403(b) Good Part IV: What Non-Discrimination Rules? – Employer Contributions

October 7, 2008 (PLANSPONSOR (b)lines) - In Part III (September 2, 2008), we talked about the 403(b) non-discrimination rule applicable to employee deferrals - referred to as the universal availability rule. In this column, we discuss the rules for employer contributions (found in section 403(b)(12)(A)(i) and Treas. Reg. §1.403(b)-5(a)).

First, a reminder regarding the plans to which these rules apply:   (1) church plans are exempt from all the 403(b) non-discrimination rules ( see section 403(b)(1)(D)); and (2) school district plans are exempt from the employer contribution rules ( see section 403(b)(12)(C), except for the limit on the amount of annual compensation that may be taken into account for plan purposes (currently, $230,000).  

So who is covered?   Plans of tax-exempt entities that are neither churches nor governmental entities.   (And keep in mind that these plans would also be subject to additional requirements under ERISA, such as the vesting rules.   Because we are talking about plans to which employer contributions are made, they do not qualify for the limited-employer-involvement exemption created by DOL Regulation §2510.3-2(f).)

The employer contribution non-discrimination rules are incorporated by reference to certain of the requirements applicable to qualified plans.   They are (section references are to the provision incorporated into the 403(b) requirements):

  • The plan cannot discriminate in favor of “highly compensated employees” ( i.e, those whose total compensation for the prior year exceeded a certain amount, currently $105,000, referred to as HCEs).    (Section 401(a)(4), plus special rules under section 401(a)(5)).  
  • The plan must limit employee compensation taken into account for purposes of determining the percentage contribution (this is the rule mentioned above for school district plans – section 401(a)(17)).
  • The plan must satisfy average contribution percentage rules related to matching contributions and employee after-tax deferrals.   (Section 401(m)).
  • The plan must meet a percentage or “average benefits” coverage rule.   (Section 410(b)).

So what does all this mean in practice?  

First, it means that the employer generally cannot make a larger contribution as a percentage of pay for the HCEs than it does for the lower paid - except under a special "permitted disparity" rule.   (Under the latter rule, the employer could make a larger contribution for employees earning above the Social Security wage base (currently, $102,000) under rules found in Code section 401(l).)    The general rule essentially means that if the HCEs receive a contribution equal to 6% of pay, the low paid would need to receive the same percentage of pay contribution.   Note, however, that the employer could provide lower or no contributions for the HCEs, since the requirement is only that you cannot discriminate in favor of the high paid.

Second, consider the annual compensation limit.   Suppose an executive earns $300,000, and the entity makes a $23,000 contribution on his or her behalf.    Mathematically, that is a contribution equal to 7.66% of pay.   However, under the compensation limit of $230,000, it is treated as a 10% of pay contribution - which means that the rest of the employees would need to get a 10% of pay contribution.  

Third, this rule also comes into play in the average contribution percentage limitation.   That rule provides essentially, that the percentage matching contribution for the HCEs may not exceed the percentage for all eligible employees for the prior plan year by the greater of (i) 125% or (ii) the lesser of (a) 200% or (b) the percentage for all employees plus two percentage points.   (Yes, this is confusing.)   So, if the amount of matching contributions as a percentage of pay for all employees was 4%, the matching contribution that could be made for the HCEs could not exceed 6%, and the contribution would need to be based on the $230,000 compensation limit.  

Fourth, consider the special coverage rule for employer contributions.   The deferral coverage test is universal availability.   But for employer contributions, in general, the plan must provide benefits for at least 70% of the eligible non-highly compensated employees (or 70% of the percentage of the high paid who are receiving benefits).   Consider a plan with 10 HCEs and 30 non-highly compensated eligible employees.   If all 10 of the HCEs receive contributions, then at least 21 of the lower paid would need to receive a contribution (70% of 30 employees).   If only 5 of the HCEs (or 50%) receive the contribution, however, then only 11 lower paid workers (70% of 50%, rounded up) would need to receive a contribution.   (There is another test, the "average benefits test" that is beyond the scope of this column.)

  Section 403(b)(12) incorporates one additional requirement that is not referred to in the 403(b) Regulations - the requirement under Code section 401(a)(26) that says defined benefit pension plans must cover at least 40% of the work force or 50 employees, whichever is less.   While not specifically addressed in the preambles to the proposed or final regulations, the omission appears to be based on the position that 403(b) plans are defined contribution plans (except for certain grandfathered defined benefit arrangements - see 69 Federal Register, page 67083), so that the special coverage rule for defined benefit plans would not apply.  

The rules are complex and require plans of tax exempt entities to be careful in making employer contributions.   However, within the complexity, there is room for a certain amount of creativity in plan design that may be used to achieve specific entity goals with respect to their employees.

- Bruce Ashton, Reish Luftman Reicher & Cohen

NOTE: This feature is to provide general information only, does not constitute legal advice as part of an attorney-client relationship, and cannot be used or substituted for legal or tax advice.

   In the last column, we included an example dealing with leased employees (See 403(b) Good III: What Non-Discrimination Rules? - Universal Availability ).   While the example was intended to illustrate the application of the rule permitting exclusion of employees covered by a 401(k) plan, it suggested that leased employees could be eligible for a 403(b) plan.   The 403(b) regulations make it clear that only common law employees are eligible, which would not include leased employees.   ( See Treas. Reg. §1.403(b)-2(b)(9))   Our apologies for any confusion.

- Bruce Ashton, Reish Luftman Reicher & Cohen

NOTE: This feature is to provide general information only, does not constitute legal advice as part of an attorney-client relationship, and cannot be used or substituted for legal or tax advice.