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By David E. Kenty, Esq. Schnader, Harrison, Segal & Lewis LLP, Philadelphia, PA
Retirement plans funded with §403(b) contracts and those funded through qualified trusts and annuities under §§ 401(a) and 403(a) are directed at different audiences. Section 403(b) contracts are available to public school employees, at the primary, secondary and higher education levels. Qualified plans are available to employees of business corporations.
However, there is a significant area of overlap between the §403(b) contract and qualified plan worlds: private sector exempt organizations that are exempt under §501(c)(3). In this large, and apparently growing, sector of the economy, employers can choose to fund their retirement plans using either §403(b) contracts or qualified plans. In fact, an eligible employer could use both. An employer with an appetite for some complexity might use a qualified plan for employer nonelective contributions, and §403(b) contracts for employee elective deferrals.
Worksheet 10 of 388 T.M., Tax Deferred Annuities -- Section 403(b) is a side-by-side comparison that highlights the differences between the two types of retirement plans. The following analysis attempts to provide useful guidance to an employer faced with this choice.
1. Discrimination Testing of Elective Deferrals. Among the most significant advantages of §403(b) contracts is the absence of discrimination testing for elective deferrals. Elective deferrals under qualified plans are subject to the familiar actual deferral percentage (ADP) test in §401(k)(3), which limits the average deferral percentage of highly compensated employees to a specified percentage over the average deferral percentage of nonhighly compensated employees.
In contrast, §403(b) contracts are subject only to a universal eligibility provision with respect to elective deferrals (with certain exceptions) under §403(b)(12). Thus, the highly compensated participants may make elective deferrals up to the maximum permitted under §402(g) ($16,500 for 2009). Section 414(v)(2)(B)(i) permits catch-up contributions ($5,500 for 2009) under either a § 403(b) contract or a qualified plan without regard to the nondiscrimination rules.
2. Coverage by ERISA. Certain §403(b) contracts may escape coverage under ERISA. If the employer makes no nonelective contributions, and limits its involvement to making payroll deduction contributions to §403(b) contracts selected by employees, the employer's involvement may be sufficiently circumscribed under DOL Regs. §2510-2(f) to avoid sponsoring or maintaining a plan for purposes of ERISA. This result could have some advantages, freeing the employer from responsibility for reporting and disclosure (Form 5500 annual reports and summary plan descriptions), federal law fiduciary obligations, joint and survivor annuity payment requirements and fidelity bonding. However, ERISA can function as a shield as well as a sword. A plan that is not subject to ERISA is vulnerable to state law regulation, potentially including state law contract remedies, domestic relations law and creditors rights law.
Historically, §403(b) arrangements that seek to be exempt from ERISA have not operated under plan documents. It remains to be seen how the new plan document requirement of Regs. §1.403(b)-3(b)(3) will affect the ERISA coverage of §403(b) arrangements after 2009.
3. Funding Arrangements. Like §403(b) contracts, qualified plans may be funded through annuity contracts (fixed or variable) or mutual fund custodial accounts held by qualified financial institutions. In addition, however, qualified plans can be funded through trusts using professional trustees or investment managers. Even a participant-directed qualified plan could create investment funds managed by one or more independent managers, rather than use a “retail” insurance company separate account or mutual fund. Moreover, qualified plans can establish brokerage arrangements that enable participants to choose specific stocks, bonds, real estate or even commodities for their plan accounts. Thus a plan that wanted to provide the broadest possible investment alternatives would probably choose a qualified plan instead of §403(b) contracts.
However, this freedom to offer broader range of investment vehicles may be matched, to some extent, by the latitude offered under many §403(b) contracts to exchange one such contract for another issued by a different carrier. There is, moreover, one funding vehicle that is available only as a §403(b) contract, a retirement account for a church and related organizations. Section 403(b)(9) and regulations give the sponsor of such a plan broad latitude to design it to accomplish the purposes of the sponsoring organization.
4. Limitations on Annual Additions. Section 403(b) contracts and qualified plans are subject to the same basic limitations on total (employer plus employee) annual contributions. However, they are aggregated in different ways with other similar plans. Qualified plans are aggregated with other qualified plans maintained by the same employer (and its controlled group). In contrast, §403(b) contracts are aggregated under §415(k)(4) with plans of other employers that are controlled by the employee. For example, if a doctor made contributions to a hospital's §403(b) contract, and also to a Keogh plan maintained with respect to the doctor's private practice, the two plans would be aggregated for purposes of applying the limit on annual contributions. Thus if an exempt organization has employees who maintain separate professional practices or other businesses, its employees might prefer the additional retirement savings opportunities available under qualified plans.
5. Risk of Disqualification. Excess elective deferrals by a single participant may cause a qualified plan to lose its qualified status. In contrast, under Regs. §1.403(b)-3(d), excess contributions have an adverse effect only on the participant for whom excess contributions are made. In practice, qualified plans are seldom disqualified in their entirety, because the IRS is generally willing to enter into a closing agreement that preserves or reinstates qualified status upon payment of an employer sanction. However, an employer that wants to minimize its involvement in an elective deferral arrangement might have less potential liability with respect to § 403(b) contracts than with respect to a qualified plan.
6. In-Service Withdrawal of Nonelective Employer Contributions. The qualified plan rules for in-service withdrawal of nonelective employer contributions are more flexible than those for such contributions made to §403(b)(7) mutual fund custodial accounts. A qualified profit sharing plan may permit withdrawal of employer contributions upon completion of a specified period of participation or a specified event, independent of any showing of hardship. However, the withdrawal restrictions for mutual fund custodial accounts in §403(b)(7)(A)(ii) permit elective deferrals, but not nonelective employer contributions, to be withdrawn before termination of employment. This disparity could lead an employer that wants to offer mutual funds as funding vehicles, but not through an annuity contract, to make its nonelective contributions to a qualified plan rather than a §403(b) plan.
7. Church Plans. Plans maintained by churches and related organizations are favored in a number of respects under §403(b). These include
• exemption from ERISA vesting requirements;
• exemption from ERISA eligibility standards;
• use of retirement income accounts as funding vehicles;
• increased limits on annual contributions; and
• exemption from nondiscrimination rules (for employees other than those providing medical, educational or other services to the public).
It is important to distinguish between two different definitions of church plan for purposes of the §403(b) rules. Plans that are exempted from ERISA include all those sponsored by churches or church controlled organizations, so long as they have not elected to be subject to ERISA. The church organizations that are exempt from the nondiscrimination rules of §403(b)(12) are only those that do not derive their income from provision of services (such as medical and educational) to the public.
In the half century since Congress created §403(b) contracts, the regulatory regime has evolved to resemble ever more closely the qualified plan rules. In fact, the IRS announced at the end of 2008 that it intends to create an application for determination procedure for §403(b) contracts. There remain, however, material differences in the two sets of rules, so that employers that have a choice should consider carefully the relative advantages and disadvantages.
For more information, in the Tax Management Portfolios, see Kenty, 388 T.M., Deferred Annuities -- Section 403(b), and in Tax Practice Series, see ¶5630, Tax Sheltered Annuities.
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