The Internal Revenue Service (IRS) understands that, but it also wants to be sure that 403(b) sponsors, like you, have the tools needed to fix those mistakes. Taking a page from the home improvement do-it-yourself trend, the IRS released its 403(b) Fix-It Guide on February 21 (see “IRS Offers 403(b) Fix-It Guide”).
The Guide is designed to assist employers with putting their 403(b) plans back on the compliance track with the 403(b) regulations. The Guide summarizes ten common 403(b) plan defects; explains how to identify and correct those issues; and indicates when the fix can be handled via the Self-Correction Program or requires a Voluntary Correction Program filing (including a user fee) with the IRS.
While the Fix-It Guide identified ten common mistakes, it can be broken down into a few basic categories which are summarized below.
Sponsoring a 403(b) plan as an ineligible employer
403(b) plans can only be offered by public schools or 501(c)(3) non-profit organizations. Since state law usually provides the authority for public schools to establish 403(b) plans, the defect typically arises in the private sector. If an employer is not a 501(c)(3) entity or loses that tax-exempt status, the employer is not eligible to sponsor a 403(b) plan.To minimize adverse tax consequences to employees, the IRS will permit such a plan to be frozen. This means that contributions, including rollovers and/or transfers, can no longer be accepted into the plan. Employees will be permitted to access their accounts in accordance with the terms of the plan document (typically, when employees terminate employment, become disabled, reach age 59 ½, or die). This fix can only be handled by the employer filing an application with the IRS under the Voluntary Correction Program of the IRS’ Employee Plans Compliance Resolution System.
Untimely adoption of 403(b) plan document
Employers had a preview of this part of the IRS’ Fix-It Guide when the Service released its updated Employee Plans Compliance Resolution System (EPCRS) on December 31, 2012. An employer who did not adopt its written 403(b) plan by December 31, 2009 can fix this retroactive to 2009 by submitting a Voluntary Correction Program application to the IRS.
Misinforming eligible employees about the 403(b) plan
Deferrals to a 403(b) plan are considered non-discriminatory if all eligible employees are notified about their ability to participate in the plan, both when first eligible and then on an annual basis thereafter. If an eligible employee has been overlooked, the employer can fix this situation by making a corrective contribution, plus earnings, to reflect the lost deferral opportunity for the impacted employee. The 403(b) Fix-It Guide provides safe harbor formulas to enable the employer to calculate the lost salary deferral amount to make a corrective contribution. The corrective contribution must also include lost earnings.
Contributing in excess of IRC limits
Employee salary reduction contributions made cannot exceed the Code’s annual deferral limit (in 2013, $17,500 before any available catch-up contributions). In addition, if a participant is a longer service employee with specified types of employers and/or at least 50 years old, contribution limits can be even more complicated. Amounts must first be allocated under any available 15 Years of Service Catch-up and only then as an Age 50+ Catch-up.
If the plan also permits employer contributions, then the total of all employee (other than the Age 50+ Catch-up Contribution) and employer contributions cannot be greater than the Code’s annual additions limit (in 2013, 100% of compensation up to $51,000). Any employer non-elective contributions made to former employees for up to five years after the year of termination (which must be based on includible compensation for the employee’s last year of service) must also comply with this limit.
The IRS anticipates that an employer may not always be successful in juggling these limits. To bring the 403(b) plan back into compliance, the Fix-It Guide allows the employer to determine what contributions are in excess of these limits and then make corrective distributions (plus any attributable earnings) to impacted participants:
- If the annual elective deferral limit (including available catch-ups properly determined) is exceeded, the employer can make a corrective distribution of the excess amount plus earnings by April 15 following the calendar year in which the excess was deferred. After that time period, an impacted participant will be taxed on that excess both in the year of deferral and in the year when the amount is actually distributed.
- If the limit on total annual contributions is exceeded (including instances where the employer made post-termination contributions to former employees), the employer can make a corrective distribution of the excess amount only by the end of the year in which the excess occurred. Otherwise, such excesses need to be tracked as 403(c) non-qualified contributions.
Not operating the plan in accordance with plan terms
For many sponsors, 2009 was the first year that a written plan document was required. Those employers might have experienced “growing pains” if the terms of that plan document did not match day-to-day operation. For example, permitting loans or hardship withdrawals even if the plan document did not include these features. The Fix-It Guide enables such employers to amend the plan document retroactively (but not earlier than 2009). If there were proper plan administration practices and procedures in place, this issue can be handled via self-correction without an IRS filing.
Permitting loans or hardships greater than the IRC rules
If a participant’s loan amount or the loan term is more than permitted under the Internal Revenue Code, the employer can correct these defects upon filing with the IRS under the Voluntary Correction Program, seeking corrective repayments and/or modification of the loan terms, as appropriate. Similarly, if a withdrawal did not meet the IRS’ regulatory hardship rules, the employer should seek repayment of the amount from the individual for redeposit into his account under the 403(b) plan.
As is the case with a home repair, hoping that a defect will disappear on its own is often a costly and ineffective solution. The IRS 403(b) audit activity continues, and monetary sanctions and attorney fees can mount up if an employer chooses to wait to correct a 403(b) issue only upon audit. The IRS’ 403(b) Fix-It Guide provides a blueprint for 403(b) sponsors and their counsel to identify and resolve common issues with the plan document or administration, as well as whether the employer can use the IRS’ Self-Correction Program or must file an application under the Voluntary Correction Program.
Linda Segal Blinn, J.D.*, is vice president of Technical Services for ING U.S. Retirement’s Tax-Exempt Markets. In this capacity, Blinn provides general legislative, regulatory, and compliance information to assist employers in operating their retirement plans.
This material was created to provide accurate information on the subjects covered. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. These materials are not intended to be used to avoid tax penalties, and were prepared to support the promotion or marketing of the matters addressed in this document. The taxpayer should seek advice from an independent tax advisor.* Linda is not a practicing attorney.
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