or the date at which distributions must commence from a participant's 403(b) annuity contract is April 1 of the calendar year immediately following the calendar year in which the participant attains age 70 1/2 or retires, whichever occurs last.

    Example 28: Participant has a 403(b) annuity contract with a 501(c)(3) organization and attains age 70 1/2 in 2002, but has not retired from employment by the end of 2002. This participant's RBD is April 1 of the calendar year following the year in which the participant retires.

4.72.13.7.2  (03-01-2005)
More Than One 403(b) Annuity Contract

  1. The required minimum distribution must be calculated separately for each 403(b) contract. However, an employee who is a participant in more than one 403(b) contract -- with the same or a separate employer -- may total the amounts required to be distributed from each and satisfy the minimum distribution requirement through distributions from one or more 403(b) contracts. 403(b) contracts cannot be aggregated with IRAs or qualified plans for purposes of satisfying these minimums. See Notice 88-38, 1988-1 C.B. 524.

4.72.13.7.3  (03-01-2005)
Bifurcated Account

  1. If the issuer or custodian keeps the records necessary to identify the pre-1987 account balance, the minimum distribution commencement requirements apply only to benefits that accrue after December 31, 1986, including the income on pre-1987 contributions.

    1. Prior law (generally requiring distributions by the end of the calendar year in which the participant attains age 75) would apply to pre-1987 accruals.

    2. If records are not kept, the entire account balance is subject toIRC section 401(a)(9).

    3. The minimum distribution incidental benefit (MDIB) requirement applies to the entire account balance, although prior law applies to the pre-1987 account balance in this regard. See Treas. Reg. 1.403(b)-2, Q&A-3.

    4. If no actual amount is required to be distributed by April 1, 1988, because of these rules, the participant may treat December 31, 1988, as the RBD for all purposes under IRC section 403(b)(10). See Notice 88-39, 1988-1 C.B. 525.

    Example 28: Employer is a 501(c)(3) organization maintaining a 403(b) plan (Plan) on behalf of its employees. The Plan was established in 1972. The funding vehicles for the Plan are annuity contracts. The issuer of the annuity contracts kept records of the pre-1987 account balance for a participant who attains age 70 1/2 in 2000 and has not retired. The RBD for the pre-1987 account balance must be no later than the end of the calendar year in which the participant attains age 75 or, if later, April 1 of the calendar year immediately following the calendar year in which the participant retires. The RBD for the post-1986 account balance must be no later than April 1 immediately following the calendar year in which the participant retires.

4.72.13.7.4  (03-01-2005)
Excise Taxes

  1. For years after December 31, 1988, the excise tax under IRC section 4974 for failure to make minimum distributions applies to 403(b) plans.

  2. The excess distributions tax under IRC section 4980A was repealed with respect to excess distributions received after December 31, 1996.

4.72.13.7.5  (03-01-2005)
Examination Steps

  1. Check all documents concerning the RBD.

  2. Request data on the age of participants and former participants.

  3. Test check to determine whether distributions have begun timely.

4.72.13.8  (03-01-2005)
Early Distribution Restrictions

  1. Congress intended that pre-tax contributions to a 403(b) plan should generally be used for retirement and thus, IRC section 403(b) imposes early distribution restrictions on contributions to a 403(b) annuity contract. These restrictions are based on distribution events and relate to the earliest date at which distributions from a 403(b) annuity contract may be made. Distributions generally may not be made prior to a distribution event. A 403(b) plan may properly distribute amounts any time after such an event has occurred (as long as the minimum distribution rules are complied with).

4.72.13.8.1  (03-01-2005)
Annuity Contracts

  1. Under IRC section 403(b)(11), salary reduction contributions (and amounts attributable thereto) used to purchase annuity contracts described in section 403(b)(1) for years beginning after December 31, 1988, are not permitted to be distributed earlier than:

    1. attainment or age 59 1/2

    2. death

    3. disability

    4. severance of employment or

    5. hardship of the employee (not including earnings, except as provided in the following sentence). Note: Amounts held in a 403(b)(1) annuity contract as of the close of the last year beginning before January 1, 1989, and amounts contributed as non-salary reduction contributions are not subject to distribution restrictions.

  2. Certain loans may also violate IRC section 403(b)(11) or (b)(7). For example, a loan that is repaid through a reduction in the participant's accrued benefit results in an actual distribution for purposes of IRC section 403(b)(11).

    Example 29: Employee A began participating in a 403(b) plan (Plan) in 1989. The Plan is funded through both salary reduction and non-salary reduction contributions, which are invested in annuity contracts. A is 30 years old, has not separated from service and is not disabled. In 2002, A makes a $ 5,000 withdrawal that is not a hardship withdrawal. If any portion of the withdrawal is attributable to salary reduction contributions and the earnings thereon, the early distribution restrictions of IRC section 403(b)(11) would be violated.

    Example 30: The same facts as to Example 29, except that the Plan provides only for non-salary reduction contributions. A's withdrawal does not violate IRC section 403(b)(11) (although A must pay an early distribution tax under IRC section 72(t)). See 4.72.13.8.5.

4.72.13.8.2  (03-01-2005)
Custodial Accounts

  1. UnderIRC section 403(b)(7), a distribution from a custodial account may not be paid or made available to a distributee before the employee attains age 59 1/2 , severs employment, dies or becomes disabled.

  2. Salary reduction contributions, as well as any other amounts held in the custodial account as of the close of the last year beginning before January 1, 1989, may be distributed upon hardship of the employee.

    Example 31: Employee A is a participant in a 403(b) plan (Plan). Contributions under the Plan are strictly non-salary reduction. In 2000, A withdraws $10,000 from the Plan. A has not severed employment or become disabled. A is 40 years old. The funds in A's 403(b) account are invested in a custodial account. Since the contributions are invested in a custodial account, A's withdrawal violates IRC section 403(b)(7).

4.72.13.8.3  (03-01-2005)
Retirement Income Accounts

  1. A retirement income account is subject to the distribution restrictions that apply under IRC section 403(b)(11).

4.72.13.8.4  (03-01-2005)
Grandfathered Annuity Contracts

  1. Unlike other 403(b) annuity contracts, a distribution event is not required for a distribution from a grandfathered annuity contract purchased by an Indian tribal government to the extent it is rolled over under IRC section 403(b)(10) to an appropriate funding vehicle.

4.72.13.8.5  (03-01-2005)
Early Distribution Tax under IRC section 72(t)

  1. IRC section 72(t) restricts premature distributions from a 403(b) plan by imposing a 10% additional income tax with respect to distributions that are made prior to the events described in IRC section 72(t). These events differ from those under IRC sections 403(b)(7) and (b)(11).

  2. The section 72(t) tax generally applies to all distributions except for those:

    1. made after the attainment of age 59 1/2, separation from service after age 55, death, disability, or

    2. which are part of a series of substantially equal payments made over the life or life expectancy of the employee or the joint lives or life expectancies of the employee and the employee's designated beneficiary.

  3. A distribution allowable under IRC section 403(b)(7) or (b)(11) may nevertheless be subject to IRC section 72(t).

    • For example, the tax applies to early distributions of non-salary reduction contributions made to an annuity contract even though IRC section 403(b)(11) would not restrict such distributions. Note: In Examples 29, 30 and 31, A is also subject to the additional tax under IRC section 72(t).

4.72.13.8.6  (03-01-2005)
Examination Steps

  1. Examine the provisions of the basic plan document (if applicable) and funding vehicles regarding withdrawals.

    1. If withdrawals are permitted at any time and the plan provides for salary reduction contributions or is funded through a custodial account, check the operation of the plan to see whether any distributions have been made prior to the events described above.

  2. To determine an employee's eligibility for a hardship distribution, consult rules applicable to hardship distributions under IRC section 401(k).

  3. Look at beginning and ending account balances to determine whether minimum distributions have been made. Also, check Forms 1099-R.

4.72.13.9  (03-01-2005)
Transfers and Rollovers

  1. Within certain limits, funds may be moved by transfer or rollover from one 403(b) plan or contract without being includible in gross income in the taxable year of the transfer or rollover.

4.72.13.9.1  (03-01-2005)
Transfers

  1. Transfers of funds between 403(b) plans or contracts are not considered actual or deemed distributions and consequently they are not currently taxable if the transferred funds continue to be subject to the same or more stringent distribution restrictions. See Rev. Rul. 90-24. Note: As discussed in 4.72.13.8, the statutorily imposed restrictions differ between 403(b)(1) annuity contracts and 403(b)(7) custodial accounts, so transfers between these types of arrangements may be difficult. There is no Code requirement that a transfer from a 403(b) plan or contract be permitted, or that a 403(b) plan or contract have language to effect or accept a transfer (unlike direct rollover distributions, see text 4.72.13.9.2).

  2. Transfers may also be made from a 403(b) plan to a governmental defined benefit plan for the purchase of permissive service credits under IRC section 415(n)(3). See IRC section 403(b)(13).

  3. Note that many state plans have not been amended to permit such a transfer, nor are they required to do so, and the funds transferred must be used specifically to purchase permissive service credits that fall within the definition of section 415(n)(3).

    Example 32: A 403(b)(1) annuity contract is purchased entirely with non-salary reduction contributions. The funds under the annuity may be transferred tax free to a 403(b)(1) annuity contract or 403(b)(7) custodial account.

    Example 33: A 403(b)(1) annuity contract is purchased with salary reduction contributions. Funds may be transferred tax free to a 403(b)(7) custodial account, or a 403(b)(1) annuity contract if they continue to be subject to identical or more stringent distribution restrictions.

    Example 34: Employer makes both salary reduction and non-salary reduction contributions to a custodial account. Funds from the 403(b)(7) custodial account may be transferred tax free to another 403(b)(7) custodial account, or to a 403(b)(1) annuity contract if the transferred funds continue to be subject to the same or more stringent distribution restrictions.

    The transfer may be made regardless of whether a complete or partial interest is transferred, the transfer is directed by the individual, or the individual is a current or former employee, or a beneficiary of a former employee. These transfers may be made without violating the non-transferability requirement under IRC section 401(g). See Rev. Rul. 90-24, 1990-1 C.B. 97.

    Example 35: Employee A requests that the assets of her 403(b) custodial account be transferred to a qualified defined contribution plan. Employee A cannot have the assets transferred since the transfer does not satisfy section 403(b)(13). Employee A can only effect a transfer of 403(b) assets to a governmental defined benefit plan for the purchase of permissive service credits pursuant to 403(b)(13), if the plan so provides, or a transfer of assets from one 403(b) plan to another as provided by Rev. Rul. 90-24.

    Example 36: Employer would like to convert its 403(b) plan into a 401(k) plan by transferring all of the assets in the 403(b). There is no Code provision that would allow such a transfer. The employer also cannot accomplish a transfer through a termination of the 403(b) plan since plan termination is not a distribution event.

4.72.13.9.2  (03-01-2005)
Rollovers

  1. In a rollover from a 403(b) plan or contract, an employee's interest is distributed and reinvested in another arrangement under IRC section 403(b)(8). Distributions from a 403(b) plan or contract are not currently includible in the employee's gross income if they are properly rolled over.

    1. The requirements for a proper rollover are that all or a portion of the balance to the credit of the distributee be paid to the employee in an eligible rollover distribution; the employee rolls any portion of the property he or she receives in the distribution to an IRA, another 403(b) investment, a qualified plan or a 457(b) governmental plan; and if property other than money is distributed, the property transferred is the same as the property distributed; then the distribution (to the extent transferred) shall not be includible in gross income for the taxable year in which paid.

    2. A proper rollover must be completed within 60 days of the employee's receipt of the distribution. The 60-day period may be waived by the Service in cases of hardship. See Rev. Proc. 2003-16.

    3. Distributions not properly rolled over are currently includible in the employee's gross income and may be subject to additional tax under IRC section 72(t). Unlike transfers, there must be a distribution event under the plan or contract to have an eligible rollover distribution.

  2. An eligible rollover distribution from a 403(b) plan or contract is any distribution made to an employee of all or a portion of the balance to the credit of the employee, not including required minimum distributions; periodic distributions; hardship distributions that occur after December 31, 1999; or distributions not otherwise includible in gross income. See Notice 99-5, 1999-3 I.R.B.10.

    1. Unless made in the form of a direct rollover, all eligible rollover distributions are subject to 20% mandatory income tax withholding, even if they are subsequently properly rolled over (and thus excludable from gross income). The payor (i.e., insurer or custodian) is responsible for the withholding.

    2. A direct rollover is both exempt from withholding and excludable from gross income.

    3. A direct rollover is an eligible rollover distribution from a 403(b) plan or contract that is paid directly from the 403(b) plan or contract to an IRA, another 403(b) plan or contract, a plan qualified under section 401(a), or a 457(b) governmental plan.

    Example 37: Employee, age 59 1/2, received a $150,000 eligible rollover distribution from a 403(b) plan on May 5, 2003. Twenty percent, or $30,000, was withheld by Payor/Insurer. On June 20, 2003, Employee rolled over $120,000 (the amount he actually received from Payor/Insurer) to an IRA. The $30,000 withheld by Payor/Insurer and not rolled over is subject to federal income tax for 2003. Employee could have avoided income tax by rolling over an additional $30,000 from other funds.

    Example 38: The same facts as Example 37, except that Employee elected a direct rollover of the $150,000 eligible rollover distribution. The $150,000 is not subject to withholding and is excludable from Employee's gross income.

  3. Under IRC sections 403(b)(10) and 401(a)(31), a 403(b) contract must permit an employee to elect a direct rollover of an eligible rollover distribution to a specified IRA or a 403(b) plan or contract. The employee must also have a meaningful right to elect a direct rollover. This means that within a reasonable period of time prior to making the eligible rollover distribution, the payor must provide an explanation to the employee of his right to elect a direct rollover and the income tax withholding consequences of not electing a direct rollover.

  4. 403(b) plans must be operated in compliance with the above rules. The underlying document must reflect the direct rollover requirements.

4.72.13.9.2.1  (03-01-2005)
Special Rule for Rollovers

  1. Special rules relate to a rollover from a grandfathered 403(b) annuity contract purchased by an Indian tribal government. A grandfathered 403(b) contract is one that is purchased by an Indian tribal government in a plan year beginning prior to January 1, 1995.

  2. Prior to January 1, 1998, a distribution from such a contract may be made absent a distribution event under IRC section 403(b)(7) or (b)(11) if it is rolled over to a cash or deferred arrangement under IRC section 401(k), another 403(b) plan, or an IRA. Such a rollover may be accomplished pursuant to IRC section 403(b)(8) or IRC section 403(b)(10) (regarding a direct rollover).

    1. This also holds true for a distribution after December 31, 1997, except that the rollover must be a direct rollover to an IRA or 403(b) annuity.

4.72.13.9.3  (03-01-2005)
Examination Steps

  1. See whether transferred funds are accounted for separately and continue to be subject to at least as stringent early distribution restrictions.

  2. Transfers are not distributions and are therefore not reported on the Form 1099-R.

4.72.13.10  (03-01-2005)
Tax Consequences of IRC Section 403(b) Failures

  1. This section lists typical IRC section 403(b)failures (403(b) failures) or defects and indicates the scope of resulting tax consequences.

  2. In general, there are three categories of failures:

    1. plan failures,

    2. annuity contract failures, and

    3. transactional failures. Note: Because of overlap, however, these categories should be used as a guide only and any failure discovered on an examination should be analyzed based on the particular facts related to the failure.

  3. In general, plan failures affect the plan as a whole and result in income inclusion with respect to all annuity contracts purchased under the plan.

  4. Annuity contract failures generally relate to the annuity contract and result in income inclusion with respect to the affected annuity contract.

  5. Transactional failures generally arise from a transaction with respect to an otherwise valid 403(b) plan or annuity contract. They result in income inclusion with respect to a portion of contributions made to purchase the annuity contract.

  6. These failures may also result in additional income tax withholding, FICA taxes, FUTA taxes (with respect to an ineligible employer), FICA and FUTA withholding, and excise taxes. However, if the failures are corrected pursuant to one of the Service's correction programs (see 4.72.13.1.2, which provides an overview of EPCRS), the Service will not pursue the collection of income tax or withholding for income tax resulting from the failure. Corrections of failures may result in their own tax consequences.

    Special Note: Unlike a qualified plan under IRC section 401(a), Title II of ERISA does not require that a 403(b) plan have a plan document or that the plan operate in accordance with its written terms. However, employers should be aware that Title I of ERISA may impose such requirements.

4.72.13.10.1  (03-01-2005)
Plan Failures

  1. Plan failures cause a plan not to be a 403(b) plan.

    1. The plan for this purpose is the aggregate annuity contracts (including custodial accounts and retirement income accounts) established by the employer on behalf of its employees, unless the plans are separate or the plans are properly disaggregated.

    2. Except with respect to text 4.72.13.10.1.1, employer is defined as the common law employer and any related employer under IRC section 414(b), (c), (m) or (o).

  2. For plan failures, all contributions made to the plan beginning in the taxable year of the failure are includible in the participants' gross income (except contributions subject to a substantial risk of forfeiture). Contributions made under a defective 403(b) plan may not be rolled over to an eligible retirement plan.

  3. Ineligible employer. If the employer was never eligible to maintain a 403(b) plan, the plan was never a 403(b) and IRC section 403(c) or IRC section 83 governs.

    1. If the employer was a 501(c)(3) organization but loses its 501(c)(3) status, the exclusion is lost for any contributions made while the employer is ineligible.

    2. The plan may regain its status as a 403(b), but includible compensation includes only compensation earned during the most recent one-year period of service while the employer was eligible, and only years of service performed while the employer was a 501(c)(3) organization are included in years of service in calculating the exclusion.

  4. Annuity contracts not purchased until participants reach retirement age or status. See text 4.72.13.3.1. In this case, the plan is intended to be funded through annuity contracts (and not custodial accounts) but the employer fails to purchase the annuity contracts (until retirement age). In the absence of appropriate funding vehicles, the plan from its inception is not a 403(b) plan.

  5. Discrimination with respect to non-salary reduction (including matching and non-matching) or salary reduction contributions. The IRC section 4979 excise tax may apply if the plan has excess aggregate contributions under IRC section 401(m)(6).

  6. Failure to satisfy the minimum participation rules.

  7. Inadequate coverage.

4.72.13.10.2  (03-01-2005)
Annuity Contract Failures

  1. Following is a list of failures that generally pertain to the annuity contract.

    1. These failures cause a participant's annuity contract to fail to satisfy the requirements of IRC section 403(b), and consequently, all contributions made under the annuity contract beginning in the taxable year of the failure will be includible in the participant's gross income (except contributions that are subject to a substantial risk of forfeiture).

    2. The earnings on premiums paid for the purchase of a 403(b)(1) annuity contract (and not custodial accounts) are not includible in gross income.

  2. Annuity contract failures may also cause other problems for the plan. If the failure is systemic, the plan in its entirety may be adversely affected. For example, this might be true in failures a. through e., g. and j. below if a single insurer or custodian is involved.

    1. Annuity contract not purchased from an insurance company or not a 403(b) annuity contract (for example, the purchase of a life insurance contract).

    2. Custodial account not maintained by bank or an approved non-bank trustee.

    3. Failure of custodial account to invest exclusively in regulated investment company stock.

    4. Violation of incidental death benefit requirements.

    5. Failure of annuity contract (and not a custodial account) to satisfy the non-transferability requirement of IRC section 401(g) (in either form or operation).

    6. Impermissible distribution under IRC section 403(b)(7) or (b)(11). This failure includes an improper transfer (see Rev. Rul. 90-24), a distribution disguised as a loan, and the executing on a security in the event of default on a loan. The IRC section 72(t) tax may also apply.

    7. Failure to provide a direct rollover (in form or operation).

    8. Pattern of violating the minimum distribution rules.

    9. Uncorrected excess deferrals. The exclusion allowance does not apply with respect to an annuity contract with excess deferrals that are not timely corrected. The excess deferrals are includible in gross income in both the year contributed and the year distributed. SeeIRC section 402(g)(6) and text 4.72.13.5.

    10. Failure of annuity contract to preclude excess deferrals. For plan years beginning on or after January 1, 1998, the exclusion allowance does not apply with respect to contributions made to purchase the contract.

4.72.13.10.3  (03-01-2005)
Transactional Failures

  1. Following is a list of failures that do not adversely affect the 403(b) status of the annuity contract or plan as a whole.

    1. Excess 415 amounts. Excess 415 amounts result in current income inclusion of the excess. The annuity contract or custodial account is bifurcated into a non-qualified annuity (comprised of the excess and earnings thereon) and qualifying 403(b) annuity. If excess 415 amounts are made to a custodial account, theIRC section 4973excise tax also applies. See text 4.72.13.5.2.

    2. Certain loans. The amount of a loan that does not satisfy the requirements of IRC section 72(p) is a deemed distribution that is includible in gross income. (If the participant's account balance is reduced to satisfy the loan balance, there is an actual distribution which could violate IRC sections 403(b)(11) and (b)(7) and the failure becomes an annuity contract failure.)

    3. Isolated instance of failure to satisfy minimum distribution requirements. The participant may be subject to the IRC section 4974 excise tax if the tax is not waived by the Service. The required minimums are includible in gross income on distribution.

    4. Salary reduction agreement not legally binding. Amounts contributed under the inadequate agreement are includible in gross income. In the absence of non-salary reduction contributions, the entire annuity contract is adversely affected. This failure may also overlap with a failure to provide salary reduction contributions universally to all non-excludable employees. See text 4.72.13.4.

    5. Salary reduction agreement applies to amounts currently available to the employees at the effective date of the agreement.

    6. Participation of non-employees.

    7. Timely corrected excess deferrals.

4.72.13.11  (03-01-2005)
Glossary

  1. Annuity contract: Refers either specifically to an annuity contract under IRC section 403(b)(1), or to any 403(b) funding vehicle, including a custodial account or retirement income account. It also includes an annuity contract not qualifying under IRC section 403(b). Individual annuity contracts purchased by an employer on behalf of an employee are treated as a single annuity contract pursuant to IRC section 403(b)(5).

  2. Custodial account: A type of funding vehicle under which assets are held by a bank or other person approved by the Commissioner and invested in regulated investment company stock (mutual funds) as required by IRC section 403(b)(7). The term also includes custodial accounts not qualifying under IRC section 403(b).

  3. Direct rollover: An eligible rollover distribution from a 403(b) plan that is paid directly from the plan to an IRA or another 403(b) plan.

  4. Elective contributions: Contributions that arise because of an employee's election between current compensation or deferral under the plan.

  5. Elective deferrals: Defined in IRC section 402(g)(3), elective deferrals are elective contributions by a participant made to a qualified CODA, a SEP, a 403(b) plan, a simple individual retirement account, except they do not include contributions made pursuant to one-time irrevocable elections at initial eligibility to participate in the plan nor contributions made as a condition of employment. They are subject to the IRC section 402(g) limit of $13,000 for 2004.

  6. Eligible rollover distribution: Any distribution from a 403(b) plan made to an employee of all or a portion of the balance to his credit, not including required minimum distributions, periodic distributions and distributions not otherwise includible in gross income.

  7. Excess contributions: A term used for purposes of the excise tax under IRC section 4973, they are contributions to a custodial account in excess of the IRC section 415 limit.

  8. Excess deferrals: Elective deferrals that are in excess of the IRC section 402(g) limit.

  9. Funding vehicle: Refers to the type of investment arrangement for the assets of a 403(b) plan.

  10. Includible compensation: Generally all salary, bonuses and other wages from the employer includible in gross income for the employee's most recent one-year period of service ending with or within the taxable year and excluding amounts contributed on the employee's behalf to a 403(b) or qualified plan. Includible compensation includes elective deferrals (and amounts which are not includible in gross income by reason of IRC section 125 or 457(b)). Includible compensation is used for testing contributions to a 403(b) plan under the section 415 limit.

  11. Limitation year: The 12-month period used for applying the 415 limit. It is usually the calendar year, unless the participant elects otherwise or is in control of the employer.

  12. Matching contributions: Any employer contributions made to a defined contribution plan or a 403(b) plan on behalf of an employee on account of the employee's elective deferrals or employee contributions.

  13. Non-elective contributions: Contributions that are not elective contributions.

  14. Non-matching contributions: Non-salary reduction contributions which are not matching contributions.

  15. Non-salary reduction contributions: Non-salary reduction contributions are contributions that are not salary reduction contributions. They include both matching and non-matching employer contributions.

  16. Qualified organization: For purposes of the catch-up limits under IRC section 402(g), an educational organization (as defined in IRC section 170(b)(1)(A)(ii)), a church or related organization (as defined in IRC section 414(e)), a hospital, a home health service agency, or a health and welfare service agency (as defined in IRC section 1861(o) of the Social Security Act).

  17. Required beginning date: The date at which distributions of a minimum amount must commence.

  18. Retirement income account: Generally, a defined contribution program specifically for a church or a related organization maintaining a 403(b) plan. In rare instances, a retirement income account may be a defined benefit plan.

  19. Salary reduction agreement: The agreement between the employer and employee under which salary reduction contributions are made.

  20. Salary reduction contributions: Contributions made by an employer as a result of an agreement with the employee to take a reduction in salary or forego an increase in salary, bonuses or other wages. See also elective deferrals.

  21. Vested amount: The participant's allocable portion in the 403(b) plan that is nonforfeitable. It is the amount to which the exclusion allowance applies.

  22. Years of service: Used in computing eligibility for the catch up election under section 402(g), it includes all years of service with the employer ending with or within the taxable year.


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