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403(b)

What is a 403(b) Plan?

Section 403(b) of the Internal Revenue Code (IRC) describes a special type of defined contribution retirement plan available only to public schools, tax-exempt organizations, and certain ministers. Section 403(b) provides an exclusion from current income for employer contributions and employee pre-tax elective deferrals if certain requirements are satisfied.

There are three categories of funding arrangements to which Section 403(b) applies: (1) annuity contracts issued by an insurance company; (2) custodial accounts (held by a bank) invested solely in mutual funds; and (3) retirement income accounts (permitted only for church plans). Employers typically adopt a 403(b) plan by arranging to purchase contracts from one or more Section 403(b) “vendors.” A 403(b) plan is sometimes referred to as a tax-deferred annuity or a tax-sheltered annuity plan (TSA).

Section 403(b) plans are similar to Section 401(k) plans in many respects. However, there are some important differences. In addition to the restrictions on eligible employers and funding vehicles described above:

  • Employee elective deferrals to a 403(b) plan are subject to their own special nondiscrimination rules, and not the average deferral percentage (ADP) test that generally applies to 401(k) plans
  • There is no special income tax averaging for lump-sum distributions from 403(b) plans
  • Section 403(b) includes a special catch-up rule for certain long-term employees
  • Tip

Throughout this article, the term “Section 403(b) contract” includes annuity contracts, custodial accounts, and retirement income accounts.

  • Tip

Throughout this article, the term “church” includes traditional (“steeple”) churches as well as “qualified church-controlled organizations” (QCCOs), as defined in IRC Section 3121(w)(3)(B). Church plans are subject to numerous special rules, the full treatment of which is beyond the scope of this article.

  • Caution

All Section 403(b) contracts you purchase for an employee are generally treated as a single contract for purposes of complying with Section 403(b)’s requirements. Other aggregation rules may also apply.

Ten requirements for a valid Section 403(b) contract

In order for employee pre-tax elective deferrals and employer contributions to enjoy the benefit of exclusion from immediate taxation, a Section 403(b) contract must satisfy all of the following requirements:

  1. The contract must be maintained pursuant to a written plan
  2. The contract must be purchased by an eligible employer — it cannot be purchased by a qualified plan or a governmental 457(b) plan
  3. Employee benefits under the contract must be nonforfeitable at all times [employer contributions may be subject to a vesting schedule, but nonvested contributions must be accounted for separately, and are not treated as 403(b) assets until they vest]
  4. The plan (other than a church plan) must meet applicable nondiscrimination requirements
  5. The contract must provide that employee elective deferrals to the plan, and all other plans of the employer, do not exceed the annual employee elective deferral limit ($19,500 in 2020, up from $19,000 in 2019), plus applicable catch-up contributions
  6. The contract cannot be transferable
  7. The contract must comply with required minimum distribution (RMD) rules
  8. The plan must allow eligible rollover distributions to be directly rolled over to other eligible retirement plans
  9. The contract must satisfy the “incidental benefit rule” requirements of the Code
  10. The contract must provide that contributions to an employee’s account do not exceed the annual additions limit in any year [the lesser of 100% of includible compensation, or $57,000 (in 2020, up from $56,000 in 2019) plus certain catch-up contributions]

Failure to satisfy these requirements can have serious adverse tax consequences. See “Questions & Answers,” below.

Which employers can have a 403(b) plan?

Your organization is eligible to adopt and maintain a 403(b) plan if it is exempt from federal income tax under IRC Section 501(c)(3) (a “tax-exempt organization”), or if it is a state-sponsored public school. Section 403(b) plans may also be adopted for certain ministers.

Tax-exempt Section 501(c)(3) organizations include entities organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or education purposes. Section 501(c)(3) organizations can also include certain qualifying organizations that sponsor amateur competition, or that exist for the purpose of preventing cruelty to children or animals. Qualifying tax-exempt organizations include:

  • Charities
  • Social welfare agencies
  • Private hospitals
  • Health-care organizations
  • Private schools
  • Religious institutions
  • Research facilities

Public employers that have the same attributes as nonpublic 501(c)(3) organizations (for example, government-operated hospitals, libraries, and museums) may also qualify as 501(c)(3) organizations, and may adopt 403(b) plans.

State-sponsored educational organizations that can adopt a Section 403(b) plan are those described in IRC Section 170(b)(1)(A)(ii), regardless of whether they qualify as Section 501(c)(3) organizations. An educational organization must normally maintain a regular faculty and curriculum, and must normally have a regular enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. Included in this category are public schools, state colleges, and state universities.

  • Tip

Indian tribal governments may also establish 403(b) plans for employees of their public school systems. Other special rules also apply to tribal governments.

Section 403(b) accounts can also be established for the following ministers:

  • Ministers employed by Section 501(c)(3) organizations
  • Self-employed ministers (a self-employed minister is treated as employed by an eligible tax-exempt organization)
  • Ministers (chaplains) who are employed by organizations that are not 501(c)(3) organizations, and function as ministers in their day-to-day professional responsibilities with their employers
  • Caution

A self-employed minister cannot set up a 403(b) account for his or her own benefit. Only the organization with which the minister is associated can set up an account for the minister’s benefit. However, a self-employed minister is allowed to make contributions directly to a retirement income account established by the organization for the minister’s benefit (the minister is treated as both employee and employer for this purpose).

  • Caution

If your organization is a member of a controlled group (IRC Section 414), you may need to treat all employers in the group as a single employer when complying with Section 403(b)’s nondiscrimination rules and certain other requirements. The final regulations formalize the IRS position that separate tax-exempt employers may be treated as members of a controlled group if they share 80% or more of the same directors or trustees, or if one entity controls 80% or more of the other entity’s directors or trustees (the “board control test”). The regulations also allow separate tax-exempt employers to voluntarily elect to be treated as a single employer in some cases. Regulations have not yet been issued covering the controlled group rules that apply to public schools (these employers can continue to rely on the guidance provided in Notice 89-23). (The controlled group rules do not apply to church plans.) The rules governing controlled groups are complicated. Be sure to consult a qualified professional.

Tax advantages of 403(b) plans

As with many other types of retirement plans, employees who participate in a 403(b) plan may enjoy significant tax benefits, including the following:

Employees can make pre-tax contributions

If your plan permits, employee elective deferrals to a 403(b) plan can be made on a pre-tax (salary-reduction) basis. The contribution is taken directly from the employee’s salary and invested in the 403(b) plan before any taxes are withheld. This means that the amount each employee defers to the plan is not included in his or her gross income. The employee pays less current income tax because his or her taxable income is lower than it would otherwise be. The annual limit for pre-tax contributions is $19,500 in 2020 (up from $19,000 in 2019).

Employees can make after-tax Roth contributions

If your plan permits, your employees can elect to designate all or part of their elective deferrals as Roth 403(b) contributions. Your employees’ Roth contributions are made on an after-tax basis. Roth 403(b) contributions don’t provide any up-front tax benefit, but they’re always tax-free when distributed from the plan. Earnings on Roth contributions are also tax-free if paid to the employee in a qualified distribution. The annual limit for elective deferrals (aggregate pre-tax and Roth) is $19,500 in 2020 (up from $19,000 in 2019).

Taxes deferred on employer contribution

Employees are not taxed on employer contributions to 403(b) plans until those contributions are distributed from the plan.

Tax-deferred growth

Funds held in a 403(b) plan grow on a tax-deferred basis. Any earnings on plan investments are not taxable as long as they remain in the plan. Only when an employee begins to receive distributions from the plan will he or she pay income tax on the earnings (earnings on Roth contributions are tax-free if paid to the employee in a qualified distribution). Depending on investment performance, this creates the potential for more rapid accumulation (and therefore a larger retirement fund) than money invested outside a tax-deferred plan.

Employees age 50 or older can contribute more than the annual deferral limit

If your plan permits, employees age 50 and older may make an additional yearly “catch-up” contribution to the plan (over and above the regular employee elective deferral limit, and over and above the annual addition dollar limit). The catch-up contribution amount is $6,500 in 2020 (up from $6,000 in 2019), and is indexed for inflation. The purpose of this provision is to help older individuals increase their savings as they approach retirement. Catch-up contributions can be either pre-tax elective deferrals or, if your plan permits, after-tax Roth contributions

Long-service employees can contribute more than the annual deferral limit

If your plan permits, employees with 15 or more years of service may also be eligible to make a special catch-up contribution to the plan in addition to the age 50 catch-up contribution. See “Special Section 403(b) catch-up limit,” below. (This special catch-up contribution is over and above the regular employee elective deferral limit, but is included in the annual addition dollar limit.)

Tax-free rollovers are allowed

See “Rollovers,” below.

Participants may qualify for the tax saver's credit

Certain low- and middle-income taxpayers may claim a partial, nonrefundable income tax credit (“Saver’s Credit”) for amounts contributed to 403(b) plans and certain other retirement savings vehicles.

The maximum annual contribution to all plans eligible for the credit is $2,000. In addition, the amount of the credit (if any) depends on your employee’s adjusted gross income (AGI). Only joint returns with AGI of $65,000 or less, head of household returns of $48,750 or less, and single returns of $32,500 or less are eligible for the credit. Here are the credit rates based on 2020 AGI limits:

Joint Filers Heads of Household Single Filers Credit Rate
$0 - $39,000
$0 - $29,250
$0 - $19,500
50% of contribution
$39,001 - $42,500
$29,251 - $31,875
$19,501 - $21,250
20%
$42,501 - $65,000
$31,876 - $48,750
$21,251 - $32,500
10%
Over $65,000
Over $48,750
Over $32,500
0%

To claim the credit, your employee must be at least 18 years old and not a full-time student or a dependent on another taxpayer’s return.

Other advantages of 403(b) plans

You are not required to contribute to the plan

You can set up your 403(b) plan to be funded entirely through salary-reduction contributions by your employees. Consequently, it may be possible to adopt a 403(b) plan with minimal employer cost — in this case, the only additional expense involved would be for plan installation and administration. A 403(b) plan funded largely or solely by salary-reduction contributions may actually reap some savings to you as a result of lower state or local (but not federal) payroll taxes.

Employees may find it easier to save for retirement

Because employees make 403(b) contributions through payroll deductions, they may find it easier to save. The money is “out of sight, out of mind.”

Plan loans can be made available to plan participants

You may structure your 403(b) plan to allow employees to borrow as much as one-half of their vested benefits, to a maximum of $50,000.

  • Note

For a loan made to a qualified individual between March 27, 2020, and September 22, 2020, you may structure your 403(b) plan to allow employees to borrow as much as 100% of their vested benefits, to a maximum of $100,000. A qualified individual means an individual who is diagnosed with coronavirus or whose spouse or dependent are diagnosed with coronavirus, as well as an individual who experiences adverse financial consequences as a result of factors related to the coronavirus pandemic. These factors may include quarantines, furloughs, the inability to work due to lack of child care, and business closings.

  • Caution

All loans are required to bear a reasonable rate of interest, and must not be offered in a discriminatory fashion.

  • Caution

All loans are required to bear a reasonable rate of interest, and must not be offered in a discriminatory fashion.

In-service withdrawals can be made available to plan participants

See “Distributions,” below.

Creditor protection

Funds held in a 403(b) plan are fully shielded from your employee’s creditors under federal law in the event of the employee’s bankruptcy. If your 403(b) plan is covered by the Employee Retirement Income

Security Act of 1974 (ERISA), plan assets are also generally fully protected under federal law from the claims of both your employees and your creditors, even outside of bankruptcy (some exceptions apply). State law may provide additional protection.

If your plan has discretionary (nonelective) employer contributions, it may be "integrated" with Social Security

The IRS views the benefits provided by your 403(b) plan and those provided by Social Security as one retirement program. Because Social Security provides a higher percentage of salary benefit to lower-paid employees, the IRS allows a 403(b) plan that has discretionary contributions to allocate more of those contributions to higher-paid employees within specific limits (this is technically known as permitted disparity).

Disadvantages of 403(b) plans

Reporting, disclosure, and other requirements may apply to 403(b) plans

If your plan is subject to ERISA, it may be subject to the same reporting, disclosure, vesting, joint and survivor, fiduciary, and other requirements that apply to qualified retirement plans under Title 1 of that law. See “Section 403(b) plans and ERISA,” below.

Plan investment choices may be limited

The investment choices available to participants in a 403(b) plan are fairly limited. The IRC generally allows only annuity contracts (fixed or variable, individual or group) or mutual fund custodial accounts to be used as funding vehicles for 403(b) plans. By contrast, IRAs, and other types of employer-sponsored retirement plans, can (and often do) provide a wider range of investment choices.

For some employees, the lack of investment options may be a factor in their decision about whether to participate in a 403(b) plan. To encourage employee participation, some 403(b) plans in recent years have been offering more investment choices, and more flexibility to allocate money among the choices offered. For example, employees may be given the choice of either annuity contracts and/or mutual funds, or the ability to choose among several insurers or families of mutual funds. Again, however, the investment restrictions imposed by the tax code present a challenge to employers trying to expand their employees’ options.

In addition to annuity contracts and custodial accounts, 403(b) plans maintained by churches may be funded with “retirement income accounts.” Retirement income accounts are sometimes referred to as 403(b)(9) plans or arrangements (for the IRC section authorizing them). A retirement income account is a defined contribution program established by a church to provide retirement benefits to its employees and certain ministers (certain defined benefit retirement income accounts are grandfathered). Retirement income accounts are not subject to any investment restrictions. Retirement income accounts can also “self-annuitize” (that is, they can provide benefits in the form of a life annuity from plan assets without purchasing annuity contracts from a life insurance company). The church’s plan document must specifically state its intent that an account qualify as a retirement income account.

  • Caution

A 403(b) account (other than a retirement income account) cannot be funded with life insurance or endowment contracts. Contracts issued before September 24, 2007, are grandfathered. The final regulations clarify, however, that an annuity contract may provide life insurance protection as long as the death benefit is merely incidental to the primary purpose of providing retirement benefits.

You may need professional assistance to establish and administer your 403(b) plan

The final regulations generally require that Section 403(b) annuity contracts be purchased pursuant to a written plan that, in form and operation, satisfies the requirements of Section 403(b) and the final regulations. In addition, if your plan is subject to ERISA, additional reporting, disclosure, and other requirements apply. You may therefore require professional assistance to establish and administer your plan.

Like all defined contribution plans, a specific benefit level isn't guaranteed

Unlike defined benefit plans, 403(b) plans do not guarantee a specific benefit at retirement. Participant accounts are subject to market forces, so if plan investments perform badly, participants could suffer a financial loss.

Access to plan benefits may be limited before termination of employment

See “Distributions,” below.

Types of Section 403(b) plans — salary-reduction vs. employer-funded

Section 403(b) plans generally fall into one of two categories: a salary-reduction plan or an employer-funded plan.

Salary-reduction plan

The salary-reduction plan is the most widely used type of 403(b) plan. This type of plan is funded solely by employee salary-reduction contributions. A participating employee elects to defer a certain amount of money to the plan (typically, a percentage of his or her salary), rather than receiving that amount as taxable compensation. This arrangement is called a salary-reduction plan because the amount deferred to the plan is a pre-tax contribution, thereby reducing the employee’s taxable income. The employee’s contributions are called “elective deferrals.” Since the amount deferred to the plan is automatically deducted from the employee’s salary each pay period, the employee may find it more convenient to save with this arrangement.

  • Tip

You can (but you’re not required to) let employees designate all or part of their Section 403(b) elective deferrals as after-tax “Roth” contributions. In this case, there’s no up-front tax benefit, but qualified distributions of Roth contributions and related earnings are completely tax-free when distributed to the employee from the plan. [See “Roth 403(b) accounts,” below.]

  • Tip

You can also let employees make (non-Roth) after-tax contributions to your 403(b) plan. These contributions are tax-free when distributed from the plan. However, the earnings on these contributions are subject to income tax when distributed.

Employer-funded plan

The employer-funded 403(b) plan is typically funded by both employer contributions and employee contributions (although employee contributions are not necessarily required). Employer contributions may be a fixed percentage of each employee’s compensation or may be discretionary on the part of the employer. They may also include matching contributions that are a specified percentage of each employee’s contribution.

  • Technical Note

Employer contributions are sometimes referred to as “nonelective” contributions to distinguish them from employee elective deferrals. Nonelective contributions are employer contributions that are not made pursuant to a salary-reduction agreement with the employee.

  • Tip

Employers can make nonelective 403(b) contributions on behalf of former employees for up to five years after the year the employee no longer receives compensation from the employer (subject to any applicable nondiscrimination rules).

Additional tax considerations

No employer tax deduction

With many types of employer-sponsored retirement plans, the employer’s contributions to the plan are tax deductible for federal income tax purposes. Contributing to the plan can therefore reduce the employer’s taxable income, saving money in taxes. However, any employer that is eligible to have a 403(b) plan generally does not pay any federal income tax in the first place. This means that deductibility of contributions is typically not an issue for such employers.

Income tax — employee pre-tax and employer contributions

Your employee’s pre-tax deferrals aren’t currently includible in the employee’s income — they’re tax-deferred, and included in income only when distributed from the plan. Likewise, your employee isn’t taxed on any employer contributions you make to his or her 403(b) account until a distribution is taken from the plan. Similarly, investment earnings on employee pre-tax contributions and employer contributions grow tax-deferred, and aren’t subject to income tax until withdrawn.

  • Caution

Taxable income from a 403(b) plan is always taxed at ordinary income tax rates even if the income represents long-term capital gains from investments held within the plan.

Income tax — employee Roth contributions

You can (but aren’t required to) let your employees designate all or part of their elective deferrals as Roth 403(b) contributions. Because your employee’s Roth contributions are made on an after-tax basis, there is no up-front tax benefit. They’re included in your employee’s gross income at the time the employee makes the contribution to the 403(b) plan. And because they’re made on an after-tax basis, an employee’s Roth contributions are always tax-free when distributed from the plan. Investment earnings on an employee’s Roth contributions grow tax-deferred while they remain in the 403(b) plan. Whether they’re subject to tax when distributed depends on whether the distribution is qualified or nonqualified.

 

If an employee receives a qualified distribution from his or her Roth account, the entire amount distributed, both the Roth contributions and investment earnings, is totally free from federal income tax. A qualified distribution is a payment from an employee’s Roth account that meets both of the following requirements:

  • The payment is made after your employee turns age 59½, becomes disabled, or dies
  • The payment is made after the end of the five-year period that starts with the year the employee makes his or her first Roth contribution to your 403(b) plan
  • Example

Nicole makes her first Roth 403(b) contribution to your plan in December 2016. So the first year of Nicole’s five-year waiting period is 2016. The five-year waiting period ends on December 31, 2020.

  • Tip

You can let your employees roll over Roth contributions from another employer’s 401(k) or 403(b) plan to your Roth 403(b) plan. If your plan accepts these rollovers, then the five-year period starts with the year your employee made his or her first contribution to the prior employer’s plan (if that’s earlier than the year the employee first contributed to your plan).

If a payment doesn’t satisfy the conditions for a qualified distribution, the portion of the payment that represents the return of your employee’s Roth contributions will still be tax-free, but the portion of the payment that represents earnings on those contributions will be subject to income tax and a potential 10% premature distribution tax (unless an exception applies).

A distribution that’s made before the five-year waiting period has elapsed will always be a nonqualified distribution. A distribution that’s made before the earliest of age 59½, disability, or death (for example, a distribution to your employee upon termination of employment before attaining age 59½) will also always be a nonqualified distribution.

  • Tip

IRS regulations provide that each distribution from a Roth 403(b) account is deemed to consist of a pro-rata share of an employee’s Roth contributions and investment earnings on those contributions.

Early distribution penalty

A federal 10% premature distribution tax may be assessed on the taxable portion of distributions made prior to age 59½. Exceptions to the penalty tax include distributions to an employee age 55 or older as a result of separation from service, distributions as a result of disability or death, certain substantially equal periodic payments, distributions pursuant to a qualified domestic relations order, distributions to pay certain deductible medical expenses, certain corrective distributions of excess deferrals and excess contributions, and qualified reservist distributions.

  • Note

The penalty tax does not apply to up to $100,000 of coronavirus-related distributions to an individual during 2020.

Payroll taxes

Employee elective deferrals (pre-tax and Roth contributions), but not employer contributions, are generally subject to FICA and FUTA payroll taxes. (Special rules may apply to church plans, certain ministers, and certain governmental plans.)

Estate tax

The entire vested value of a 403(b) plan account is included in a deceased participant’s gross estate for federal estate tax purposes.

Roth 403(b) accounts

As indicated above, you don’t have to allow Roth contributions to your 403(b) plan. But if you do, the plan can’t be a “Roth only” plan. That is, if your plan allows Roth contributions, then employees must be allowed to make both Roth contributions and pre-tax contributions.

Technically, an employee makes a Roth 403(b) contribution by making an elective deferral under the plan, and then irrevocably designating all or part of that deferral as a Roth 403(b) contribution. Roth 403(b) contributions are treated the same as pre-tax 403(b) elective deferrals for all plan purposes, except that they’re included in an employee’s taxable wages at the time of contribution [that is, Roth 403(b) contributions are after-tax contributions].

Your 403(b) plan must establish separate accounts to track each employee’s Roth 403(b) contributions, and any gains or losses on those contributions. The taxation of distributions from an employee’s Roth 403(b) account is also determined separately from any other plan dollars.

  • Tip

Even though a Roth 403(b) account is treated as a “separate contract,” the amount an employee can borrow, or withdraw on account of hardship, is determined based on the employee’s combined Roth and non-Roth plan account balances. In addition, Roth and non-Roth account balances are combined to determine whether an employee’s vested accrued benefit is $5,000 or less, allowing it to be involuntarily cashed-out upon termination of employment. However, the Roth and non-Roth account balances are treated separately when determining whether a cashed-out participant’s vested accrued benefit exceeds $1,000, requiring an automatic rollover to an IRA in some cases.

Contribution limits

The IRC contains overlapping limitations that apply when determining exactly how much can be put into a 403(b) plan for each employee (the “maximum amount contributable,” or MAC). If contributions to your plan consist solely of employee elective deferrals, then the employee’s MAC is the lesser of the annual elective deferral limit, or the IRC Section 415 annual additions limit (both described below). If the only contributions to your plan are employer contributions, then the employee’s MAC is the Section 415 annual additions limit. If your plan provides for both employee elective deferrals and employer contributions, then the MAC is the Section 415 annual additions limit, and the elective deferral limit determines whether an employee has made any excess deferrals for the year. The IRS provides worksheets for determining an employee’s MAC in Publication 571. The limits described below establish the maximum amount that may be contributed under the law — your plan can provide more restrictive limits if you wish.

Annual elective deferral limit

An employee’s annual elective deferral limit is the sum of three amounts: (1) the general deferral limit, (2) the age-50 catch-up contribution limit, and (3) the special 403(b) catch-up contribution limit.

  1. The general deferral limit: An employee may make elective deferrals (pre-tax and/or Roth, if permitted) of up to $19,500 of his or her compensation to a 403(b) plan in 2020 (up from $19,000 in 2019).
  2. The age-50 catch-up contribution limit: You may (but are not required to) allow employees age 50 and over to make “catch-up” contributions each year ($6,500 in 2020, up from $6,000 in 2019) over and above the general deferral limit. These individuals may therefore contribute up to $26,000 on a pre-tax basis in 2020.
  3. The special 403(b) catch-up contribution limit: The general deferral limit is also increased by an additional amount for long-service employees (those with 15 or more years of service) of certain employers. (See “Special Section 403(b) catch-up limit,” below.) The maximum annual special catch-up contribution is $3,000. The lifetime aggregate catch-up contribution under this special rule is $15,000. Employees who are eligible for both the age 50 catch-up contribution and the maximum special 403(b) catch-up contribution may be able to make elective deferrals of up to $29,000 in 2020.
  • Caution

Any catch-up contribution for an employee who is eligible for both the age 50 catch-up and the special Section 403(b) catch-up is treated first as a special Section 403(b) catch-up and then as an age-50 catch-up. The importance of this ordering rule is shown by the example below.

  • Example

Rhonda, age 55, has 15 years of service with her employer, a tax-exempt hospital. Rhonda has not made any prior catch-up contributions. Rhonda is eligible to make elective deferrals in 2020 of up to $19,500 under the general elective deferral limit. Rhonda is also eligible to make $6,500 age 50 catch-up contributions, and $3,000 special Section 403(b) catch-up contributions. Rhonda makes elective deferrals in 2020 totaling $23,000. These will be treated under the ordering rules as $19,500 of regular elective deferrals, $3,000 of special Section 403(b) catch-up contributions, and $500 of age-50 catch-up contributions. Thus Rhonda will use up $3,000 of her lifetime $15,000 special Section 403(b) catch-up contribution limit.

If your employee participates in multiple retirement plans, he or she can’t make total elective deferrals that would exceed the annual elective deferral limit ($19,500 in 2020 plus any applicable catch-up contribution). Deferrals to 401(k) plans, 403(b) plans, SIMPLEs, and SAR-SEPs are included in this limit, but deferrals to Section 457(b) plans are not. That is, employees who participate in both a 403(b) plan and a 457(b) plan can defer the full dollar limit to each plan — a total of $39,000 in 2020 (plus any catch-up contributions).

If you allow your employee to contribute more than the annual deferral limit to plans you sponsor, then 403(b) status may be lost for all 403(b) contracts you’ve purchased for the employee unless the excess deferrals are timely corrected. You can avoid the loss of 403(b) status by distributing the excess deferrals, plus earnings, by April 15 of the following tax year, but only if your plan provides for such distributions. The portion of the distribution attributable to excess deferrals is taxable to your employee in the year of contribution, while the earnings are taxable in the year of receipt.

  • Tip

The IRS has established a comprehensive program for correcting retirement plan defects, including those in Section 403(b) plans. The rules governing that program, the Employee Plans Compliance Resolution System (EPCRS), are currently found in Revenue Procedure 2016-51.

Your employee is responsible for making sure the annual deferral limit isn’t exceeded if he or she participates in plans of unrelated employers during a calendar year. If your employee’s elective deferrals exceed the annual limit because he or she contributed too much in the aggregate to your plan and plans of one or more unrelated employers, then your employee must withdraw the excess by April 15 of the following year to avoid adverse tax consequences. If your employee fails to do so, the excess will be treated as taxable income both in the year contributed to the plan and again in the year the excess contributions (and earnings) are distributed from the plan. (This applies to both pre-tax and Roth excess contributions.) However, there is no loss of 403(b) status for the annuity contracts you’ve purchased for the employee. Your plan is not required to permit the distribution of excess deferrals.

Special Section 403(b) catch-up limit

If an employee has at least 15 years of service with an educational organization (such as a public or private school), hospital, home health service agency, health and welfare service agency, church, or convention or association of churches (or associated organization), the annual elective deferral limit is increased in any year by the least of:

  1. $3,000
  2. $15,000, reduced by the sum of additional elective deferrals made in prior years because of this rule, or
  3. $5,000 times the employee’s years of service for the organization, minus the total elective deferrals made by the employee for earlier years

Your plan may, but is not required to, allow employees to make additional elective deferrals pursuant to this special rule. Note that under this special catch-up rule, the maximum additional catch-up contribution in any year is $3,000, and the lifetime aggregate catch-up contributions an employee can make is $15,000.

Section 415 annual additions limit

There is also an overall limit on the total contributions (“annual additions”) that can be made to an employee’s 403(b) accounts under your plan for a given year. That limit is the lesser of (a) $57,000 (in 2020, up from $56,000 in 2019), or (b) 100% of the employee’s includible compensation. Total annual additions are the sum of employer contributions, employee elective deferrals (pre-tax and Roth), employee after-tax contributions, plus any forfeitures reallocated from other employees’ accounts. The Section 415 limits apply to the aggregate annual additions made to all Section 403(b) contracts you’ve purchased for an employee.

  • Caution

The Section 415 annual additions limit generally applies separately to qualified defined contribution plans you sponsor in addition to your 403(b) plan (for example, a 401(k) plan).

The $57,000 dollar limit includes the special Section 403(b) catch-up contribution, but not the age 50 catch-up contribution. That is, the annual additions limit is increased only by the amount of any age 50 catch-up contributions.

  • Tip

Church employees may elect to substitute an annual limit of $10,000 (even if more than 100% of includible compensation) up to a total lifetime limit of $40,000, for the regular Section 415 annual additions limit.

If annual additions to an employee’s 403(b) contract exceed the Section 415 annual additions limit for any year, then 403(b) status will be lost — but only for the portion of the Section 403(b) contract that includes the excess. However, the entire contract will lose its 403(b) status unless the issuer of the contract maintains separate accounts for the portion of the contract that includes the excess and the portion that represents the rest of the contract.

  • Tip

You may be able to avoid the loss of Section 403(b) status for the contract if you correct the error on a timely basis. The IRS has established a comprehensive program for correcting retirement plan defects, including those in Section 403(b) plans. The rules governing that program, the Employee Plans Compliance Resolution System (EPCRS), are currently found in Revenue Procedure 2016-51.

Excess Section 415 contributions are currently includible in the participant’s gross income. A 6% cumulative excise tax is also imposed on the employee for excess contributions made to a Section 403(b) custodial account. The 6% excise tax is payable each year the excess continues in the account. The excise tax applies only to the excess contributions and not to earnings on the contributions. The excise tax does NOT apply to excess annual additions to 403(b) annuity contracts or retirement income accounts.

Distribution rules

The rules governing distributions from 403(b) plans are complex, and vary depending on the type of contribution (employer versus employee) and the type of account from which the distribution is made (custodial account versus annuity contract). Your 403(b) plan can generally contain distribution rules that are more restrictive, but not more liberal, than the law allows.

In general, an employee’s access to his or her 403(b) retirement benefit is limited before the employee has a “severance from employment,” except as described below. For purposes of the distribution rules, an employee generally has a severance from employment on any date on which the employee ceases to be employed by an employer that is eligible to maintain the Section 403(b) plan. For example, a severance from employment would occur when an employee ceases to be employed by an eligible employer, even though the employee may continue to be employed by an entity that is part of the same controlled group but that is not an eligible employer. Other examples of situations that constitute a severance from employment include:

  • An employee transferring from a tax-exempt organization to a for-profit subsidiary of the tax-exempt organization
  • An employee ceasing to work for a public school, but continuing to be employed by the same state, and
  • An individual employed as a minister for an entity that is neither a state nor a Section 501(c)(3) organization ceasing to perform services as a minister, but continuing to be employed by the same entity

Distribution of employee elective deferrals (from custodial accounts, annuity contracts, and retirement income accounts)

Amounts attributable to employee Section 403(b) elective deferrals (pre-tax and Roth) generally may not be paid to a participant from a Section 403(b) contract before the participant has a severance from employment, has a hardship, becomes disabled (within the meaning of IRC Section 72(m)(7)), or attains age 59½.

  • Caution

The distribution restrictions described above do not apply to elective deferrals (not including earnings) that were contributed to annuity contracts or retirement income accounts before January 1, 1989 (provided these dollars are accounted for separately).

Hardship withdrawals: In general, the same rules that apply to hardship withdrawals from 401(k) plans apply to 403(b) plans. You can let your employees withdraw their elective deferrals (and pre-1989 earnings) prior to age 59½ if the employee, or the employee’s spouse, dependent, or plan beneficiary, incurs a financial hardship. Hardship withdrawals are permitted only for immediate and heavy financial need and only in an amount necessary to meet that financial need. Examples of immediate and heavy financial need include the need to:

  • Pay medical bills for your employee, and his or her spouse, children, other dependents, or plan beneficiary
  • Pay costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments)
  • Pay post-secondary tuition for your employee and his or her spouse, children, other dependents, or plan beneficiary
  • Prevent an eviction from or foreclosure of the employee’s principal residence
  • Pay funeral expenses for an employee’s parent, spouse, children, other dependents, or plan beneficiary
  • Repair damage to the employee’s principal residence after certain casualty losses, and
  • Pay income tax and/or penalties due on the hardship withdrawal itself

In 2019, an employee may be barred from taking a hardship withdrawal to the extent the employee is eligible for a non-hardship withdrawal or a loan from your 403(b) plan or from any other retirement plan you sponsor. The rule permitting this expires at the end of 2019.

  • Caution

IRS regulations contain complex rules that apply to hardship withdrawals from 403(b) plans. A pension professional can help guide you through the various plan design options available to you.

  • Caution

Hardship distributions of pre-tax contributions are subject to ordinary income tax. They’re also generally subject to the federal 10% additional penalty tax on distributions prior to age 59½ (unless an exception applies), and possibly a state penalty tax. The taxation of hardship withdrawals from an employee’s Roth 403(b) account depends on whether the distribution is a qualified or nonqualified withdrawal.

  • Caution

The amount of a hardship withdrawal is limited to the total amount of your employee’s elective deferrals (pre-tax or Roth) to the plan, amounts attributable to qualified nonelective contributions, and qualified matching contributions that are not held in a custodial account, reduced by the amount of any previous hardship withdrawals. Investment earnings on elective deferrals aren’t available for hardship withdrawal, except for certain pre-1989 grandfathered amounts.

Distribution of after-tax employee contributions (from custodial accounts, annuity contracts, and retirement income accounts)

If your plan permits after-tax (non-Roth) contributions, you can let employees withdraw those dollars, and applicable earnings, from a Section 403(b) contract at any time.

Distribution of employer contributions from custodial accounts

Amounts held in a custodial account attributable to employer nonelective contributions (that is, your employer discretionary or matching contributions and earnings) generally may not be paid to a participant before the participant has a severance from employment, becomes disabled [within the meaning of IRC Section 72(m)(7)], or attains age 59½. This rule also applies to amounts transferred out of a custodial account to an annuity contract or retirement income account, including earnings thereon.

Distribution of employer contributions from annuity contracts or retirement income accounts

Amounts held in an annuity contract or retirement income account attributable to employer nonelective contributions (that is, your vested discretionary or matching contributions) generally may not be paid to a participant before the occurrence of a “stated event.” Under this rule, an annuity contract is generally permitted to provide for a distribution after an employee reaches a specified age, after the employee has been a plan participant for at least five years, after a contribution has been in the trust for a specified period of time (at least two years), after the employee becomes disabled, or upon the occurrence of some other identified event such as severance from employment, or the occurrence of a financial need (including the need to buy a home).

  • Tip

The distribution restrictions described above do not apply to contracts issued by an insurance company before January 1, 2009.

Qualified reservist distributions

You can design your 403(b) plan to allow “qualified reservist distributions.” A qualified reservist distribution is a distribution of elective deferrals and earnings (1) to a reservist or national guardsman ordered or called to active duty after September 11, 2001, for a period in excess of 179 days or for an indefinite period, and (2) that’s made during the period beginning on the date of such order or call to duty and ending at the close of the active duty period. Qualified reservist distributions are exempt from the 10% early distribution penalty tax.

Loans

Another (often better) way that you can allow a needy plan participant to access his or her money in a 403(b) plan is by allowing participant loans. You may structure your 403(b) to allow employees to borrow as much as one-half of their vested benefits, to a maximum of $50,000. Loans are required to bear a reasonable rate of interest, and must not be offered in a discriminatory fashion.

  • Note

For a loan made to a qualified individual between March 27, 2020, and September 22, 2020, you may structure your 403(b) plan to allow employees to borrow as much as 100% of their vested benefits, to a maximum of $100,000. A qualified individual means an individual who is diagnosed with coronavirus or whose spouse or dependent are diagnosed with coronavirus, as well as an individual who experiences adverse financial consequences as a result of factors related to the coronavirus pandemic. These factors may include quarantines, furloughs, the inability to work due to lack of child care, and business closings.

A loan program can be an especially valuable feature to encourage employee participation in the plan because, in contrast to a hardship withdrawal, a loan will generally not be taxable or subject to the early withdrawal penalty tax (assuming that the loan is repaid on time and all other requirements are met).

QDROs

The final regulations confirm that 403(b) plans subject to ERISA can distribute assets to an alternate beneficiary under a qualified domestic relations order (QDRO), regardless of whether the employee has severed employment or is otherwise currently eligible to receive a distribution under the plan.

Termination of the plan

The final regulations allow you to terminate a 403(b) plan and distribute benefits to plan participants if certain conditions are satisfied. (Prior to the issuance of the final regulations, the ability to do so had been unclear.)

Rollovers

In general you can, but aren’t required to, let employees roll over assets from certain other retirement plans into your 403(b) plan. For example, you can allow participants to roll over pre-tax (but not after-tax) IRA funds to your plan. Pre-tax IRA funds generally include deductible contributions to the IRA, tax-deferred

earnings, and rollovers of taxable dollars from an employer-sponsored plan. You can also let your participants roll over eligible taxable and nontaxable (after-tax) funds from another employer’s qualified, governmental 457(b), or SIMPLE IRA plan to your 403(b) plan. Your plan must receive any after-tax contributions in a direct rollover and must account for those contributions (and any earnings) separately.

While you’re not required to accept rollover contributions into your plan, you must let employees roll over eligible distributions from your plan to an IRA or another employer’s retirement plan, if the other plan agrees to accept the contributions. Surviving spouses must be given the option to roll over inherited 403(b) funds to the spouse’s own IRA or another employer’s plan. Beneficiaries other than surviving spouses must be given the opportunity to directly roll over inherited 403(b) funds to an inherited IRA.

Special rules apply to Roth 403(b) contributions and earnings. Distributions from an employee’s Roth 403(b) account can only be rolled over to a Roth IRA, or to a Roth account in another employer’s 401(k), 403(b), or 457(b) plan. And a Roth 403(b) account can only receive a rollover contribution from another 401(k), 403(b), or 457(b) Roth account — not from a Roth IRA.

A rollover can be direct or indirect. With a direct rollover, the funds are moved directly from the 403(b) plan to an IRA or other employer plan. With an indirect rollover, the participant first receives the distribution from the 403(b) plan, and then rolls it over to an IRA or to another eligible employer plan within 60 days. In either case, as long as the rollover follows all applicable rules, it will be treated as a tax-free transfer of assets. If an eligible rollover distribution is not directly rolled over to an IRA or another eligible retirement plan, you are required to withhold 20% from the taxable portion of the distribution for federal income tax purposes. (The participant will receive a credit for tax withheld when he or she files a federal income tax return for the year.)

  • Caution

The 60-day indirect rollover rules can’t be used to roll over the nontaxable portion of a 403(b) distribution to a qualified employer plan or to another 403(b) plan. The direct rollover rules must be used. In addition, the receiving plan must agree to separately account for the nontaxable dollars and earnings.

  • Caution

Your plan must provide a timely notice [a “402(f) notice”] explaining the rollover rules, the withholding rules, and other related tax issues when making an eligible rollover distribution.

  • Caution

Certain distributions cannot be rolled over. These include:

  • Required minimum distributions (RMDs)
  • Certain periodic payments
  • Hardship distributions
  • Corrective distributions of excess deferrals, excess contributions, or excess annual additions (plus any income on those contributions)

"In-plan" conversions

If your plan permits Roth 403(b) contributions, you can also let your employees transfer all or part of the non-Roth portion of their account into their designated Roth account (i.e., effectively converting their non-Roth funds to Roth).

Your employees have to pay federal income tax now on the amount they convert (reduced by any basis the employee has in the converted funds), but qualified distributions from their Roth accounts in the future will be entirely income tax free. Further, the converted amount is not subject to the additional 10% early withdrawal tax (but that tax may be reclaimed by the IRS if an employee receives a nonqualified distribution from his or her Roth account within five years of the conversion).

  • Caution

When considering a rollover, to either an IRA or to another employer’s retirement plan, your employees should consider carefully the investment options, fees and expenses, services, ability to make penalty-free withdrawals, degree of creditor protection, and distribution requirements associated with each option.

Section 403(b) plans and ERISA

ERISA is a 1974 federal law that governs many aspects of retirement plans. Title I of ERISA imposes requirements that cover reporting and disclosure, participation and vesting, funding, fiduciary responsibilities, and administration and enforcement. Title I of ERISA applies to all “employee benefit plans,” which generally include all retirement plans unless specifically excluded.

A Section 403(b) plan established or maintained by a state, a political subdivision, or a state agency or instrumentality (that is, a “governmental plan”) is specifically exempt from ERISA Title I. Church plans are also specifically exempt from ERISA Title I, unless the church plan affirmatively elects to be subject to ERISA’s requirements.

Section 403(b) plans other than governmental or church plans are generally subject to ERISA Title I. However, an important exception (the DOL “safe harbor”) applies if the organization that sponsors or maintains the 403(b) plan plays a very minimal role in the ongoing administration of the plan. Specifically, a plan will not be subject to ERISA Title I if:

  • The 403(b) plan is funded completely through employee salary deferrals (i.e., no employer contributions)
  • Employee participation is completely voluntary
  • Rights under the plan are solely enforceable by the employee or the employee’s authorized representative or beneficiary
  • The employer’s involvement is limited to: permitting third-party providers to publicize their products to participants, requesting information from providers, summarizing information for participants, collecting and remitting employee contributions, holding group annuity contract(s) covering employees, and providing reasonable investment choices

The final regulations generated concern that an employer’s actions required to comply with the regulations, including the requirement that the employer maintain a written plan document, might result in sufficient “involvement” to cause plans previously exempt from ERISA’s coverage to lose their safe harbor protection. In response, on July 24, 2007, the Department of Labor issued Field Assistance Bulletin No. 2007-02 addressing this issue. The Field Directive clarifies that the DOL safe harbor is still available, but because employers can comply with the regulations in a number of ways, the facts and circumstances of each case will control. However, the Directive indicates that the following activities will not generally cause the employer’s involvement to be significant enough to subject the plan to ERISA:

  • Maintaining a written plan document
  • Conducting administrative reviews of the 403(b) plan’s structure and operation for tax compliance defects (including discrimination testing and compliance with contribution limits); fashioning and proposing any necessary corrections; working with third parties to correct tax defects; and keeping records of its activities
  • Providing employment information to contract providers, such as an employee’s address, compensation, hours of service, etc.
  • Allocating in the plan document responsibility for performing administrative functions to other parties
  • Periodically reviewing the documents that make up the plan for conflicting terms and compliance with the IRC and regulations
  • Limiting contract exchanges to providers who have adopted the employer’s plan (assuming the providers offer employees a reasonable choice of contracts), or limiting the number of providers the plan will forward elective deferrals to if employees can transfer their funds to nonplan providers as provided in the final regulations
  • Terminating the 403(b) plan in accordance with the regulations

The DOL cautions that an employer cannot, however, have responsibility for or make discretionary determinations in administering the 403(b) plan. Examples of such discretionary determinations are authorizing plan-to-plan transfers, processing distributions, satisfying applicable qualified joint and survivor annuity requirements, and making determinations regarding hardship distributions, qualified domestic relations orders (QDROs), and eligibility for or enforcement of loans. Further, negotiating with contract providers to change the terms of their products for other purposes, such as setting conditions for hardship withdrawals, would be a form of employer involvement outside the safe harbor.

How to set up a 403(b) plan

The procedure for establishing your 403(b) plan will differ depending on the type of organization you are, whether your plan will be subject to ERISA, the type of investments you wish to provide, and the level of involvement you wish to have in administering the plan. In general, you’ll need to meet with 403(b) vendors (for example, mutual fund providers and insurance companies) and decide which you’ll use for your plan. In some cases, the 403(b) vendors may provide most of the assistance you need in establishing the plan. In other cases, you’ll need significant assistance from qualified lawyers and other professionals. The following summarizes just a few of the steps you’ll need to take to establish your plan.

Have a written plan developed for your organization

The final regulations require that all 403(b) plans be maintained pursuant to a written plan document (or documents) that contains all the material terms and conditions for benefits under the plan. (Previously, only plans subject to ERISA were arguably required to have a written plan document.) The process of drafting a plan document will allow you to flesh out all of the design features of your plan.

  • Tip

Church plans with no retirement income accounts are exempt from the plan document requirement.

Plans can incorporate other documents by reference, including the 403(b) annuity contract or custodial account. Any documents incorporated by reference become part of the plan. If a plan incorporates other documents by reference, then, in the event of a conflict with another document (for example, an annuity contract), except in rare and unusual cases, the plan document would govern. In the case of a plan funded through multiple 403(b) vendors, the preamble to the regulations indicates that the IRS expects the employer to adopt a single plan document to coordinate administration among the various vendors, rather than having a separate plan document for each vendor.

A plan can allocate to the employer or another person (but not employees) the responsibility for performing functions to administer the plan, including functions to comply with Section 403(b). Any allocation must identify who is responsible for compliance with IRC requirements that apply based on the aggregated contracts issued to a participant, including the requirements for obtaining plan loans and hardship withdrawals.

The easiest and quickest way to establish a 403(b) plan generally is to use a plan pre-approved by the IRS, for example a prototype or volume submitter plan, designed by a bank, insurance company, mutual fund, or other institution. An employer that adopts a pre-approved plan generally has assurance that its plan document complies with IRC Section 403(b). With these plans, the sponsoring institution does most of the paperwork to install the plan at a low or minimal cost to you. In return, you keep most or all of the plan funds invested with that institution. If you decide that you do not want to use a prototype plan, you can instead hire an attorney or pension consultant to design a plan specifically for your organization. This is usually more expensive than using a plan already pre-approved by the IRS.

  • Tip

The IRS has issued Revenue Procedure 2007-71, which contains model language that public schools may use to draft a written 403(b) plan document. Other types of eligible employers may also tailor the model language for their 403(b) plans.

Have participants complete enrollment forms

Unless your 403(b) plan will be exclusively employer funded, you’ll need to have plan participants complete enrollment forms before the plan’s effective date so that employee contributions can be immediately effective. The enrollment form will specify how much the employee will contribute to the 403(b) plan from each paycheck (typically expressed as a percentage of the employee’s pre-tax compensation). The form will also specify how much of the contribution will be pre-tax and how much will be Roth or non-Roth after-tax contributions (if your plan permits those contributions). You can also allow your employees to specify how their 403(b) account will be invested. An employee may generally make or modify an election at any time before the affected compensation would otherwise become payable.

  • Tip

Individual account plans [like 403(b) plans] often allow participants to make investment decisions with respect to their accounts. In general, your plan fiduciaries can avoid liability for investment decisions made by plan participants if participants exercise sufficient control over the investment of their individual accounts, as determined under ERISA Section 404(c). If Section 404(c)’s specific requirements are met, a plan fiduciary may be responsible for the investment alternatives made available to participants, but not for the specific investment decisions made by participants.

You may also provide that employees will automatically be enrolled in your 403(b) plan, unless they affirmatively elect not to participate. See “What is an auto-enrollment arrangement?” below.

Establish annuity contracts or custodial accounts for plan participants

Individual accounts in a 403(b) plan can be any of the following:

  • An annuity contract, which is a contract provided through an insurance company
  • A custodial account, which is an account invested in mutual funds
  • A retirement income account set up for church employees that can be invested in annuities, mutual funds, or other investments

Provide a copy of the summary plan description, and other required disclosures, to all eligible employees

If your plan is subject to ERISA, you must provide a copy of the summary plan description (SPD) to all eligible employees within 120 days after your 403(b) plan is adopted. A SPD is a booklet that describes the plan’s provisions and the participants’ benefits, rights, and obligations in simple language. On an ongoing basis, you must provide new participants with a copy of the SPD within 90 days after they become participants. You must also provide employees (and in some cases former employees and beneficiaries) with summaries of material modifications to the plan. In most cases you can provide these documents electronically (for example, through e-mail or via your company’s intranet site). ERISA may require that you also provide additional information to participants. For example, if you allow employees to direct their own investments, specific detailed information about the plan and its investments must be provided on a periodic basis.

Make contributions on a timely basis

The final regulations provide that employers must transmit plan contributions to the insurer or custodian within a reasonable period of time (for example, within 15 business days in the case of employee salary deferrals).

If your plan is subject to ERISA, the timing of your contributions must also meet Department of Labor requirements. In general, employers of all sizes must transmit employee contributions to their 403(b) plans as soon as they can reasonably be segregated from the employer’s general assets, but no later

than the 15th business day of the month following the month in which contributions are received or withheld by the employer. Employers that sponsor a plan covering fewer than 100 participants (small plans) are deemed to be in compliance with the deposit rules if contributions are paid to the plan within seven business days of receipt or withholding.

File the appropriate annual report with the IRS

If your 403(b) plan is subject to ERISA, you may need to file an annual report (Form 5500 series) with the IRS and DOL. You may also be required to file audited financial statements with your Form 5500.

Questions & Answers

Which employees are eligible to participate in a 403(b) plan?

Generally, if you allow any employee to make elective deferrals to your 403(b) plan, then you must allow all your employees to make elective deferrals. This is called the “universal availability” rule. You may, however, elect to exclude certain employees, including:

  • Employees who normally work fewer than 20 hours per week
  • Employees who participate in another eligible deferred compensation plan, such as a 401(k) plan or a Section 457 plan
  • Employees who are nonresident aliens with no U.S. source income
  • Certain employees who are students and work for a university
  • Employees whose annual elective deferrals would total $200 or less
  • Tip

The final regulations clarify that an employee normally works fewer than 20 hours per week if, and only if:

  • The employer reasonably expects the employee to work fewer than 1,000 hours in the 12-month period beginning on the employee’s hire date, and
  • For each subsequent 12-month period, the employee actually worked less than 1,000 hours in the previous 12-month period. (Employers can use plan years as the measuring period instead.)

An employee is treated as being able to make elective deferrals only if the employee has an “effective opportunity” to make such deferrals. Whether an employee has an effective opportunity to defer is based on all of the relevant facts and circumstances, including notice of the availability of the election, the period of time during which an election may be made, and any other conditions on elections. This “effective opportunity” requirement is not satisfied unless you allow an employee to make or change an elective deferral at least once during each plan year.

  • Tip

The universal availability rule does not apply to church plans.

  • Tip

The universal availability rule applies separately to each common law employer (even if the employers are members of the same controlled group), and in some cases can even be applied separately to geographically distinct and independent operating units of an employer.

  • Caution
The universal availability rule requires that if any employee is allowed to make Roth contributions to the plan, then all employees must be allowed to make Roth contributions.
  • Caution

The universal availability rule also generally requires that all employees be able to defer the statutory maximum amount or, if less, at least as much as any other employee can defer under his or her 403(b) contract.

  • Caution

No right or benefit (other than employer matching contributions) can be conditioned on your employee’s making or not making elective deferrals.

A 403(b) plan can only cover the employees of an eligible employer (with the exception of certain self-employed ministers). Independent contractors are not considered employees, and are therefore generally not eligible to participate in a 403(b) plan. Employee status under Section 403(b) is generally determined by employee status for federal employment tax purposes under common law principles. Whether an individual is a common law employee or independent contractor is most likely to arise with professionals such as physicians. See the 20 steps for determining employee status in Rev. Rul. 87-41, 1987-1 C.B. 296.

Can an employee who makes salary-reduction contributions to a 403(b) plan also make tax-deductible contributions to a traditional IRA?

Possibly. In most cases, when a traditional IRA owner is not covered by an employer-sponsored retirement plan, his or her contributions to the traditional IRA are fully tax deductible for federal income tax purposes. However, when the traditional IRA owner (or his or her spouse) is covered by such a plan [including a 403(b) plan], the ability to make tax-deductible IRA contributions may be limited or even phased out entirely. The amount of the tax deduction (if any) would depend on the IRA owner’s federal income tax filing status and modified adjusted gross income (MAGI) for the year. [Note that employees can generally make after-tax contributions to a traditional IRA regardless of how much they earn, and regardless of whether they (or their spouse) are covered by an employer sponsored retirement plan.]

Can an employee who makes salary-reduction contributions to a 403(b) plan also contribute to a Roth IRA?

Yes, participation in a 403(b) plan has no impact on an employee’s ability to contribute to a Roth IRA. However, annual contributions to a Roth IRA may be limited depending on your employee’s filing status and modified adjusted gross income (MAGI) for the year.

When do employees vest in their 403(b) plan accounts?

Vesting is the process by which participants in a 403(b) plan or other retirement plan earn the right to nonforfeitable benefits under the plan. A 403(b) plan participant is always 100% vested in his or her elective deferrals, and any investment earnings on those amounts. Participants need not be immediately vested in your employer contributions (matching or discretionary contributions). But if your plan is subject to ERISA, then you must comply with that law’s minimum vesting standards.

Those standards require that employer contributions either (1) vest 100% after three years of service (“cliff vesting”), or (2) vest 20% for each year of service beginning with the participant’s second year of service and ending with 100% after six years of service (“graded” or “graduate” vesting). Of course, your vesting schedule can always be less (but not more) restrictive than ERISA’s requirements.

  • Tip

Although Section 403(b) plans are allowed to impose a vesting schedule on employer contributions, some employers choose not to do so because they would rather avoid the additional administration a vesting schedule entails. For example, nonvested employer contributions are not treated as 403(b) assets, and must be separately accounted for, until they vest. (Nonvested amounts are subject to the rules of IRC Section 403(c), governing nonqualified annuities, until they vest.) Also, employers who impose a vesting schedule on employer contributions may not be able to adopt a prototype 403(b) plan. In addition, employer contributions to 403(b) plans do not count as annual additions until they vest, complicating administration of the plan’s Section 415 annual additions limit.

Do you need to have the IRS approve your 403(b) plan?

You do not need to obtain IRS approval for your 403(b) plan. As noted above, you can adopt a pre-approved plan, and generally have assurance that your plan document complies with IRC Section 403(b). Alternatively, you can have a plan document drafted specifically for your organization, and seek a private letter ruling from the IRS if you want assurance that your plan meets applicable laws.

Is a 403(b) plan subject to the required minimum distribution rules of IRC Section 401(a)(9)?

  • Note

Required minimum distributions for defined contribution plans (other than Section 457 plans for nongovernmental tax-exempt organizations) and IRAs have generally been suspended for 2020. The waiver includes distributions for 2019 with an April 1, 2020, required beginning date that were not taken in 2019.

Yes. Participants in a 403(b) plan are generally subject to the same required minimum distribution rules that apply to IRAs. Required minimum distributions (RMDs) are amounts that a participant must withdraw annually from his or her plan account, beginning no later than April 1 of the year following the year in which age 70½ (age 72 if attain age 70½ after 2019) is reached or, if later, April 1 of the year following the year of the participant’s retirement from the employer maintaining the plan (the participant’s “required beginning date,” or RBD).

  • Caution

A 5% owner’s RBD is April 1 of the calendar year following the year in which the employee attains age 70½ (age 72 if attain age 70½ after 2019).

If your employee has more than one Section 403(b) annuity contract, a required distribution is calculated separately for each contract. These amounts are then added together to determine the employee’s RMD for the year. The employee can withdraw the RMD from any one or more of the 403(b) annuity contracts. Section 403(b) contracts an individual owns as an employee are treated separately from 403(b) contracts an individual holds as beneficiary for purposes of calculating RMDs. These rules are similar to the rules that apply to taxpayers with more than one traditional IRA.

  • Tip

The RMD rules do not apply to 403(b) account balances that existed on December 31, 1986 (“old money”). However, any post-1986 earnings, and any new contributions after 1986, are subject to the RMD rules. Pre-1987 balances that are transferred to another 403(b) plan in a plan-to-plan transfer will retain their grandfathered status. However, if an employee receives a distribution and then makes a rollover (including a direct rollover) to another 403(b) plan, that grandfathered status will be lost. Any distributions in excess of required distributions for a year are deemed to reduce the employee’s pre-1987 balance.

  • Caution

While the IRC Section 401(a)(9) RMD rules do not apply to the December 31, 1986, 403(b) contract balance, those amounts must still be distributed in accordance with the “incidental benefit requirement” of Treasury regulation 1.401-1(b)(1)(I). Refer to Treasury Regulation Section 1.403(b)-6(e) for further information.

Are 403(b) plans subject to discrimination testing?

The answer depends on the type of contribution, and the type of employer sponsoring the plan. Church plans are exempt from all nondiscrimination testing requirements (including the effective availability rule described above in “Which employees are eligible to participate in a 403(b) plan?”).

Governmental plans are exempt from all nondiscrimination requirements except the effective availability rule. Governmental plans must also comply with IRC Section 401(a)(17), which limits the amount of compensation that can be taken into account when an employer determines its contribution for an employee under the plan ($280,000 for 2019, up from $275,000 in 2018).

For all other 403(b) sponsors, employee elective deferrals must satisfy the effective availability rule, and employer contributions and employee after-tax contributions must satisfy the nondiscrimination rules generally applicable to employer qualified plans. These include IRC Section 401(a)(4), which generally prohibits employer discretionary contributions that discriminate in favor of highly compensated employees, Section 401(a)(17) (limiting compensation that can be taken into account), Section 401(m) (which prohibits employee after-tax contributions and employer matching contributions from discriminating in favor of highly compensated employees), and Section 410(b) (which prohibits discrimination with respect to plan participation).

  • Caution

Employee pre-tax deferrals are not subject to the “ADP test” (average deferral percentage test) that applies to pre-tax contributions to 401(k) plans. The effective availability test applies instead. However, employee after-tax contributions and employer matching contributions are subject to the same “ACP test” (average contribution percentage test) that applies to 401(k) plans.

  • Tip

You don’t have to perform ACP testing if you create a “safe harbor” 403(b) plan. See below.

  • Tip

You don’t have to perform ACP testing if your plan includes a “qualified auto enrollment program.” See “What is an automatic enrollment arrangement?,” below.

What is a safe harbor 403(b) plan?

A safe harbor 403(b) plan is one that, by design, satisfies the ACP test that applies to employer matching contributions. The safe harbor requires that you make a fully vested contribution equal to either:

  • A dollar-for-dollar match of all non-highly compensated employee deferrals up to 3% of compensation and 50-cents-on-the-dollar match of deferrals between 3% and 5% of compensation, or
  • 3% of compensation for all non-highly compensated employees, regardless of whether these employees contribute to the plan

Employers using the safe harbor 403(b) rules must give each eligible employee a written notice of the employee’s rights and obligations under the plan that satisfies specific content and timing requirements.

What is an automatic enrollment arrangement?

Your plan can provide that employees will automatically be enrolled in your 403(b) plan as soon as they become eligible. Your employee will then have to affirmatively elect not to participate in the plan. There are several different types of automatic enrollment arrangements.

A basic automatic enrollment arrangement must state that employees will be automatically enrolled in the plan unless they elect otherwise and must specify the percentage of an employee’s wages that will be automatically deducted from each paycheck for contribution to the plan. The document must also explain that employees have the right to elect not to have salary deferrals withheld or to elect a different percentage to be withheld.

An eligible automatic contribution arrangement (EACA) is similar to the basic automatic enrollment plan but has specific notice requirements. An EACA can allow automatically enrolled participants to withdraw their contributions within 30 to 90 days of the first contribution.

A qualified automatic contribution arrangement (QACA) is a type of automatic enrollment arrangement that automatically passes IRS ACP discrimination testing requirements. The plan must include certain required features, such as automatic employee contributions (including annual increases), fully vested employer contributions [generally, the same as the contribution required in a safe-harbor 403(b) plan], and specific notice requirements.

What is a highly compensated employee?

For 2020, a highly compensated employee is an individual who:

  • Had compensation in 2019 in excess of $125,000 (and, if the employer elects to adopt this additional requirement, was in the top 20% of employees in terms of compensation for that year), or*
  • Was a 5% owner of the employer during 2019 or 2020

* Limit rises to $130,000 in 2020

Can funds in a 403(b) plan be transferred to another 403(b) investment while a participant is still employed?

The final regulations provide for three specific kinds of nontaxable exchanges or transfers of amounts in Section 403(b) contracts. Specifically, a nontaxable exchange or transfer is permitted if: (1) it is a mere change of investment within the same plan (that is, a “contract exchange”); (2) it constitutes a plan-to-plan transfer, so that there is another employer plan receiving the exchange; or (3) it is a transfer to purchase permissive service credit (or a repayment to a defined benefit governmental plan). Any other exchange or transfer is treated as a taxable distribution of benefits if the exchange occurs after a distributable event (assuming the distribution is not rolled over to an eligible retirement plan) or as a taxable conversion to a Section 403(c) nonqualified annuity contract if a distributable event has not occurred.

A contract exchange (that is, a permissible change of investment within the same plan) is allowed only if it satisfies certain conditions in order to facilitate compliance with tax requirements. Specifically, the new contract must include distribution restrictions that are not less stringent than those imposed on the contract being exchanged. In addition, the employer must enter into an agreement with the issuer of the new contract under which the employer and the issuer will from time to time in the future provide each other with certain information. This includes information concerning the participant’s employment and information that takes into account other Section 403(b) contracts or qualified employer plans, such as whether a severance from employment has occurred for purposes of the distribution restrictions and whether the hardship withdrawal rules in the regulations are satisfied. Additional information that is required is information necessary for the resulting contract or any other contract to which contributions have been made by the employer to satisfy other tax requirements, such as whether a plan loan constitutes a deemed distribution under Section 72(p). The regulations also permit an employer to transfer 403(b) assets from one vendor to another without employee consent.

Under the final regulations, 403(b) plan-to-403(b) plan transfers are permitted if the participant whose assets are being transferred is an employee or former employee of the employer (or business of the employer) that maintains the receiving plan and certain additional requirements are met. [Plan-to-plan transfers to a qualified plan, a Section 457(b) plan, or any other type of plan that is not a Section 403(b) plan, are generally prohibited.]

  • Caution

Participants should determine whether any surrender charges apply before transferring out of a 403(b) investment.

What happens if a contract fails to satisfy Section 403(b)'s requirements?

While a full discussion is beyond the scope of this article, in general, if a contract fails to satisfy the requirements of Section 403(b), then beginning with the year of failure all employee pre-tax contributions and vested employer contributions to the plan are included in the affected employee’s gross income. Employer contributions that haven’t yet vested are included in the employee’s gross income when they vest. Earnings that have accrued in a custodial account are also generally included in income (earnings in an annuity contract are generally not included in income until actually distributed).

Distributions from a failed contract are not eligible for rollover. Section 403(b) failures may also result in additional income tax withholding, FICA taxes, FUTA taxes, and excise taxes.

If a contract fails to satisfy Section 403(b), then not only that contract, but any other contract you’ve purchased for that employee, would also fail to be a Section 403(b) contract. If a 403(b) plan fails to have a required written plan document, or if the plan is adopted by an ineligible employer, or if the plan fails to satisfy applicable nondiscrimination rules, then none of the contracts issued under the plan would qualify as a Section 403(b) contract.

Generally, any operational failure other than those described above that is solely within a specific employee’s contract (for example, the employer permits the employee to defer more than allowed to plans maintained by that employer) will generally not impact contracts purchased for other employees.

The consequences of failing to satisfy contribution limits that apply to 403(b) plans are discussed above in “Contribution limits.”

  • Tip

You may be able to avoid the loss of Section 403(b) status for your plan (or for particular contracts within your plan), and the related adverse tax consequences, if you correct the plan defects on a timely basis. The IRS has established a comprehensive program for correcting retirement plan [including 403(b) plan] problems. The rules governing that program, the Employee Plans Compliance Resolution System (EPCRS), are currently found in Revenue Procedure 2013-12.

Do you have fiduciary responsibility for your employees' 403(b) accounts?

  • Caution

This section assumes that your 403(b) plan is subject to ERISA. Special considerations apply to plans that are not subject to that law.

Self-directed plans and ERISA Section 404(c)
You (or the applicable plan fiduciary) have a fiduciary responsibility to exercise care and prudence in the selection and appropriate diversification of plan investments. Failure to meet that duty could result in your liability to the plan for any losses incurred. You may even have liability for imprudent investment choices by your employees if your plan allows participants to select the investments in their account (“self-directed plans”). However, you may be able to limit your liability for investment losses that occur as a result of a participant’s exercise of investment control over his or her own account if you satisfy the requirements of Section 404(c) of ERISA. Section 404(c) requires that you:

  • Allow participants to choose from a broad range of investments with different risk and return characteristics
  • Allow participants to give investment instructions at least as often as every three months
  • Give participants the ability to diversify investments generally and within investment categories, and
  • Give each participant sufficient information to make informed investment decisions.

Default investments
If you adopt an automatic enrollment arrangement (for example, a QACA), you may have situations where a participant is contributing to the plan, but has not yet made an affirmative investment election. If your employee has not made an affirmative investment election you (or the applicable plan fiduciary) may have a fiduciary duty under ERISA to invest automatic enrollment contributions in a prudent manner for that participant, and you could be liable for investment losses if your plan’s default investments are deemed imprudent. However, you can avoid this potential liability if your plan’s default investments are “qualified default investment arrangements,” (QDIAs) as defined by U.S. Department of Labor (DOL) regulations. For more information on QDIAs, visit the DOL web site.

Several additional requirements must also be satisfied:

  • Participants must have been given an opportunity to provide investment direction, but have not done so
  • A notice generally must be furnished to participants in advance of the first investment in the QDIA and annually thereafter
  • Participants must have the opportunity to direct investments out of a QDIA as frequently as from other plan investments, but at least quarterly
  • DOL regulations limit the fees that can be imposed on a participant who opts out of participation in the plan or who decides to direct their investments
  • The plan must offer a broad range of investment alternatives, as defined in the DOL’s regulation under section 404(c) of ERISA
  • Caution

The DOL regulations do not absolve plan fiduciaries of the duty to prudently select and monitor QDIAs.

Investment education
If you sponsor a self-directed plan, you may assume an additional responsibility — participant education. A balance must be struck between providing not enough — or too much — investment educational support for plan participants. Too much and you could be considered to be providing investment advice, and become legally responsible for your employees’ investment decisions. Employee education is an issue to be carefully considered when implementing a qualified retirement plan.

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