Those rules changed in some important ways under the final 403(b) regulations, published in July of 2007 and generally effective January 1, 2009, and under additional employer aggregation (controlled group) rules.
The rules, which continue to differ markedly from 401(k) plan rules, have long been the subject of cautionary remarks from legal advisers and IRS spokespersons, and more recently have been the subject of focused IRS audits and questionnaires (compliance checks or mini-audits). IRS questionnaires mailed to large numbers of public school districts looked for an anticipated set of impermissible exclusions, such as class exclusions of substitute teachers, part-time employees and others.
Different nondiscrimination rules apply to different types of contributions:
- Elective employee deferrals: For both public and private employers (other than churches), if the opportunity to make these contributions is available to anyone, it must be available to everyone, with limited permissive exclusions.
- All other contributions: For private employers (other than churches), these have been subject to more complicated testing rules, similar to 401(k) plans, though with certain more generous definitions, exclusions, and safe harbor provisions.
One new regulation which indirectly affects the nondiscrimination rules requires that plan provisions be reflected in a formal, written plan document, either a single document or a collection of documents. While this requirement does not itself define or modify the nondiscrimination rules, it does something that is perhaps just as important: in defining the groups of eligible and ineligible employees, it provides a roadmap for determining compliance (or noncompliance) with the rules, and thus highlights the importance of careful planning and equally careful drafting. An improper exclusion written into the plan will result in either a failure to comply with the rules (if the exclusion is followed) or a failure to follow the terms of the plan.
An important rule change for contributions other than employee elective deferrals is the termination of a set of “transition rules” issued by the IRS in 1989, intended to ease the transition to what was then a very new set of rules for 403(b) plans. These transition rules included certain design-based safe harbor tests for employer contributions other than matching contributions. As one example, if plan participation by non-highly compensated employees (NHCEs) was at least 50% of all NHCEs and at least 30% of all of the active participants, then the highest contribution for an HCE currently accruing benefits, expressed as a percentage of compensation, could be as much as 40% greater than the lowest contribution for an NHCE without violating non-discrimination rules.
However, these transition rules are gone, and the affected contributions are now subject to many of the same rules that have applied to 401(a) plans (including the subset of 401(k) plans). Those rules contain some of their own-and for the most part, less generous-safe harbor provisions.
In applying the nondiscrimination rules to 403(b) plans, certain organizations which are under common control are required to be treated as a single employer. Along with the final 403(b) regulations, Treasury issued a final regulation under Code Section 414, which provided both mandatory and permissive aggregation and disaggregation rules, applicable to many types of plans sponsored by tax-exempt employers, including 403(b) plans. A primary provision defines common control to include the fact that at least 80% of the directors of an organization are representatives of, or directly or indirectly controlled by, another organization.
Universal availability rules governing elective deferrals have also been changed. A permissive exclusion for employees who normally worked less than 20 hours a week, a provision for which little additional guidance had been provided, has been replaced with a 1000-hour test: employees can be excluded as a group (but not selectively within the group) if they worked less than 1000 hours in the previous year. For newer employees, the 1000-hour test is forward looking.
While this new test provides more definition, it also creates new issues. For example, if a plan utilizes the exclusion, an employee returning from leave who still might have satisfied the forward looking 20-hour-per-week test, might fail under the 1000 hour look-back, and be excluded from participation in the year of return. Additionally, certain exclusions available under prior guidance (visiting professors, collectively-bargained employees, vows of poverty) will be eliminated in the near future.
The new rules governing nondiscrimination, coupled with additional complexities such as the nature of the employer sponsoring the plan or the existence and details of other plans maintained by the employer, may create questions and issues for 403(b) plans that should not be ignored and should be discussed with a knowledgeable attorney, adviser, or plan provider.
-Richard Turner, Vice President and Deputy General Counsel for VALIC
Turner has worked extensively with retirement plans and products for 25 years and is a frequent speaker on the topic. He is also a contributing author of the "403(b) Answer Book."