Section 403(b) Plan Design and Compliance
(Posted on December 5, 2018 by )


Go to: 403(b) Plan Overview | Eligible Employers and Employees | ERISA Coverage of 403(b) Plans | Qualification Requirements | 403(b) Plan Contributions | 403(b) Plan Distributions | Implementation and Operation | Correcting 403(b) Plan Errors | Terminating 403(b) Plans | EP Subcommittee Report: 403(b) Plan Issues and Recommendations | Advantages and Disadvantages of 403(b) Plans

This practice note discusses the rules that apply when eligible tax-exempt organizations (or their employees) establish tax-sheltered annuities, custodial accounts, or retirement income accounts, as described in Section § 403(b) of the Internal Revenue Code (403(b) plans). While all employers are eligible to set up a defined benefit plan, and most tax-exempt nongovernmental employers are eligible to set up 401(k) plans, 403(b) plans are another option for certain tax-exempt and governmental organizations. These organizations may establish a 403(b) plan (sometimes called a tax-sheltered annuity plan or a TSA), which can fulfill most of the functions of a qualified plan, including allowing for pre-tax employee elective contributions, while offering various advantages to employers over a traditional qualified plan design.
This practice note addresses the following topics:

For more information on 403(b) plans, see Employee Compensation and Benefits Tax Guide ¶ 502.14 and the IRS website resource for 403(b) plans.

403(b) Plan Overview

A 403(b) plan is a type of retirement plan providing for deferred taxation on certain contributions and earnings made by specific kinds of tax-exempt organizations (primarily, public schools and 501(c)(3) tax-exempt organizations) for their employees and by certain ministers. I.R.C. § 403(b)(1). For the participant, a 403(b) plan appears much like a 401(k) plan in that it provides for an individual account for each participant. However, 403(b) plan investment options are more limited. 403(b) plans are subject to some, but not all of the requirements that apply to 401(k) and other retirement plans qualified under I.R.C. § 401(a). A 403(b) plan can allow employees, the employer, or both to contribute to the plan. Also, like a 401(k) plan, a 403(b) plan can include a qualified Roth contribution program.

Although 403(b) plans have been around in some form for over 50 years, the Treasury Department only issued final regulations under I.R.C. § 403(b) in 2007, which generally became effective in 2009. 72 Fed. Reg. 41,127 (July 26, 2007).

Eligible Employers and Employees

Only certain types of employees are eligible to participate in a 403(b) plan, essentially restricting 403(b) plan sponsors to certain tax-exempt organizations, schools (including colleges and universities) sponsored by state and local governments, and ministers or their employers or deemed employers. If a plan permits ineligible employees to participate, the plan may lose its tax-favored status (unless a correction is made under the IRS Employee Plans Correction Resolution System (EPCRS); see Correcting 403(b) Plan Errors later in this practice note).

The following types of employees are eligible to participate in a 403(b) plan:

  • 501(c)(3) employees. Employees of tax-exempt organizations established under I.R.C. § 501(c)(3) and cooperative hospital service organizations (501(c)(3) organizations), as described further below.
  • School employees. Individuals who are (1) involved in the daily operations of a public school, college, or university that is sponsored by a state, local, or Indian tribal governmental body (public school systems), as described further below under “Public School Systems” or (2) civilian faculty and staff of the Uniformed Services University of the Health Sciences. See below for further discussion.
  • Ministers. Ministers described in I.R.C. § 414(e)(5), provided they are:
    • Employed by a 501(c)(3) organization
    • Self-employed –or–
    • Not employed by a 501(c)(3) organization, but functioning as a minister in their daily responsibilities with their employer, such as a chaplain for a state-run prison

I.R.C. § 403(b)(1)(A); 26 C.F.R. § 1.403(b)-2(b); I.R.S. Maintaining Eligibility to Sponsor a 403(b) Plan.

501(c)(3) Organizations

All 501(c)(3) organizations must be organized and operated exclusively for a purpose that is:

  • Charitable
  • Religious
  • Educational
  • Scientific
  • Literary
  • For public safety testing
  • For fostering national or international amateur sports competition –and/or–
  • For preventing cruelty to children or animals

I.R.C. § 501(c)(3).

Other 501(c)(3) organization requirements are that none of its earnings may inure to any private shareholder or individual, and the entity may not attempt to influence legislation as a substantial part of its activities nor participate in any campaign activity for or against political candidates. In addition, assets of the organization must be permanently dedicated to an exempt purpose and, upon dissolution, the assets must be distributed for a charitable purpose. 26 C.F.R. § 1.501(c)(3).

Most 501(c)(3) organizations (or their parent organizations) are required to have an IRS determination as to their status. There is an exception for filing for church and related organizations (and other I.R.C. § 508 excepted organizations) and entities organized before October 9, 1969. An online search tool providing a list of organizations with determination letters can be found on the IRS website at EO Select Check. Information regarding the application process is available in I.R.S. Publication 557, Tax Exempt Status for Your Organization.

A cooperative hospital service organization described in I.R.C. § 501(e) is treated as if it were a 501(c)(3) organization if it is organized and operated solely to perform on a centralized basis certain services for two or more tax-exempt or governmental hospitals. Rev. Rul. 72–329, 1972–2 C.B. 226.

Public School Systems

A public school system eligible to adopt a 403(b) plan is a state-sponsored educational organization that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. Included in this category are employees of public schools and state colleges or universities. 26 C.F.R. § 1.403(b)-2(b)(14).

The employer must be a state, a political subdivision of a state, or an agency or instrumentality of one of these. I.R.C. 403(b)(1)(A)(ii). Implementing regulations interpret “state” to include the District of Columbia and Indian tribal governments as provided under I.R.C. § 7871(a)(6)(B). 26 C.F.R. § 1.403(b)-2(b)(20).

Both faculty and nonacademic staff (e.g., custodial staff) performing services for the educational organization may be covered by the 403(b) plan, but elected or appointed officials (holding positions in which persons that are not education professionals may serve) are not eligible. Members of the school board and university regents or trustees are not eligible. 26 C.F.R. § 1.403(b)-2(b)(10). Additional guidance on this issue may be found in the I.R.S. 403(b) Plan Fix-It Guide.

Employers Not Permitted to Adopt 403(b) Plans

Adoption of a purported 403(b) plan by an organization not qualified to adopt one is a common violation of the I.R.C. § 403(b) rules. Correction under the IRS EPCRS program (discussed below) can preserve the tax-deferred status of contributions made prior to the discovery of ineligibility.

When analyzing employer eligibility, several special situations should be considered:

  • Non-501(c)(3) organizations, even if tax exempt. Only a 501(c)(3) organization can adopt a 403(b) plan. Organizations that are tax exempt under another subparagraph of I.R.C. § 501(c) are not eligible employers. Examples of ineligible employers are trade associations exempt under I.R.C. § 501(c)(6) and unions exempt under I.R.C. § 501(c)(5).
  • Governmental organizations other than public school systems. A governmental organization can adopt a 403(b) plan only if it is a public school system, as described above, with the following exceptions:
    • A governmental organization that is also a 501(c)(3) organization can maintain a 403(b) plan. An organization affiliated with government may qualify for I.R.C. § 501(c)(3) exemption if it is separately incorporated or formed to accomplish one or more exempt purposes. For example, a public hospital may receive 501(c)(3) status. However, an organization may not
      obtain 501(c)(3) status if it has governmental regulatory or enforcement powers that would be beyond those permitted by an organization described in I.R.C. § 501(c)(3).
    • A governmental organization can have mixed functions. For example, a prison would not normally be a public school, and therefore could not maintain a 403(b) plan for its employees. However, employees of the education section of a prison (designed to provide educational opportunities to prisoners) could participate in a 403(b) plan. I.R.S. General Couns. Memo. 38666 (Mar. 27, 1981).
  • Nonqualifying affiliates of a 403(b) plan authorized entity. An affiliate of an organization authorized to maintain a 403(b) plan cannot participate in the plan unless the affiliate also would be an eligible employer. For example, it is common for a private university described in I.R.C. § 501(c)(3) to own a taxable technology start-up to engage in commercialization of
    university-based research. Even though the technology company is wholly owned by the university, and its earnings are paid as dividends to the university, employees of the technology company cannot participate in a 403(b) plan. To the extent that some employees may divide their time between the university and its taxable affiliate, only their compensation from the
    university can be counted for purposes of the 403(b) plan.

ERISA Coverage of 403(b) Plans

Most private employer-sponsored 403(b) plans are subject to the Employee Retirement Income Security Act (ERISA), which has several requirements that parallel rules for qualified defined contribution and qualified defined benefit plans under the Internal Revenue Code, but don’t otherwise directly apply to 403(b) plans, including:

  • Vesting rules under ERISA § 203(a)(2)(B) (29 U.S.C. § 1053(a)(2)(B)) and I.R.C. § 411(a)(2)(B)
  • Asset transfer rules under ERISA § 208 (29 U.S.C. § 1058) and I.R.C. § 414(l)
  • Qualified joint and survivor annuity rules under ERISA § 205 (29 U.S.C. § 1055) and I.R.C. § 401(a)(11)
  • Anti-cutback rules as applied to transfers under ERISA § 204(g) (29 U.S.C. § 1054(g)) and I.R.C. § 411(d)(6)

So, 403(b) plans that are subject to ERISA must also comply with these rules as well as ERISA’s reporting and disclosure requirements, and—perhaps more significantly—such 403(b) plan sponsors are subject to ERISA’s fiduciary and prohibited transaction rules, unless an exemption applies.

For further information on ERISA reporting requirements, see Dep’t of Labor Field Assistance Bulletin 2009-02 (July 20, 2009) and Field Assistance Bulletin 2010-01 (Feb. 17, 2010) (hereinafter, FAB 2010-01).

ERISA fiduciary status may be a particular area of concern in light of recent litigation targeting several university 403(b) plans asserting breaches of fiduciary duty. E.g., Vellali, et al. v. Yale University, et al. 3:16-cv-01345 (D. Conn.), Sacerdote, et al. v. New York University 1:16-cv-06248 (S.D.N.Y.); Sweda, et al. v. The University of Pennsylvania, et al. 2:16-cv-04329 (E.D. Pa.); Clark, et al. v. Duke University, et al. 1:16-cv-1044 (M.D.N.C.); Munro, et al. v. University of Southern California, et al. 2:16-cv-06191 (C.D. Cal.).

Sponsor-Based Exemptions from ERISA Coverage

The ERISA rules do not apply to governmental plans or nonelecting church plans, which are generally exempt from ERISA. (Church plans may elect to be covered by ERISA.) ERISA § 4(b)(1), (2) (29 U.S.C. § 1003(b)(1), (2).

Non-ERISA 403(b) Plans

An exemption from ERISA Title I (governing reporting and disclosure, participation and vesting, funding, and fiduciary requirements) is available even for 403(b) plan sponsors that are subject to ERISA if the arrangement meets certain requirements that minimize employer involvement (non-ERISA 403(b) plans). A non-ERISA 403(b) plan is a program with limited employer involvement that provides for the purchase of annuity contracts or custodial accounts invested solely in mutual funds that is not recognized as an ERISA § 3(2)(A) employee pension benefit plan because it is not treated as “established or maintained by an employer.” 29 C.F.R. § 2510.3-2(f); see Dep’t of Labor Field Assistance Bulletin 2007-02 (July 24, 2007) (hereinafter, FAB 2007-02); FAB 2010-01.

Department of Labor (DOL) regulations provide safe harbor rules for non-ERISA 403(b) plans. To qualify for the safe harbor, the 403(b) plan must satisfy the following requirements:

  • Voluntary participation. Participation in the plan must be completely voluntary for employees.
  • Employee enforceability. All rights under the arrangement are enforceable solely by the employee, a beneficiary of the employee, or an authorized representative of the employee or beneficiary.
  • Restricted employer involvement. The sole involvement of the employer must be limited to the following activities:
    • Permitting annuity contractors (including any agent or broker who offers annuity contracts or who makes available custodial accounts) to publicize their products to employees
    • Requesting information concerning proposed funding instruments or annuity contractors
    • Summarizing information on funding instruments or annuity contractors for employee review and analysis
    • Collecting contributions as required by salary reduction agreements or by agreements to forego salary increases, remitting such contributions to annuity contractors, and maintaining records of such amounts (i.e., no employer contributions are permitted)
    • Holding in the employer’s name one or more group annuity contracts (including the right to act as an employee representative for contract amendments)
    • Limiting the funding instruments made available to employees, or the annuity contractors who may approach employees, in a manner designed to afford employees a reasonable choice in light of all relevant circumstances (described further below)
  • No employer compensation. The employer receives no direct or indirect consideration or compensation, in cash or otherwise, except reasonable compensation to cover expenses properly and actually incurred in the performance of its duties pursuant to the salary reduction agreements or agreements to forego salary increases.

29 C.F.R. § 2510.3-2(f).

The circumstances that may be considered by an employer desiring to limit the non-ERISA 403(b) plan funding media or products or annuity contractors include (but are not limited to):

  • The number of employees affected
  • The number of contractors who have indicated interest in approaching employees
  • The variety of available products
  • The terms of the available arrangements
  • The administrative burdens and costs to the employer
  • The possible interference with employee performance resulting from direct solicitation by contractors

Id.

Note that the non-ERISA 403(b) plan safe harbor covers only arrangements that are limited to employee elective deferrals. There can be no employer contributions of any kind. 29 C.F.R. § 2510.3-2(f)(3)(iv). The DOL has provided guidance on other issues concerning the safe harbor, as discussed in the following sections.

Employer Administrative Reviews Permitted for Non-ERISA 403(b) Plans

Certain employer activities designed to ensure that a 403(b) plan continues to be tax compliant under I.R.C. § 403(b) are permissible activities that will not take a non-ERISA 403(b) plan out of the safe harbor. This is because employers have an interest separate from acting as their employees’ authorized representatives in ensuring that the 403(b) plan’s annuity contracts and custodial accounts are tax compliant. Specifically, for example, the employer can be liable to the IRS for potentially substantial penalty taxes, correction fees, and employment taxes on employee salary deferrals for noncompliance, even if the violation was caused by an employee or annuity contractor. Thus, an employer’s compliance monitoring activities are consistent with the safe harbor (including in correcting errors). FAB 2007-02; FAB 2010-01; Dep’t of Labor Information Letter (Feb. 27, 1996).

However, to clearly indicate the employer’s limited involvement in the plan, where the written plan document allocates responsibility for performing administrative functions to persons other than the employer, the relevant document(s) should identify the parties that are responsible for administrative functions, including those related to tax compliance. The documents should delineate the employer’s limited role in the activity and allocate discretionary determinations to the annuity provider or participant or other third party selected by the provider or participant. FAB 2007-02; FAB 2010-01.

Impermissible Employer Discretion in Non-ERISA 403(b) Plans

If the employer exercises discretion in administering the plan, it may be deemed to have taken over control as the plan sponsor, resulting in the loss of ERISA Title I exemption (unless it is a governmental or nonelecting church plan, exempt from Title I requirements). Such prohibited exercises of discretion include determinations authorizing, directly or indirectly through a third-party administrator:

  • Administering distributions, including hardship distributions, domestic relations orders, and processing participant loans
  • Satisfying applicable qualified joint and survivor annuity requirements –or–
  • Plan-to-plan transfers or contract exchanges

FAB 2007-02; FAB 2010-01; Dep’t of Labor Adv. Op. 94-30A (Aug. 19, 1994).

Thus, maintaining a non-ERISA 403(b) plan’s exemption from ERISA is practical only if the annuity and/or custodial account providers are willing to take on the bulk of administrative duties under the plan, and the employer is willing to concede control of most plan functions to them. As discussed below, this can lead to compliance issues because each vendor is typically unaware of what other vendors are doing.

Qualification Requirements

The following sections outline the qualification rules for all 403(b) plans to be eligible for tax-favored status under 26 C.F.R. § 1.403(b)-3:

  • Funding restrictions
  • Written document requirement
  • Nondiscrimination rules
  • Contribution and benefit rules and limitations
  • Rollover distribution requirements
  • Required minimum distribution rules
  • Nontransferability rule

These rules are separate from any requirements under ERISA, which would also apply to 403(b) plans that are subject to ERISA (see the discussion in the previous section, ERISA Coverage of 403(b) Plans, regarding non-ERISA 403(b) plans). See 403(b) Plan Distributions for further discussion on distribution requirements.

Funding Restrictions

There are only three categories of funding arrangements that can be used for a 403(b) plan:

  • Annuity contracts (26 C.F.R. §§ 1.403(b)-2(b)(2), -8(c)). Generally, 403(b) plan annuity contracts must be issued by a state-regulated insurance company and offer an annuity form of benefit.
  • Custodial accounts (I.R.C. § 403(b)(7) and 26 C.F.R. § 1.403(b)-8(d)). These are separate accounts that must be held by a financial institution described in I.R.C. § 401(f)(2) and:
    • Be invested solely in mutual funds
    • Comply with the 403(b) plan distribution limitations (described under 403(b) Plan Distributions below)
    • Be operated for the exclusive purpose of providing benefits for participants or their beneficiaries –and–
    • Meet the rules in 26 C.F.R. § 1.403(b)-8(d)(2) regarding distribution limitations
  • Church retirement income accounts (I.R.C. § 403(b)(9) and 26 C.F.R. § 1.403(b)-9). Church sponsors of 403(b) plans may use retirement income accounts to fund plan benefits, which allow for increased investment flexibility. They must:
    • Be maintained under a separate accounting
    • Limit benefits only to gains or losses on invested assets
    • Be operated for the exclusive purpose of providing benefits for participants or their beneficiaries

26 C.F.R. § 1.403(b)-8.

Unlike a qualified plan, a 403(b) plan (other than certain grandfathered self-insured state and local government 403(b) plans or a church retirement income account) cannot be funded through a trust that holds stocks, bonds, or other investments. See 26 C.F.R. §§ 1.403(b)-8(c)(3), -9.
The 403(b) plan must specify which specific contracts will be available under the plan. The issuers of such contracts are known as approved vendors.

Written Document Requirement

A 403(b) plan must be documented in a written defined contribution plan that satisfies certain regulatory requirements and be operated in compliance with the plan. Specifically, the written plan document must set forth all the material terms and conditions regarding the following:

  • Eligibility
  • Contributions and benefits
  • Contribution limitations
  • Contracts available under the plan (approved vendors) –and–
  • Time and form of benefit distributions (including rules for rollover and required minimum distributions)

26 C.F.R. § 1.403(b)-3(b)(3)(i).

The plan also may set forth certain optional features that are consistent with but not required under I.R.C. § 403(b). These include:

  • Hardship withdrawals
  • Plan loans
  • Plan-to-plan transfers (or from annuity contract to annuity contract) –and–
  • Acceptance of rollovers to the plan

Id.

As provided in the final regulations, the existence of a written plan facilitates the allocation of plan responsibilities among the employer, the issuer of the contract, and any other parties involved in implementing the plan. Without such a central document for a comprehensive summary of responsibilities, there is a risk that many of the important responsibilities required under the statute and final regulations may not be allocated to any party. Failure to adopt a written plan document, or to follow its terms, is a common plan defect that is correctable under the IRS EPCRS program. See Correcting 403(b) Plan Errors.

Multiple Documents

The written plan document can consist of more than one document. That is, plans are permitted to incorporate other documents, such as annuity contracts and custodial agreements. 26 C.F.R. § 1.403(b)-3(b)(3)(ii).

Considerations for Non-ERISA 403(b) Plan

Consider advising a tax-exempt employer that wishes to maintain non-ERISA 403(b) plan status to exclude from its written plan document any provisions concerning hardship withdrawal distributions, loans, plan-to-plan transfers, and acceptance of rollovers. Employer involvement in those activities can jeopardize the non-ERISA 403(b) plan status. These provisions may appear instead in the annuity contract, custodial account agreement, or other ancillary document prepared by the third party administering the relevant aspect of the arrangement. Under the safe harbor rules, the employer could presumably limit the funding media or products available to employees, or the annuity contractors who may approach employees, to ones that agreed to include and administer such provisions. 29 C.F.R. § 2510.3-2(f)(3)(vii); FAB 2007-02.

Model Language

The IRS has provided model language for 403(b) plans designed to satisfy requirements under I.R.C. § 403(b) for public school sponsors, which can be modified for other types of eligible employers. Rev. Proc. 2007-71, 2007-2 C.B. 1184 (see March 2015 revised version available on the IRS website). See also the section entitled “Pre-approved 403(b) Plans,” under Implementation and Operation below.

Nondiscrimination Rules

The section 403(b) nondiscrimination rules are designed to ensure that coverage under a 403(b) plan does not discriminate in favor of highly compensated employees. Church-sponsored 403(b) plans are exempt from these rules. I.R.C. § 403(b)(1)(D). Their application to other plans depends on whether the plan is maintained by a government or a private employer:

  • Governmental and private employer plans are subject to the universal availability rule for elective deferrals.
  • Private employer plans are also subject to similar nondiscrimination rules as defined contribution and defined benefit plans qualified under I.R.C. § 401(a).

Universal Availability for Elective Deferrals

Plans of governments and private employers (but not churches) that permit elective deferrals under their 403(b) plans must make them available to all employees, subject to the exceptions for excludable employees noted below. This is the case even if the employee has not met the plan’s age and service requirements for employer contributions. I.R.C. § 410(b)(12)(A)(ii); 26 C.F.R. § 1.403(b)-5.

Aggregation rules are as follows:

  • Individual 501(c)(3) organizations are treated separately, even if related to other 501(c)(3) entities.
  • Government employers are aggregated if they are part of a common payroll.
  • If an employer has historically treated geographically distinct units as separate for employee benefit purposes, then such units can be treated separately for universal availability but only if the unit is run independently on a day-to-day basis. An exception to this exception applies to units within the same Standard Metropolitan Statistical Area.

26 C.F.R. § 1.403(b)-5(b)(3).

Excludable Employees

Certain employee groups may be excluded (on a universally basis) from participation in a 403(b) plan without violating the universal availability rule:

  • Any employee not willing to contribute more than $200 per year
  • Employees who work less than 20 hours per week or any lower number stated in the plan document (I.R.C. § 403(b)(12)(A) (ii)), but only if:
    • The employer expects the employee to work fewer than 1,000 hours for the 12 months beginning on the date of hire, and
    • The employee does work fewer than 1,000 hours in each subsequent plan year (or, if the plan so provides, each subsequent 12-month period) thereafter
  • Employees eligible to make salary deferral contributions to another 403(b), government 457(b), or 401(k) plan of the employer
  • College work-study students described in I.R.C. § 3121(b)(10) –and–
  • Nonresident aliens with no U.S. source income

I.R.C. § 403(b)(12)(A); 26 C.F.R. §§ 1.403(b)-5(b)(3)(i), -5(b)(4)(ii).

Universal availability rule compliance is an issue for many 403(b) plans. For example, a school often hires substitute teachers whose work schedule is unpredictable. The employer may initially not permit elective deferrals based on an expectation they will work less than 20 hours per week and will not exceed 1,000 hours for they year (a permissible exception, as noted above). However, if this is done, the employer needs to carefully track actual hours to ensure that a substitute that ceases to qualify for an exempt category is given the opportunity to participate. As an alternative, many employers simply permit all employees, regardless of hours worked, to make elective deferrals.

In the past, several 403(b) plans misapplied the part-time employee exclusion by extending it to employees for any plan years where an employee did not meet the hours threshold during the immediately prior year, even if they had been permitted to contribute to the plan previously. The IRS has offered limited relief for such plans to bring their plans into compliance under the 403(b) remedial amendment period if they timely amend the plan in accordance with the transition relief and operate the plan in a manner compliant with the once-in-always-in rule for exclusion years beginning on or after January 1, 2019. I.R.S. Notice 2018-95, 2018 IRB LEXIS 617.

Notice Requirement

There is a notice component to the universal availability rule. Employers must provide all eligible employees with an annual notice concerning the opportunity to make salary deferrals to a 403(b) plan offering elective deferrals. The notice must also advise employees how they can make or change the amount designated for salary deferral purposes. I.R.C. § 403(b)(12)(A); 26 C.F.R. § 1.403(b)-5(b)(2).

No Contingent Benefits

Finally, the universal availability rule prohibits 403(b) plans from making an employee’s right to receive any employee benefit contingent on his or her decision to make an employee elective deferral contribution to the 403(b) plan (other than matching contributions, plan loan benefits relating to a deferral amount, or alternative benefits, credits, or cash under a cafeteria plan available in lieu of the 403(b) plan contribution).

Universal Availability Rule Compliance Review

Following are steps for universal availability compliance and monitoring:

  • Review the 403(b) plan document and administrator’s practices and procedures concerning universal availability.
  • Review eligibility rules generally for 403(b) plan compliance. Remember that employers cannot exclude employees based on job classifications, such as visiting professors or adjuncts, student workers or interns, substitute teachers, seasonal or temporary employees, administrative workers, bus drivers, custodial staff, cafeteria workers. Only individuals falling in a permissible excludable class under the terms of the plan can (and must) be excluded.
  • If part-time employees are excluded, establish procedures for determining excludable status and implement periodic testing to ensure the 20-hour-per-week and 1,000-hour-per-year rules continue to be satisfied for all excluded individuals.
  • Ensure the annual notice provides an accurate description of the 403(b) plan eligibility requirements and is distributed each year.

For a thorough discussion of issues relating to universal availability compliance, see the 2015 report by the Employee Plans Subcommittee of the IRS’s Advisory Committee on Tax Exempt and Government Entities (ACT), available at ACT, 2015 Report of Recommendations, pp. 28-38.

Other Nondiscrimination Rules

The plans of private employers, but not governments or churches, are subject to the same as the rules that apply to qualified plans under I.R.C. §§ 401(a)(4) (nondiscrimination in contributions and benefits), 401(a)(17) (compensation limit), 401(m) (matching and after-tax contributions), and 410(b) (minimum coverage). 26 C.F.R. §§ 1.414(c)-5(a)(1).

Unlike the universal availability rule, these nondiscrimination requirements apply on a related-entity basis under the employer aggregation rules of I.R.C. §§ 414(b), (c), (m), and (o), rather than just to the employer maintaining the plan. On their face, I.R.C. §§ 414(b) and (c), which define “controlled group,” apply only to controlled groups of corporations and two or more trades or businesses under common control. However, regulations take the position that these rules apply to tax-exempt organizations as well (other than churches) and provide rules for determining controlled group status in the case of tax-exempt organizations. 26 C.F.R. §§ 1.414(c)-5(a)(4), -5(b)(3).

Contribution and Benefit Rules and Limitations

Benefits under a 403(b) plan are based on contributions made and earnings thereon. The written plan document must specify the types of contributions allowed. 403(b) plan contributions are also subject to limitations, like other qualified plans. In the case of a private employer, such contributions must satisfy certain nondiscrimination requirements, as discussed in the previous section. As with employer contributions under a qualified plan, employer contributions, including those made by the employee under a salary reduction agreement, and earnings are not included in the employee’s income until distributed (except for after-tax and Roth contributions). I.R.C. § 403(b)(1).

A 403(b) plan can permit any or all of the following types of contributions, but the plan must specify which types are permitted:

  • Elective deferrals
  • Employer contributions (including matching, discretionary, and/or mandatory contributions)
  • Roth contributions
  • After-tax contributions
  • Rollover contributions

Each of these are described in the 403(b) Plan Contributions section below. A 403(b) plan may also provide for automatic enrollment. I.R.C. § 414(w).

Contribution Limits

Similar to contributions under 401(k) plans, contributions to 403(b) plans are subject to:

  • Maximum annual limits under I.R.C. § 402(g) on elective deferrals and Roth contributions
  • Maximum annual additions under I.R.C. § 415 on all types of contributions (other than rollovers)

Annual Limit on Elective Deferrals and Catch-Up Contributions

Elective deferral limit. The normal annual limit on elective deferrals plus contributions under an eligible Roth contribution program to a 403(b) plan is determined under the I.R.C. § 402(g) threshold, as adjusted for inflation ($18,000 in 2017), the same limit that applies to elective contributions under a 401(k) plan. I.R.C. §§ 402(g)(1)(A), 402A(c)(2); 26 C.F.R. § 1.403(b)-3(c). See the paragraph captioned “One-time election to exceed 402(g) limit” in the above discussion of elective deferrals for a special rule allowing a new 403(b) plan participant to exceed the annual limit. I.R.C. §§ 402(g)(3), 403(b)(12).
Timing rules for the return of any excess deferral resulting from a failure to comply with the elective deferral limit are found in 26 C.F.R. §§ 1.403(b)-4(f)(4).

Catch-up contribution rules. There are two catch-up contribution opportunities for eligible employees to increase the elective deferral limit for a year:

  • Age 50 catch-up –and–
  • 15-years-of-service catch-up

Age 50 catch-up contribution. If permitted by the 403(b) plan, employees who are age 50 or over at the end of the calendar year can also make catch-up contributions up to the statutory catch-up limit under I.R.C. § 414(v), as adjusted for inflation ($6,000 in 2017). The amount cannot exceed the employee’s compensation for the year. I.R.C. § 414(v); 26 C.F.R. § 1.403(b)-4(c)(2).
If an employee covered by a 403(b) plan is also covered by a 401(k) plan (or a simplified employee pension or SIMPLE retirement account), the plans are combined in applying the annual limit on elective deferrals and the age-50 catch-up limit. 26 C.F.R. § 1.402(g)-1(b).

15-years-of-service catch-up contribution. A special rule for 403(b) plans under I.R.C. § 402(g)(7) allows plans to provide for a separate catch-up right for employees having at least 15 years of service with a:

  • Public school system
  • Hospital
  • Home health service agency
  • Health and welfare service agency
  • Church –or–
  • Convention or association of churches (or associated organization)

26 C.F.R. § 1.403(b)-4(c)(3)(ii).

If permitted under the plan, this catch-up rule increases the annual limit otherwise applicable by the least of:

  • $3,000
  • $15,000, reduced by the amount of additional elective deferrals made in prior years under this rule
  • $5,000 times the number of the employee’s years of service for the organization, minus the total elective deferrals made for
    earlier years –or–
  • The participant’s compensation for the year (as defined in 26 C.F.R. § 1.403(b)-2)

26 C.F.R. § 1.403(b)-4(c)(3)(ii).

Special rules for determining years of service for this purpose are given in 26 C.F.R. § 1.403(b)-4(e). Several examples applying the catch-up rules are given in 26 C.F.R. § 1.403(b)-4(c). See also I.R.S. Publication 571, Tax-Sheltered Annuity Plans (403(b) Plans), §4.
When both catch-up opportunities are available (because a qualifying individual is age 50 or older by year-end), the employee may utilize both, but regulations require the additional amounts to be applied first to the 15-years-of-service catch-up and then to the age 50 catch-up. 26 C.F.R. § 1.403(b)-4(c)(4).

Due to its complexity and the subsequent introduction of the age-50 catch-up rules, many employers have eliminated the 15-years-of-service catch-up from their 403(b) plans. The I.R.S. 403(b) Plan Fix-It Guide identifies allowing this catch-up to an employee who does not have the required 15 years of full-time service with the same employer as a common plan defect.

Limit on Annual Additions under I.R.C. § 415

The annual additions limit that applies to qualified defined contribution plans also applies to the aggregate of all contributions to a 403(b) plan, other than rollover contributions and age-50 catch-up contributions. I.R.C. § 403(b)(1); 26 C.F.R. § 1.403(b)-4(b).

The limit is the lesser of:

  • The statutory limit, adjusted for inflation under I.R.C. § 415(d) ($54,000 for 2017 limitation years) –or–
  • 100% of includible compensation (as defined in 26 C.F.R. § 1.403(b)-2)

I.R.C. § 415(c)(1); 26 C.F.R. § 1.403(b)-4(b)(2); see also 26 C.F.R. §§ 1.415(b)-1(b)(2), (c) for special application rules relating to 403(b) plans.

It is important to establish a separate account to hold excess contributions to prevent commingling with 403(b) plan-eligible contributions. Failure to do so could taint the tax-qualified status of the entire 403(b) plan. 72 Fed. Reg. 41,136; 26 C.F.R. §§ 1.403(b)-3(b)(2), -4(f).

Special rule for former employee contributions. Where contributions continue for a former employee, the former employee’s compensation for this purpose is based on the amount earned during the most recent year of service for up to the next five taxable years. 26 C.F.R. 1.403(b)-4(d). Thus, it is possible for nonelective employer contributions to a 403(b) plan to continue for up to five years in the case of a retired or terminated participant. See 26 C.F.R. §§ 1.403(b)-3(b)(4), -4(d).

Special rule for Church employees. In lieu of the Section 415 limit, a church employee can choose to use $10,000 a year as the limit on annual additions. This is only useful if the employee’s includible compensation is less than $10,000 and if the total contributions will exceed 100% of the employee’s includible compensation. Moreover, total contributions over the employee’s lifetime under this choice cannot be more than $40,000. See 26 C.F.R. § 1.403(b)-9(b).

Aggregation of contributions under separate plans. Normally, an employee who participates in a 403(b) plan and a qualified defined contribution plan, simplified employee pension, defined benefit plan that provides for employee after-tax contributions, or individual medical benefit account that is part of a pension or annuity plan need not combine contributions made to the 403(b) plan with contributions to the other types of plans for purposes of the Section 415 limit. However, the plans must be combined if the other plan is maintained by a corporation, partnership, or sole proprietorship over which the employee has more than 50% control. I.R.C. § 415(k)(4).

For example, if a tax-exempt organization maintains both a qualified plan and a 403(b) plan, up to the lesser of $54,000 (in 2017) or 100% of compensation could be contributed to each plan. However, if a doctor employed by a tax-exempt hospital also has a qualified plan for his or her own private medical practice, the 403(b) plan of the hospital would have to be combined with the qualified plan of the private medical practice in applying the limit.

Incidental Benefit Rule

Requirements imposed on qualified plans under 26 C.F.R. § 1.401-1(b)(1)(ii) regarding the extent to which incidental life or accident or health insurance benefits may be provided as plan benefits also apply to 403(b) plans. 26 C.F.R. §§ 1.403(b)-3(a)(8), -6(g).

Nonforfeitability/Vesting

In theory, contributions under a 403(b) plan must be nonforfeitable. 26 C.F.R. § 1.403(b)-3(a)(2). As a practical matter, though, there is a workaround build into the regulations whereby forfeitable contributions are treated as not having been made to the 403(b) plan, but rather to a separate I.R.C. § 403(c) annuity (or a tax-exempt employee trust where a custodial account is used), when they are made. (Forfeitable contributions are required to be kept in a separate bookkeeping account than nonforfeitable contributions.) Then, as amounts become vested, and assuming all of the 403(b) plan conditions (other than nonforfeitability) are met for those contributions, those amounts are retroactively treated as having been made to the 403(b) plan for purposes of the maximum limits on contributions when they become nonforfeitable. 26 C.F.R. § 1.403(b)-3(d)(2).

In this way, many 403(b) plans subject employer matches, employer discretionary contributions, and/or employer mandatory contributions to a vesting schedule (vesting for employee elective deferrals would be permissible in non-ERISA 403(b) plans, but is highly unusual).

For example, a plan might provide that an employee would be 20% vested after two years, 40% after three years, 60% after four years, 80% after five years, and 100% (nonforfeitable) after six years. If an employee left after two years with an employer contribution account balance of $5,000, the employee would receive only $2,000. The remaining $3,000 in the account would, depending on the plan terms, be used for plan administrative expenses, divided among the accounts of other employees, or used to reduce future employer contributions.
To avoid participants becoming immediately subject to taxation upon a termination of the plan, however, a 403(b) plan that allows for any type of forfeitable contribution should provide for automatic full vesting upon plan termination (as would be mandatory for a traditional qualified plan).

Vesting Requirements for Plans Subject to ERISA

For 403(b) plans that are subject to ERISA, any vesting schedule must be at least as favorable as is required under ERISA. Thus, such 403(b) plans can subject employer contributions to three-year cliff vesting or six-year graded vesting, as described in the example given above (or more liberal vesting schedules). ERISA § 203(a)(2)(B) (29 U.S.C. § 1053(a)(2)(B)) (parallel provisions under I.R.C. § 411(a)(2)(B)).

Rollover Distribution Requirements

If a participant or beneficiary in a 403(b) plan is entitled to a distribution from the plan, the plan must give the participant or beneficiary the option to have the amount directly transferred to another plan rather than being paid to the participant or beneficiary. The qualified plan rollover rules under I.R.C. §§ 401(a)(31) and 402(c) and (f) apply (other than inherited IRA rules). Thus, 403(b) plan rollovers may be made to qualified plans, other 403(b) plans, and eligible governmental 457(b) plans (including to designated Roth accounts) as well as to I.R.C. § 403(a) annuity plans and traditional and Roth IRAs. I.R.C. § 403(b)(8), (10); 26 C.F.R. §§1.403(b)-3(a)(7), -7(b).

The qualified plan automatic cashout rules also apply, so if a plan calls for certain small benefits in excess of $1,000 to be paid to a participant without the participant’s election, the amount must be automatically directly transferred to an IRA unless the participant elects to the contrary. See I.R.C. § 401(a)(31).

Note that although rollovers out of the plan are required, accepting rollovers into a 403(b) plan is not.

Required Minimum Distributions

A 403(b) plan is treated as an individual retirement plan for purposes of satisfying the required minimum distribution (RMD) rule sunder I.R.C. § 401(a)(9). 26 C.F.R. §§ 1.403(b)-3(a)(6), -6. Special rules of application for 403(b) plans, including treatment of grandfathered benefits accruing before 1987, are found in 26 C.F.R. § 1.403(b)-6(e). Generally, 403(b) plan annuity contracts are treated like individual retirement accounts for purposes of the RMD rules. For further information on RMDs, see Employee Benefits law § 3A.02[m].

Nontransferability

Except in the case of a contract issued before January 1, 1963, 403(b) plan contracts must be nontransferable. Thus, an employee could not sell the contract to a third party. I.R.C. § 401(g); 26 C.F.R. § 1.403(b)-3(d)(2). Nor can a creditor of the employee seize the contract as payment for a debt, even in a bankruptcy situation. 11 U.S.C. § 541(b)(7). Special rules relating to the exchange of annuity contracts within a 403(b) plan and plan-to-plan transfers are considered in the discussion on distributions further below.

403(b) Plan Contributions

This section describes the different types of contributions permitted under a 403(b) plan.

Elective Deferral Contributions

Similar to 401(k) plan deferrals, these contributions to a 403(b) plan are made under a salary deferral agreement on a pre-tax basis and reduce the income shown on the employee’s Form W 2. I.R.C. §§ 402(e)(3), 403(b)(1)(E), 402(g)(3)(C). For example, if an employee whose salary is $50,000 gross contributes $5,000 to the 403(b) plan as an elective deferral, the wages reported on the Form W 2, Box 1, will be $45,000 rather than $50,000.

403(b) plan elective deferrals are subject to the following rules:

  • Annual limit. 403(b) plan elective deferrals are subject to the same annual limit as for 401(k) plans, determined on an aggregate basis for the individual, including the additional amounts for catch-up contributions, discussed further below. I.R.C. § 402(g).
  • One-time election to exceed 402(g) limit. A special rule allows plans to let an employee make a one-time irrevocable election at the time of initial eligibility in a 403(b) plan to contribute without regard to the elective deferral limitation. I.R.C. §§ 402(g) (3), 403(b)(12); I.R.S. Rev. Rul. 2000-35, 2000-2 C.B. 138.
  • Social Security/Medicare taxes apply. Like elective deferrals to a 401(k) plan, elective deferrals to a 403(b) plan are subject to applicable Social Security and Medicare taxes. I.R.C. § 3121(a)(5)(D).
  • Additional tax relief for retired public safety officers. While elective deferrals and earnings thereon from a 403(b) plan are generally all taxable when distributed. However, eligible retired public safety officers may use a distribution of up to $3,000 made directly from a 403(b) plan to pay premiums on accident, health, or long-term care insurance, without including the amount in taxable income. The premiums can be for the employee or the employee’s spouse or dependents. I.R.C. § 402(l) (3)(B).

Employer Contributions

A 403(b) plan may provide for employer matching, discretionary, or mandatory contributions. I.R.C. § 403(b)(1), (7). However, a 403(b) plan that provides for employer contributions cannot be a non-ERISA 403(b) plan. 29 C.F.R. § 2510.3-2(f)(3)(iv). Several types of employer contributions are possible:

  • Employer matching contributions. For matching contributions, the plan states the formula for matching contributions made by the employer based on the amount of the employee’s elective deferrals. For example, the employer may contribute an amount equal to 50% of elective deferrals (or, in some cases, elective deferrals and after-tax contributions). Typically, the
    match will be subject to a cap (e.g., that only contributions equal to the first 6% of an employee’s compensation will be matched).
  • Employer discretionary matching contributions. With a discretionary match, the employer decides how much to contribute toward the match. However, the plan terms must specify how the match is to be divided among employees. For example, it could specify that the match would not apply to contributions that exceeded the first 6% of an employee’s compensation, but
    that the percentage match would depend on the amount the employer chose to contribute for that year.
  • Employer discretionary contribution. With a discretionary contribution, the plan could specify that the employer may decide each year how much to contribute to the 403(b) plan, but the plan terms must set forth how the amount is to be allocated among employees (e.g., in proportion to compensation).
  • Employer mandatory contributions. With a mandatory contribution, the plan document states the amount to be contributed by the employer. For example, an employer may contribute to the 403(b) plan 5% of employee compensation each year.
  • Special rule for former employees. Subject to the limits in 26 C.F.R. § 1.403(b)-4(d), an employer may continue to make contributions on behalf of a former employee for up to five years after the year employment ends.

After-tax Employee Contributions

After-tax employee contributions do not give the employees an immediate tax benefit. However, earnings on the contributions are tax deferred until distributed from the plan, which could positively affect investment returns. I.R.S. 403(b) Plan Basics.

Roth Contributions

A 403(b) plan is recognized as an applicable retirement plan that may include a qualified Roth contribution program. I.R.C. § 402A(b), (e)(1)(B). Thus, 403(b) plans may allow employees to make elective Roth contributions. These contributions must be maintained separately from pre-tax and after-tax elective contributions and, like after-tax contributions, are treated as an elective deferral, but are not excludable from the employee’s gross income. However, for qualified distributions made from a Roth account, the earnings on the contributions are tax free, not merely tax deferred as for pre-tax or after-tax contributions. I.R.C. § 402A(d)(1); 26 C.F.R. § 1.403(b)-3(c) (incorporating rules under 26 C.F.R. § 1.401(k)-1(f)(1), (2)).

To be a qualified Roth distribution, the distribution from the 403(b) plan must be made, and must be:

  • Made at least five years after the employee first contributes to the Roth account –and–
  • Meet one of the following criteria:
    • Occur on or after the date the employee becomes age 59½
    • Be made to a beneficiary, or to the employee’s estate, after the death of the employee
    • Be attributable to the employee’s being disabled (as defined under I.R.C. § 72(m)(7)) –or–
    • Be used to pay for qualified first-time homebuyer expenses (as defined under I.R.C. § 72(2)(F))

I.R.C. § 402A(d)(2).

Rollover Contributions

A 403(b) plan can (but is not required to) permit rollovers from:

  • A qualified plan
  • Another 403(b) plan
  • A governmental 457(b) plan –or–
  • An IRA from which an employee is receiving a distribution

I.R.C. § 402(c)(1), (8).

Such rollovers continue the tax deferral on the amounts from the other plan. Id.

403(b) Plan Distributions

This section describes 403(b) plan distribution rules, describing when benefit distributions are generally permitted and special distributions rules for plan terminations, domestic relations orders, and plan loans. Certain permitted exchanges and transfers that are not treated as distributions are also discussed.

General Distribution Restrictions

A 403(b) plan’s distribution provisions must limit distributions to take into account limitations under I.R.C. § 403(b)(10) similar to defined contribution qualified plans. Certain distributions that are permitted will give rise to penalties on the plan participant. A plan may, but is not required to, limit distributions to avoid penalties on the participant.

Generally, a 403(b) plan can permit a distribution to be made only once the employee:

  • Reaches age 59½
  • Has a severance from employment
  • Dies
  • Becomes disabled (within the meaning of I.R.C. § 72(m)(7)
  • Encounters financial hardship, but only for elective deferral contributions (excluding income), as described below –or–
  • Is eligible for a qualified reservist distribution

26 C.F.R. §§ 1.403(b)-6(b) to (d).

26 C.F.R. §§ 1.403(b)-6(b) to (d).

However, the restrictions above do not apply to after-tax contributions. Id. Rollover contributions are also exempt. 26 C.F.R. § 1.403(b)-6(i). Thus, for example, a plan can permit in-service withdrawals of such amounts, even if the employee has not attained age 59½.

Hardship distribution rules. To be a hardship distribution, the same rules apply as under the qualified plan distribution rules. They are only permissible for an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need. The need of the employee includes the need of the employee’s spouse or dependent. IRS regulations provide certain safe harbors under which a distribution will be assumed to meet these tests. 26 C.F.R. § 1.403(b)-6(d)(2); see 26 C.F.R. § 1.401(k)-1(d)(3). For additional compliance information, see Hardship and Unforeseeable Emergency Distribution Checklist.

Distributions Subject to Penalties

As with distributions from qualified plans, two sorts of penalties can apply to distributions from a 403(b) plan, even if the withdrawals are permitted under the plan:

  • 10% additional tax (in addition to normal income taxes) on early withdrawals under I.R.C. § 72(t) –and–
  • Loss of the special tax treatment for Roth contributions distributed within the five-year nonexclusion period under I.R.C. § 402A(d)(2)(B)

Because these limitations apply to the participant, they need not be included in the plan document. However, some plans attempt to limit plan distributions to those that will not give rise to the penalties. The 10% additional tax applies only to the amount of the distribution that is subject to income tax. For example, it would not apply to a distribution to the extent it consisted of after-tax employee contributions, but it would apply to the portion of the distribution that consisted of earnings on those contributions. It also does not apply to the extent that taxes are deferred by rolling the distribution over to another plan. The additional tax applies unless one of the exceptions under I.R.C. 72(t) is met.

For example, a 30-year-old employee could be permitted to take a distribution of elective deferrals from a 403(b) plan upon termination of employment or hardship. However, unless the distribution was rolled over, it would generate normal income taxes plus the 10% additional tax.

Distributions upon Plan Termination

Distributions can be made regardless of the above limitations upon termination of the 403(b) plan. However, if the 403(b) plan contains elective deferrals or is funded through custodial accounts, termination of the plan and the distribution of accumulated benefits is permitted only if the employer (taking into account all entities that are treated as the employer under I.R.C. §§ 414(b), (c), (m), and (o) on the date of the termination) does not make any contributions to any 403(b) plan that is not part of the terminating plan during the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan. An exception to this rule exists when less than 2% of eligible employees are eligible under the other 403(b) plan during the restricted period. 26 C.F.R. § 1.403(b)-10(a)(1).

See also Terminating 403(b) Plans below for other issues in terminating a 403(b) plan.

Domestic Relations Orders

The 403(b) regulations include a specific exception to the distribution limitation rules for domestic relations orders. 26 C.F.R. 1.403(b)-10(c). A domestic relations order is defined as any judgment, decree, or order (including approval of a property settlement agreement) that:

  • Relates to the provision of child support, alimony payments, or marital property rights to a spouse, former spouse, child, or other dependent of a participant –and–
  • Is made pursuant to a state domestic relations law (including a community property law)

I.R.C. § 414(p)(9).

A governmental or nonelecting church plan can comply with any domestic relations order (and may be subject to state domestic relations laws regarding distributions). Other plans can comply only if the order is a domestic relations order that meets certain requirements for qualified domestic relations orders (QDROs) under I.R.C. § 414(p) and ERISA § 206(d)(3) (29 U.S.C. § 1056(d)(3)). See Rev. Proc. 2007-71.

Remember that sponsors of non-ERISA 403(b) plans should not conduct any discretionary administration of the plan’s domestic relations order distributions.

Plan Loans

Loans from 403(b) plans are permissible, depending on the facts and circumstances of the loan arrangement, including whether there is a fixed repayment schedule, the reasonability of the interest rate, and the presence of repayment safeguards that a prudent lender would rely on. As for 401(k) plan loan programs, the prohibited transaction exemption requirements under ERISA § 408(b)(1) (29 U.S.C. § 1108(b)(1)) apply for ERISA-governed plans, and tax treatment is governed by I.R.C. § 72(p).

The plan document (or ancillary document) must contain material terms and conditions for the loans and identify the person responsible for administering the program. If the participant fails to repay a 403(b) plan loan, the participant’s account under the plan can be used for repayment similar to other qualified plan loans. 26 C.F.R. § 1.403(b)-6(f); see also 29 C.F.R. § 2550.408b-1 and 26 C.F.R. § 1.72(p)-1.

The taking out of a loan is not treated as an impermissible distribution. A loan that is in default is generally treated as a taxable distribution from the plan of the entire outstanding balance of the loan (a deemed distribution). A deemed distribution is treated as an actual distribution for purposes of determining the tax on the distribution, including any early withdrawal penalty. However, a deemed distribution is not treated as an actual distribution for purposes of determining whether a plan satisfies the limitations on in-service distributions. 26 C.F.R. §§ 1.403(b)-7(d), 1.72(p)-1, Q&A12, 13.

For more information on the rules for qualified plan loans, see Plan Loan Program and Plan Loan Program Checklist.

Exchanges and Transfers Not Treated as Distributions

Subject to applicable requirements, three types of in-service exchanges or transfers, described further in the following sections, are permitted without violating the 403(b) plan distribution (or nontransferability) rules:

  • Contract exchanges
  • Plan-to-plan transfers –and–
  • Asset transfers to governmental plans for purchase of permissive service credit

26 C.F.R. § 1.403(b)-10(b)(1); see also I.R.S. Retirement Plans FAQs regarding 403(b) Tax-Sheltered Annuity Plans.

Such exchanges and transfers are distinguished from rollovers (even direct rollovers from one plan to another). As discussed in the section entitled “Rollover Distribution Requirements” under Qualification Requirements above. Rollovers are available only when a distribution event has occurred. Remember that sponsors of non-ERISA 403(b) plans should not undertake any discretionary actions concerning such exchanges or transfers.

Contract Exchanges

A 403(b) annuity contract or custodial account can be exchanged for (1) another 403(b) contract or custodial account issued by an approved vendor under the same plan that receives plan contributions, or (2) another 403(b) contract or custodial account issued by a vendor that is not expressly authorized by the 403(b) plan terms (an unapproved vendor). However, an unapproved vendor exchange is permitted only if:

  • The 403(b) plan permits exchanges with unapproved vendors
  • The amount of the transferred accumulated benefit after the exchange is at least the same as before the exchange
  • The unapproved vendor’s contract is subject to distribution restrictions at least as stringent as the plan’s terms –and–
  • The 403(b) plan sponsor and the unapproved vendor enter an agreement to share information for tax reporting and plan compliance purposes (including information under 26 C.F.R. § 1.403(b)-10(b)(2)(i)(C))

26 C.F.R. § 1.403(b)-10(b)(2); Rev. Proc. 2007-71.

Plan-to-Plan Transfers

A 403(b) plan may transfer a contract or custodian account to a different employer’s 403(b) plan (e.g., on behalf of transferring employees upon a corporate transaction), subject to the following conditions:

  • The participant whose assets are being transferred is an employee (or former employee) of the employer (or business of the employer) sponsoring the receiving plan (or the assets belong to a beneficiary of such a participant)
  • The terms of both plans allow for such plan-to-plan transfers
  • The amount of the accumulated benefit after the transfer is at least the same as before the transfer
  • The receiving plan imposes distribution restrictions on the transferred assets that are at least as stringent as the transferring plan’s rules –and–
  • If the transferred assets are not the participant’s entire interest in the plan, then the receiving plan treats the amount transferred as a continuation of a pro rata portion of their interest in the transferring plan (e.g., with respect to pre-tax versus after-tax contributions)

26 C.F.R. § 1.403(b)-10(b)(3); Rev. Proc. 2007-71.

Certain Contract-to-Plan Transfers to Governmental Plans

A 403(b) plan may transfer assets held in the plan to an I.R.C. § 414(d) governmental defined benefit plan in three circumstances:

  • Purchase of permissive service credit. A governmental plan that allows participants to make voluntary contributions (in addition to any employee contributions required under the plan) to acquire deemed service credit that will be used for purposes of calculating plan benefits (so-called permissive service credit, described in I.R.C. § 415(n)(3)) may accept such
    additional permissive service credit contributions through the transfer from a 403(b) plan. 26 C.F.R. § 1.403(b)-10(b)(4)(ii)(A). This is an exception from the general rule prohibiting assets transfers between 403(b) plans and plans qualified under I.R.C. § 401(a) or eligible governmental deferred compensation plans under I.R.C. § 457(b). 72 Fed. Reg. 41,132.
  • Repayments of contributions. The assets from a 403(b) plan account can be transferred to a governmental plan where the amount is treated as a repayment of contributions for an amount previously refunded upon a forfeiture of service credit under the plan, as described in I.R.C. § 415(k)(3). 26 C.F.R. § 1.403(b)-10(b)(4)(ii)(B).
  • Rollovers. Participants may choose to roll over any eligible rollover distribution from a 403(b) plan to a governmental defined benefit that accepts rollovers. I.R.C. § 403(b)(8).

Implementation and Operation

To receive and maintain tax-favored treatment, 403(b) plans must comply in form and operation with the requirements described in this practice note. For plan document compliance, employers who adopt prototype and volume submitter pre-approved plans are able to rely on the IRS determination letter program established for pre-approved plans, described below under “Pre-approved 403(b) Plans.“ By contrast, sponsors of individually designed plans have no way to receive IRS blessing on their 403(b) plans, since the IRS decided not to adopt a determination letter program for such plans. See Rev. Proc. 2013-22, 2013-1 C.B. 985.

Adopting a pre-approved plan simplifies 403(b) plan administration for employers since the sponsor of the pre-approved plan is responsible for plan updates, among other things. Individually designed 403(b) plan sponsors must remain vigilant regarding required plan amendments due to changes to the Internal Revenue Code, Treasury Regulations, or other guidance published by the IRS.

All 403(b) plan sponsors (whether directly or via a third-party administrator) must ensure that the day-to-day operational requirements concerning eligibility, nondiscrimination, contributions, funding vehicles, and distributions continue to be satisfied. Non-ERISA 403(b) plan sponsors may take an active role in ensuring compliance (including facilitating corrections of noncompliance) without jeopardizing the plan’s safe harbor status. FAB 2007-02; Dep’t of Labor Information Letter (Feb. 27, 1996).

ERISA Considerations

If ERISA applies to the 403(b) plan (see ERISA Coverage of 403(b) Plans above), the plan must satisfy the disclosure and reporting obligations under ERISA Title I, such as:

  • Providing updated summary plan descriptions and, as needed, summaries of material modifications to participants for amendments
  • Making plan-related documents available
  • Filing Form 5500 annual reports
  • Meeting ERISA fiduciary responsibilities and avoiding prohibited transactions

For a summary of ERISA responsibilities, see ERISA Title I Fundamentals.

Pre-approved 403(b) Plans

The IRS has established a pre-approved 403(b) plan program for prototype and volume submitter plans. The sponsors of such pre-approved plans can obtain opinion or advisory letters on their plan designs, providing reassurance that their plan documents meet the necessary requirements. I.R.S. Announcement 2009-34, 2009-1 C.B. 916. The determination letter application procedures are found in Rev. Proc. 2013-22, as modified by Rev. Proc. 2014-28, 2014-1 C.B. 944, and Rev. Proc. 2015-22, 2015-1 C.B. 2015-11. Rev. Proc. 2019-4, 2019-1 I.R.B. 146.

For more information, see Pre-approved 403(b) Plans. See also IRS, 403(b) Pre-approved Plan Program – Key Provisions. The initial remedial amendment period for 403(b) plans will be March 31, 2020. This means that employers who adopt a pre-approved plan by that date can obtain retroactive relief for qualification defects arising since 2010. Rev. Proc. 2017-18, 2017-5 I.R.B. 743.

After receipt of the favorable opinion or advisory letter from the IRS, the pre-approved plan sponsor for a prototype plan or volume submitter plan must take the steps below to maintain compliance:

  • Amend plan for legal changes. Amend the plan pursuant to changes in the Internal Revenue Code, Treasury Regulations, or other guidance published by the IRS.
  • Document adopting employers. Maintain a written record of the eligible employers that have adopted the prototype plan or volume submitter plan. The list must include the names, addresses, and employer identification numbers of all eligible employers that, to the best of the plan sponsor’s knowledge, have adopted the plan. The plan sponsor must present the list
    to the IRS, if requested.
  • Disclose plan-related documents. Provide to the adopting employers the plan document, any restatements thereof, all amendments, and all opinion or advisory letters, in electronic or hard copy form, and comply with the notice requirements under the program or other written guidance.
  • Adopt notification procedures. Establish a procedure to notify adopting employers of plan amendments and restatements and of the need to timely adopt the plan and any plan restatements and the consequences for failing to do so or failing to operate the plan in accordance with plan changes.
  • Meet obligations upon discovery of noncompliance. Upon determining that a 403(b) preapproved plan as adopted by an employer may no longer satisfy the requirements of 403(b) (in a manner that is not or cannot be corrected by the preapproved plan sponsor under the EPCRS):
    • Notify the employer that the plan may no longer satisfy I.R.C. § 403(b)
    • Advise the employer that it may incur adverse tax consequences –and–
    • Inform the employer about the availability of the EPCRS

Rev. Proc. 2013-12, as modified by Rev. Proc. 2014-28 and Rev. Proc. 2015-22.

Pre-approved Plan Document Must Prevail over Conflicting Investment Arrangement

In the event of any conflict between the terms of the pre-approved plan and the terms of investment arrangements under the plan (or of any other documents incorporated by reference into the plan), the terms of the pre-approved plan must govern. An eligible employer may not rely on an opinion or advisory letter issued for a 403(b) pre-approved plan if any investment arrangement under the plan provides that the terms of the investment arrangement govern in the event of a conflict. Rev. Proc. 2013-12, § 4.01(9).

Limited Reliance

Even for pre-approved plans, however, the opinion or advisory letter addresses whether the plan document complies with I.R.C. § 403(b). It does not address ERISA requirements (if applicable), investment arrangement terms, other documents incorporated by reference, or whether the plan operates in a compliant fashion.

For general information on pre-approved plans, see
Pre-approved Plan Design and Compliance.

Correcting 403(b) Plan Errors

EPCRS for Qualification Errors

The Employee Plans Compliance Resolutions System (EPCRS) is the IRS correction program to address noncompliance issues in tax-favored retirement plans, including 403(b) plans. IRS guidance issued in 2013 substantially expanded the program’s application to 403(b) plans. The most recent iteration of EPCRS is found in I.R.S. Rev. Proc. 2018-52, 2018 IRB LEXIS 524 (effective as of January 1, 2019, updating Rev. Proc. 2016–51, 2016-2 C.B. 466), which incorporates intervening guidance regarding pre-approved 403(b) plans. See IRS, Updated Retirement Plan Correction Procedures for an overview.

The EPCRS can resolve 403(b) plan operational and documentation failures within one of the three EPCRS units:

  • Self Correction Program (SCP)
    • No filing with the IRS or penalty is involved, but the sponsor or administrator must have reasonably designed compliance practices and procedures in place.
    • Available for unintentional (1) operational violations that are either insignificant, or (2) nonegregious significant failures that are timely addressed (generally before the end of the year after the year the violation occurred).
    • Not available for documentation errors.
  • Voluntary Correction Program (VCP)
    • Formal filing with the IRS along with the payment of a penalty is required.
    • Available for (1) documentation errors (i.e., failing to have, or follow the terms of, a compliant plan document), and (2) operational failures.
    • Results in a compliance statement showing IRS approval of proposed correction method.
  • Audit Closing Agreement Program (Audit CAP)
    • Program for plans under IRS audit.
    • Involves negotiated correction of an identified failure and the payment of a sanction varying depending on nature and severity of the error.

Common 403(b) plan errors corrected under SCP include failures to follow the terms of the plan document, to permit eligible employees to make salary deferrals in violation of the universal availability rule, and to comply with the annual addition limits in I.R.C. § 415. The VCP must be used for documentation errors, including to unwind a plan upon discovery that the employer is not eligible to sponsor a 403(b) plan, to correct a plan document that fails to satisfy the applicable requirements, and to correct a failure to follow the plan document or a significant operational failure after the SCP timeliness limit.

Significance of an error is based on the facts and circumstances, taking into consideration factors such as the extent, scope, and duration of the violation, the percentage of plan assets involved and number/percentage of participants affected, the timeliness of correction, and the reason for the failure.

Fiduciary Violations

Common 403(b) plan errors corrected under SCP include failures to follow the terms of the plan document, to permit eligible employees to make salary deferrals in violation of the universal availability rule, and to comply with the annual addition limits in I.R.C. § 415. The VCP must be used for documentation errors, including to unwind a plan upon discovery that the employer is not eligible to sponsor a 403(b) plan, to correct a plan document that fails to satisfy the applicable requirements, and to correct a failure to follow the plan document or a significant operational failure after the SCP timeliness limit.
Significance of an error is based on the facts and circumstances, taking into consideration factors such as the extent, scope, and duration of the violation, the percentage of plan assets involved and number/percentage of participants affected, the timeliness of correction, and the reason for the failure. 71 Fed. Reg. 20135 (April 19, 2006); Dep’t of Labor, Voluntary Fiduciary Correction Program.

General IRS Correction Guidance

The I.R.S. 403(b) Plan Fix-It Guide also serves as a quick reference for practitioners handling potential 403(b) plan mistakes. This guide contains information on how to identify and avoid errors, along with corrective actions. The Guide contains links to other relevant IRS resources on 403(b) plan rules and compliance topics.

Terminating 403(b) Plans

The 403(b) plan regulations explicitly permit employers to terminate their plans. 26 C.F.R. § 1.403(b)-10(a)(1); see also Rev. Rul. 2011-7, 2011-1 C.B. 534 (analyzing the termination of 403(b) plans and an annuity benefit money purchase plan).

In some circumstances, however, plan termination is not possible. As a precondition to termination, all plan assets must be distributed. Id. However, in some cases, plan sponsors cannot distribute some custodial accounts because the participants have not cooperated. The regulation states that “delivery of a fully paid individual insurance annuity contract is treated as a distribution,” but does not refer at all to a custodial account. 26 C.F.R. § 1.403(b)-10(a)(1). And vendors of custodial accounts often take the position that because the contracts are owned by the participants, the plan sponsor has no right to force a distribution of cash without participant consent. In some cases, participants with custodial accounts cannot be cashed out because they cannot be located or refuse to consent to the distribution. This issue was highlighted in ACT, 2015 Report of Recommendations, pp. 43-48.

The inability to terminate a 403(b) plan extends the obligations of the sponsor (e.g., if covered by ERISA, it must continue to file an annual Form 5500). A sponsor that attempts to terminate a plan without fully complying with the rules risks tainting the termination and invalidating any rollover distributions made to participants who would not have had a distribution event were it not for termination of the plan.

EP Subcommittee Report: 403(b) Plan Issues and Recommendations

A 2015 report by the Employee Plans (EP) Subcommittee of the IRS’s Advisory Committee on Tax Exempt and Government Entities (ACT), titled “Employee Plans: Analysis and Recommendations Regarding 403(b) Plans,” analyzes several issues affecting 403(b) plans and their sponsors. ACT, 2015 Report of Recommendations, pp. 15-83. The report identifies specific areas of widespread noncompliance and recommends enhanced IRS formal or “soft” guidance and educational outreach. These areas of concern include the following:

  • Universal availability nondiscrimination rule. As discussed above, many employers, particularly those with many short-term or part-time personnel, struggle over interpreting or implementing the universal availability rule regulations. Others are simply unaware of its existence. But the consequences of noncompliance are severe (disqualification of the plan in its entirety). The subcommittee recommended steps to increase awareness of the rule and singled out employee exclusion rules as an area deserving further clarification.
  • Orphan 403(b) contracts. The 403(b) regulations required written plans to be in place generally by 2010, and for available contract vendors to be listed in the plan documentation. Plan sponsors are also required to coordinate plan administration with the vendors of former contracts via information-sharing agreements if any further contributions were to be made during
    or after 2008. 26 C.F.R. § 1.403(b)-10(b). So-called orphan contracts, issued before 2009 and frozen to new contributions (as described in Rev. Proc. 2007-71) raise some compliance questions not directly addressed in the regulations. For example, there is uncertainty as to whether operational compliance under an employee’s orphan contract could taint the status of his
    or her active 403(b) plan contracts and accounts.
  • 403(b) plan terminations. The EP Subcommittee raised the issue discussed above under Terminating 403(b) Plans wherein some employers intending to terminate a 403(b) plan are unable to because of participant or vendor noncooperation or due to missing participants. Recommendations include further clarification of the current IRS position and, if possible, creation of a good faith or de minimis rule allowing employers to treat their 403(b) plans as terminated.

The EP Subcommittee also had several recommendations to improve the EPCRS program as it relates to 403(b) plans:

  • Expand the SCP to allow corrections of certain plan loan errors.
  • Extend the availability of the DOL’s VFCP Earnings Calculator to compute lost earnings in more circumstances.
  • Develop new VCP schedules focused specifically on common 403(b) plan problems.
  • Consider lower fees for 403(b) plan sponsors due to their nonprofit status.

ACT, 2015 Report of Recommendations, pp. 49–55.

Advantages and Disadvantages of 403(b) Plans

Compared with a qualified plan such as a 401(k) plan, a 403(b) plan has several advantages:

  • Simplicity. Often vendors will fulfill most functions.
  • No nondiscrimination testing required. A 403(b) plan avoids the actual deferral percentage (ADP) test applicable to elective contributions in 401(k) plans and merely requires that elective contributions be universally available. This simplifies testing for the employer and means that highly compensated employees will not have their contributions limited because lower paid employees make low or no contributions.
  • Plan language available. The IRS provides prototype language that can be used directly by preapproved plans and as a guide for individually designed plans.
  • Generous catch-up contributions. Catch-up limitations on elective deferrals are more favorable than for 401(k) plans.
  • Limited excise taxes. Excise taxes on excess contributions apply only if the 403(b) contract is a custodial account described in I.R.C. § 403(b)(7), as opposed to an annuity contract.
  • Excess contributions do not disqualify plan. If excess contributions are made, only the amount in excess of the contribution limits is taxable, as opposed to disqualifying the entire plan due to the separate accounting rules under 26 C.F.R. § 1.403(b)-3.
  • Ability to avoid ERISA for nongovernmental/nonchurch employers. By adopting a non-ERISA 403(b) plan, an eligible 403(b) plan sponsor that would normally be subject to ERISA can avoid ERISA coverage.

Notwithstanding the advantages noted above, 403(b) plans have some disadvantages compared with qualified plans that need to be considered:

  • Employees, particularly those who have not previously worked for tax-exempt or governmental employers, may have less familiarity with 403(b) plans.
  • Hardship withdrawals are available only for elective deferrals themselves, not for income on them as they would be under a 401(k) plan.
  • In-service withdrawals are available for employer contributions only upon attainment of age 59½. This contrasts with a 401(k) plan, which can provide for in-service withdrawals of employer contributions as early as:
    • Five years after the employee begins plan participation –or–
    • Two years after the money is contributed to the plan (Rev. Rul. 1968-24, 1968-1 C.B. 150; Rev. Rul. 71-295, 1971-2 C.B. 184)
  • Some states (e.g., New Jersey and Pennsylvania) impose income taxes on all 403(b) contributions.
  • Fewer providers and more limited types of providers for 403(b) plans may result in relatively higher fees.

This excerpt from Lexis Practice Advisor®, a comprehensive practical guidance resource providing insight from leading practitioners, is reproduced with the permission of LexisNexis. Reproduction of this material, in any form, is specifically prohibited without written consent from LexisNexis.

New article: Section 403(b) Plan Design and Compliance
(Posted on December 5, 2018 by )


Lexis Practice Advisor articleA new article, Section 403(b) Plan Design and Compliance, discusses the rules that apply when eligible tax-exempt organizations establish tax-sheltered annuities, custodial accounts, or retirement income accounts, as described in Section 403(b) of the Internal Revenue Code (403(b) plans).

This article addresses the following topics:

Read more.

New Article: Pre-Approved 403(b) Plans
(Posted on November 29, 2018 by )


Internal Revenue ServiceIn March 2017, the Internal Revenue Service (IRS) began issuing advisory and opinion letters to the first preapproved retirement programs described in Internal Revenue Code (I.R.C.) § 403(b) (403(b) plans). A new article, Pre-Approved 403(b) Plans, discusses preapproved 403(b) plans, including their advantages, legal pitfalls, and other issues that an eligible employer may consider when determining whether to convert its existing 403(b) plan into a preapproved plan.

The major topics are:

Read more.

New article: Pre-approved Plan Design and Compliance
(Posted on August 13, 2018 by )


Lexis Practice AdvisorWith the IRS cutting back on determination letters for individually designed plans, more and more employers are switching to pre-approved plans. An article recently published in the Lexis Practice Advisor discusses practical considerations involved with such plans. Topics include:

Pre-approved Plan Design and Compliance
(Posted on August 13, 2018 by )


Go to: Pre-approved Plan Designs and Favored Regulatory Status | General Advantages and Disadvantages of Pre-approved Plans | Types and Requirements of Pre-Approved Plans | Limitations on Plans That May Be Pre-approved | Pre-approved Plan Providers | Implementing Pre-Approved Plans | Obtaining IRS Opinion Letters

This practice note describes the requirements for implementing pre-approved plans and advantages, disadvantages, and best practices concerning the implementation and legal review of pre-approved plans. A pre-approved plan document can be used for most types of plans qualified under section 401(a) of the Internal Revenue I.R.C. (I.R.C.) (qualified plans). Tax-sheltered annuities or custodial accounts described in I.R.C. § 403(b) (403(b) plans) can also take the form of pre-approved plans, but the procedures are rather different and are described in a different practice note. See Pre-approved 403(b) Plans.

This practice note discusses the following topics:

For information on the extent to which pre-approved plan documents may be used for various types of retirement plans, see Pre-approved Plan Eligibility Checklist.

Pre-approved Plan Designs and Favored Regulatory Status

Pre-approved Plan Designs

Pre-approved plans are retirement plans that an entity (Provider) creates for adoption by a number of unrelated employers. In contrast, individually designed plans are retirement plans that an employer sponsor or a law firm creates usually for exclusive use by the employer sponsor (and members of its controlled group).

Pre-approved plans fall into one of two categories: standardized and non-standardized plans. In both cases, the plan’s Provider submits the plan document to the Internal Revenue Service (IRS) to review and opine on whether the written form of the plan satisfies the legal requirements for qualified status. After the IRS pre-approves the plan, the Provider offers the plan to employers to adopt.

Favored Regulatory Status of Pre-approved Plans

Regulatory agencies favor pre-approved plans because they:

  • Are efficient to produce
  • Are relatively easy to implement (compared to individually designed plans)
  • Reliably reflect the many and ever-changing provisions required by the Employee Retirement Income Security Act of 1974 (ERISA) and the I.R.C.

The favored status of pre-approved plans has increased over time. Most recently, the IRS generally restricted the ability of individually designed plans to obtain favorable determination letters except upon the plan’s establishment or termination. I.R.S. Announcement 2015-19, 2015-2 C.B. 157; I.R.S. Rev. Proc. 2016-37, 2016-2 C.B. 136. By eliminating an individually designed plan’s ability to receive interim approval of the plan’s form, federal regulators have tacitly endorsed pre-approved plans as the model for future plan implementations. See, also, I.R.S. Notice 2016-03, 2016-1 C.B. 278; I.R.S. Rev. Proc. 2016-37, 2016-2 C.B. 136, Section 18 (extending the deadline for adoption of pre-approved plans in certain instances in recognition of the abolition of the remedial amendment program for individually designed plans).

General Advantages and Disadvantages of Pre-approved Plans

Use of a pre-approved plan has advantages both for the adopting employer and for the plan Provider over adoption of an individually designed plan. However, you should weigh these advantages against the disadvantages and limitations applicable to the various pre-approved plan types. Advantages, disadvantages, and certain other concerns from the perspective of the employer are discussed in the sections that follow. Also discussed are the advantages for the plan Provider.

Advantages, Disadvantages and Other Concerns from the Employer’s Perspective

Advantages for Employers

For employers, the major advantages of a pre-approved plan are simplicity, cost, and assurances of IRS approval. An employer can adopt a pre-approved plan merely by selecting among available options (any of which will satisfy IRS requirements), having the documents approved by the board of directors or other person(s) having authority, and signing. Thus, the employer saves the cost of having a plan drafted and obtaining an IRS determination letter on its qualification.

Simplicity in Form

As mentioned above, because pre-approved plans are submitted for IRS approval prior to their adoption by an employer, they are to a certain extent set in form. Nevertheless, they still allow adopting employers to make certain customization decisions. For example, the employer will decide whether to allow plan loans or provide for matching contributions, and how long a vesting schedule to provide. After the adopting employer makes these elections electronically, software systems generate the documents required for the plan.

IRS Approval

The sponsor of a new individually designed plan must apply for a determination letter in which the IRS opines on the plan’s qualified status (in form). In addition, under the revised determination letter program, such sponsor can no longer get IRS assurances on the plan between inception and termination. However, a pre-approved plan Provider gets an IRS opinion letter on the pre-approved plan, and the adopting employer can generally rely on this letter. Moreover, the Provider can get a new letter on the pre-approved plan every six years, to reflect changes in the plan and changes in applicable statutes, regulations, and other guidance.

Bundled Third Party Administrative Services

A pre-approved plan is often part of “one-stop shopping” for the employer. The plan Provider or an affiliate may also be providing investment choices under the plan, third party administrative services, etc. This saves the employer from having to find different vendors for each of the functions under the plan. Particularly for a small employer, the simplicity of a pre-approved plan is often what enables the employer to adopt a plan at all without undue expense and use of employer personnel.

Disadvantages for Employers

The major disadvantage of a pre-approved plan is that it limits the employer’s flexibility for design options. Following are examples as to why an employer might generally prefer to sponsor its own (individually designed) plan over a pre-approved plan:

  • Limited ability to implement stand-alone amendments. Employers adopting pre-approved plans generally have to completely restate the plan (and make sure that existing benefit structures are preserved) when moving to a new investment provider.
  • Limited ability to vary coverage among participants. Employers adopting pre-approved plans generally cannot have different groups of employees covered by different plans or benefit structures.
  • Inflexibility of options for certain types of plans. Many employers prefer to provide a type of plan (e.g., many cash balance and stock bonus plans) that is eligible to use pre-approved plan documents. (See Types and Requirements of Pre-Approved Plans, for more information.
  • Additional costs due to plan document inflexibility. One typical example where an employer adopting a pre-approved plan may incur an additional cost is where the pre-approved plan document requires employer contributions for all participants who have completed at least 500 hours of service during the plan year, even if they terminate employment before year end. The expense of providing contributions for individuals who are no longer working for the employer (and thus for whom the employer’s cost for the contributions is not justified by the plan’s advantages in attracting and retaining employees) may outweigh the cost savings of having a pre-approved plan, in which case the employer may prefer to design its own plan instead.

The difficulties discussed above are most often a concern to larger employers who may want to adopt more complex plans or to handle investments in-house, and who have greater costs associated with their large numbers of plan participants. However, a smaller employer that wants to maximize benefits for the owners may also prefer an individually designed plan.

Other Considerations for Employers

Two major cost-related considerations for employers are (1) whether the employer intends to purchase bundled and/or additional services (one-stop shopping) and (2) the extent to which legal review of a pre-approved plan may be necessary.

Effectiveness of One-stop Shopping

First, to the extent an employer chooses a pre-approved plan for the purpose of one-stop shopping, the plan may be less effective than anticipated. Employers must consider the following:

  • Variability of fiduciary-related costs. Though pre-approved plan providers may provide certain bundled services, they will typically not be fiduciaries within the meaning of ERISA (for ERISA plans), or relevant state law (for governmental and non-electing church plans). This means that employers may incur unexpected costs associated with necessary delegations of fiduciary duties (e.g., the prudent selection and monitoring of investments in cases where the employer does not have investment expertise). See What Your Prototype Plan Provider Doesn’t Tell You by Carol Buckmann, Cohen & Buckmann, P.C.
  • Desirability of Provider investment platforms. Pre-approved plan Providers often provide an investment platform for the plan as an additional service to employers. Employers will evaluate the cost of this (and any other bundled) services, the availability of investment options in potential Providers’ platforms, and the risk evaluation performed on these investments. Based on these considerations, an employer may decide that the potential Providers do not provide enough investment alternatives or may simply prefer to manage investments in-house.
  • Lack of substantive legal review. The plan Provider (other than a law firm that provides pre-approved plans for its employer-clients) will typically not be an attorney or authorized to provide legal advice. While the plan documents will typically specify that legal advice should be sought, many employers nevertheless just sign the documents without any legal review.

Need for Legal Review

Even without legal review, an adopting employer has assurances that a pre-approved plan meets qualification requirements. However, this does not eliminate the need for legal review. Some issues that may come to light in connection with a legal review (apart from documentary qualification issues) include:

  • Provider issues. These include issues with indemnification, responsibilities, and resolution of claims against the Provider. For example, the plan may provide that such claims must be resolved through arbitration rather than lawsuits, or that lawsuits must be filed in the plan Provider’s home state (which may be far from where the employer is located). If reviewing a pre-approved plan, you should ensure that your client is aware of the existence of any such provisions and has taken them into consideration when choosing the particular plan.
  • Insufficiency of plan provisions to protect the employer. While the opinion letter on a plan will generally provide comfort that the plan is qualified in form, it may omit crucial protections for the employer. For example, if the plan document does not give the employer the right to interpret the terms of the plan, a court may hold that provisions have a meaning quite different from that which the employer assumed. In addition, the plan may either omit a statute of limitations on bringing claims for benefits or provide one that is shorter than the maximum statute of limitations available under state law. You should explain any existing issues of this type to the adopting employer.
  • Foreign trust situs. A qualified plan must have a U.S. domestic trust. If the Provider has only executives located outside of the U.S., this requirement may not be met in operation, even if the trust document requires it. You should advise clients considering adoption of such a plan that this is a key element that they must investigate.
  • Poor plan communications. Many lawsuits are based on plan communications. You should ensure, therefore, that the summary plan description (SPD) of the plan and all other employee communications accurately describe the essential provisions of the pre-approved plan.

Advantages from the Perspective of the Provider

For Providers of pre-approved plans, the use of pre-approved plans is primarily a marketing decision. An investment company, payroll provider, insurance company, or third-party administrator may sponsor a pre-approved plan so that it can sell its services by providing the employer with a quick and inexpensive way to get the plan set up. If the sponsor had to provide an individually designed plan for each employer, the up-front cost would make the transaction less profitable to the sponsor.

Law firms may provide pre-approved plans for use by their clients as a plan that has received legal review, but is less costly than an individually designed plan and can receive IRS assurances on its status.

Types and Requirements of Pre-Approved Plans

Requirements Applicable to All Pre-Approved Plans

In some respects, the rules for standardized and non-standardized plans are similar. Both are plans that are designed by a Provider for use by adopting employers (per adoption agreements). Both types of plans must include a procedure for Providers to amend a plan on behalf of an adopting employer. Rev. Proc. 2017-41, 2017–29 I.R.B. 92, Section 5.03. In addition, pre-approved plans are subject to the following requirements:

  • Prohibition on incorporation of certain I.R.C. sections by reference. Pre-approved plans cannot incorporate by reference the I.R.C. § 415 limitations on benefits and contributions), the average deferral percentage test under I.R.C. § 401(k)(3), or the average contributions percentage test under I.R.C. § 401(m)(2), I.R.S. Rev. Proc. 2017-41, Sections 6.03(11) and (12). Plan Providers often wish to incorporate I.R.C. sections by reference, so as to avoid lengthy provisions in the plan of the required provisions and to avoid needing to amend the plan if the I.R.C. section is amended. However, the IRS is concerned that the absence of the full provision in the plan may lead to inattention to the provisions in administering the plan.
  • Preclusion of form flexibility that would violate qualification requirements. Any blanks or fill-in provisions for the employer to complete must have parameters that preclude the employer from completing the provisions in a manner that could violate the qualification requirements. I.R.S. Rev. Proc. 2017-41, Section 6.03(17).
  • Inclusion of USERRA compliance provisions. All pre-approved plans must contain language within the underlying plan document (as opposed to the adoption agreement) to comply with the Uniformed Services Employment and Reemployment Rights Act of 1994, 38 U.S.C. §§ 4301-4335. I.R.S. Rev. Proc. 2017-41, Section 5.14.
  • Inclusion of trust provisions. All pre-approved plans must include a trust or custodial account document separate from the plan document, unless the plan uses an annuity as a funding method. Rev. Proc. 2017-41, Section 4.10.

Differences among the Various Types of Pre-approved Plans

Single or Multiple Funding Media

In some pre-approved plans, each employer that adopts the plan uses a single funding medium (for example, a trust or custodial account document) as all other employers who adopt the same plan. In others, each employer who adopts the plan has a separate funding medium.

Differences between Standardized and Non-standardized Plans

There are two subsets of pre-approved plans: standardized and non-standardized. I.R.S. Rev. Proc. 2017-41. The difference between them is the method by which they comply with the rules preventing discrimination in favor of highly compensated employees.

A standardized pre-approved plan is designed so that it is impossible by its terms for it to violate any of the tests of I.R.C. § 401(a)(4) and (5) (relating to discrimination in benefits), and I.R.C. § 410(b) (relating to discrimination in plan coverage). Together, these rules constitute the I.R.C.’s non-discrimination rules. (An employer must still ensure that 401(k) contributions meet the actual deferral percentage (ADP) test of I.R.C. § 401(k)(3) and that employer matching contributions and employee after-tax contributions meet the actual contribution percentage (ACP) test of I.R.C. § 401(m).) A non-standardized plan requires the employer to monitor the plan to ensure that, as applied to its employees, the plan satisfies the I.R.C.’s non-discrimination rules.

Structure of Pre-approved Plans

A pre-approved plan can consist of a single plan document, or a basic plan document plus an adoption agreement. A pre-approved plan must also have a trust or custodial agreement, separate from the plan document(s). However, the IRS will no longer rule on whether a trust agreement for a pre-approved plan is tax-exempt under I.R.C. § 501(a).

In the case of a pre-approved plan that consists of a basic plan document plus an adoption agreement, the basic plan document provides all provisions that could possibly apply to the plan, while the adoption agreement permits the employer to select among such provisions. For example, the basic plan document for a profit-sharing plan might provide for 401(k) contributions, matching contributions, and/or contributions that are the same percentage of compensation for all employees. The adoption agreement could allow an employer to choose to have the plan provide for only contributions that are the same percentage of compensation for all employees, only 401(k) contributions, only 401(k) and matching contributions, or all three types of contributions.

A single plan document can be structured so as to have alternative versions of certain provisions, so that a particular employer’s plan can omit provisions inapplicable to that employer.

An adopting employer cannot vary the provisions of a pre-approved plan at all, beyond the options provided in the single plan document or the adoption agreement, except:

  • Amendments to the plan to add or change a provision (including choosing among options in the plan) and/or to specify or change the effective date of a provision, provided the employer is permitted to make the modification or amendment under the terms of the Pre-approved Plan as well as under § 401 or 403(a), and, except for the effective date, the provision is identical to a provision in the Pre-approved Plan
  • Sample or model amendments published by the IRS that specifically provide that their adoption will not cause such plan to fail to be identical to the Pre-approved Plan
  • Amendments that adjust the limitations under §§ 415, 402(g), 401(a)(17), and 414(q)(1)(B) to reflect annual cost-of-living increases, other than amendments that add automatic cost-of-living adjustment provisions to the plan
  • Plan language completed by the employer if such language is necessary to satisfy § 415 or 416 because of the required aggregation of multiple plans under these sections
  • Interim amendments or discretionary amendments that are related to a change in qualification requirements
  • Amendments that reflect a change of a Provider’s name, in which case the Provider must notify the IRS, in writing, of the change in name and certify that it still meets the conditions to be a Provider –and–
  • Amendments to the administrative provisions in the plan (such as provisions relating to investments, plan claims procedures, and employer contact information), provided the amended provisions are not in conflict with any other provision of the plan and do not cause the plan to fail to qualify under I.R.C. § 401

Rev. Proc. 2017-41, Section 8.03.

Standardized Plans

To ensure that it meets the I.R.C.’s non-discrimination rules for any employer that adopts it, a standardized plan is limited in the options it can provide. For a qualified plan:

  • The plan must cover all employees, other than those who have less than one year of service (YOS), who are under age 21, who are covered by a collective bargaining agreement, or who are nonresident aliens with no U.S.-source income. However, in the case of employees acquired through an asset or stock acquisition, merger, or other similar transaction involving a change in the employer of the employees of a trade or business, the plan can exclude them until the last day of the first plan year beginning after such transaction.
  • Some or all of the otherwise excludible employees as described in the preceding paragraph can be included only if the criteria for excluding such employees apply uniformly to all employees.
  • The plan may deny an accrual or allocation to an employee based on hours of service or participation on the last day of the plan year only if the employee both has less than 500 hours of service and has terminated employment before the last day of the plan year.
  • Allocations of contributions or benefits must be based on total compensation (i.e., a definition that constitutes a safe harbor definition under I.R.C. § 414(s)). I.R.S. Rev. Proc. 2011-49. (For additional information, see Compensation Definition Rules for Qualified Retirement Plans.)
  • Unless the plan is a target benefit plan or a § 401(k) and/or 401(m) plan, the plan must, by its terms, satisfy one of the design-based safe harbors to ensure compliance with I.R.C. § 401(a)(4) and (5).
  • All benefits, rights, and features under the plan (other than those, if any, that have been prospectively eliminated) are currently available to all employees benefiting under the plan.
  • Any past service credit under the plan must meet the 401(a)(4) safe harbor.
  • Section 401(k) plans that provide for in-service hardship distributions must only provide for safe-harbor distributions. (See discussion of hardship distributions, below.)

I.R.S. Rev. Proc. 2017–41, Section 5.16.

Non-standardized plans

A non-standardized plan does not contain the above provisions that ensure that the plan will meet the I.R.C.’s non-discrimination rules, except that such plan:

  • May (but is not required to) contain the requirement that hardship distributions under a 401(k) plan must be limited to safe-harbor distributions –and–
  • May (but is not required to) give the adopting employer the option to select total compensation as the compensation to be used in determining allocations or benefits

Rev. Proc. 2017-41, Section 5.15. If a non-standardized plan permits non-safe-harbor hardship distributions, such distributions must be subject to nondiscriminatory and objective criteria contained in the plan. Rev. Proc. 2017-41, Section 6.03(14).

Thus, except in the case of a governmental or nonelecting church plan, inappropriate selections regarding coverage or benefits can cause a non-standardized plan to lose the protection of IRS pre-approval. However, pre-approval still provides assurances that the plan will meet IRS requirements other than the Non-discrimination Rules.

Limitations on Plans That May Be Pre-approved

Not all types of plans eligible for qualified status can be pre-approved. The IRS sets forth certain types which are allowed, and excludes plans with certain features, as described below. I.R.S. Rev. Proc. 2017-41.

Plans Permitted

Pre-approved plans can include plans qualified under Internal Revenue I.R.C. (I.R.C.) § 401(a) or 403(a) (qualified plans), including plans that permit employee pretax salary deferral contributions (also known as (401(k) contributions or elective deferrals).

Most pre-approved qualified plans are profit-sharing plans. To the extent that they provide 401(k) contributions, they are known as 401(k) plans. However, most other types of qualified plans can also be pre-approved. Qualified plans eligible for the pre-approved form include:

  • Money purchase plans (which may be combined with a 401(k) or other profit sharing plan in the same plan document)
  • Defined benefit plans, including cash balance plans (but the types of cash balance plans permitted are limited)
  • Effective February 1, 2017, employee stock ownership plans within the meaning of I.R.C. § 4975(e)(7) (ESOPs), other than ESOPS that
    • Are a combination of a stock bonus plan and a money purchase plan –or–
    • Provide for the holding of preferred employer stock

Restrictions on Plans

Certain types of qualified plans cannot be pre-approved plans:

  • Multiemployer plans
  • Collectively bargained plans (although a pre-approved plan can cover collectively bargained employees, so long as its terms are not modified by the collective bargaining agreement)
  • Stock bonus plans other than ESOPs
  • ESOPs that are a combination of a stock bonus plan and a money purchase plan
  • ESOPs that provide for the holding of preferred employer stock
  • Group trusts described in I.R.S. Rev. Rul. 81-100, 1981-1 C.B. 326, as modified by later guidance
  • Statutory hybrid plans other than cash balance plans
  • Cash balance plans that contain a variety of provisions prohibited by Rev. Proc. 2017-41, or fail to contain a variety of provisions mandated by that revenue procedure
  • Any defined benefit plan that provides a benefit derived from employer contributions that is based partly on the balance of the separate account of a participant
  • Target benefit plans, other than plans that satisfy the 401(a)(4) safe harbors
  • Governmental defined benefit plans that include “deferred retirement option plan” (DROP) features, or similar provisions in which a participant earns additional benefits for continued employment post-normal retirement age in the form of credits to a separate account under the same plan
  • Fully-insured § 412(e)(3) plans (plans funded by individual insurance contracts), other than non-statutory hybrid plans that by their terms satisfy the safe harbor in § 1.401(a)(4)-3(b)(5)
  • Plans that provide for medical accounts under I.R.C. §§ 401(h) or 105
  • Eligible combined (defined benefit/defined contribution) plans
  • Variable annuity plans and plans that provide for accruals that are determined in whole or in part based on the value of or rate of return on identified assets, including plan assets
  • Plans that include so-called fail-safe provisions for I.R.C. § 401(a)(4) or the average benefit test under I.R.C. § 410(b)

Rev. Proc. 2017-41, Section 6.03.

Pre-approved plans can include governmental plans and church plans that have not elected to be covered by ERISA (non-electing church plans). However, because such plans are exempt from ERISA and from many of the I.R.C. qualification requirements, but are subject to special requirements under state law, the plan documents used for governmental plans and nonelecting church plans must be separate from each other, and also separate from the documents used for ERISA-covered plans. Rev. Proc. 2017-41, Section 9.06.

Pre-approved Plan Providers

Plan Providers

The IRS provides different procedural requirements to apply for an opinion letter, depending on whether the plan is or is not a “mass submitter” plan as described below. Mass submitters usually have reduced procedural requirements and get expedited treatment from the IRS, because of the high volume of Providers they represent, and the number of identical or near-identical plans they submit to the IRS. This makes it easier and more efficient for review purposes. “Substantially identical” plans may receive expedited review, even if they are not mass submitter plans.

Provider. A Provider of a pre-approved plan must be a U.S. business that has at least 15 employer-clients that it reasonably expects to adopt the sponsor’s lead basic plan document. A sponsor that meets the 15 employer-clients requirement can request opinion letters for a number of additional basic plan documents and adoption agreements provided it has at least 30 employer-clients in the aggregate, each of which is reasonably expected to adopt at least one of the Provider’s basic plan documents. Although there is no specific deadline for having the 15 or 30 employer-clients adopt the plan, the IRS reserves the right at any time to request from the Provider a list of the employers that have adopted or are expected to adopt the Provider’s pre-approved plans, including the employers’ business addresses and employer identification numbers.

Providers must make reasonable and diligent efforts to ensure that adopting employers of the Provider’s plan have actually received and are aware of all plan amendments.

Mass submitter. A “mass submitter” is a U.S. business that submits opinion letter applications on behalf of at least 30 unaffiliated Providers that have “word-for-word identical” basic plan documents to the mass submitter’s lead plan. In addition, if the mass submitter has additional plans, it can submit applications regardless of the number of Providers for the mass submitter’s other plan(s).

Mass submitters who have met the “30 Provider” requirement can submit additional applications for Providers with identical plans and Providers that have “minor modifications” to the mass submitter’s plan. The IRS will review submissions with respect to minor modifications on an expedited basis and opinion letters will be issued to the Provider as soon as possible.

Mass submitters usually have reduced procedural requirements and get expedited treatment from the IRS, because of the high volume of Providers they represent, and the number of identical or near-identical plans they submit to the IRS. This makes it easier and more efficient for review purposes.

All of these terms have specific meanings. For example, the term “word-for-word identical plan” includes a “flexible” plan. This feature permits the prototype’s Provider to remove certain sections of a mass submitter’s plan because they do not apply or because the financial institution offering the plan does not offer the provision. If the prototype’s Provider does not offer loans, for example, then the section in the plan and the adoption agreement that refers to loans is removed and generally replaced with “reserved.” Plans can have as many as six administrative flexible provisions and six investment flexible provisions.

A “minor modification” is a minor change to an otherwise word-for-word identical plan of the mass submitter that does not require an in-depth technical review. For example, a change from five-year 100% vesting to three-year 100% vesting is a minor modification. On the other hand, a change in the method of accrual of benefits in a defined benefit plan would not be considered a minor modification. A minor modification must be submitted by the mass submitter on behalf of the Provider that will adopt the modified plan.

Implementing Pre-Approved Plans

At minimum, implementing a pre-approved plan requires multiple documents. For a plan taking the form of a basic plan document plus an adoption agreement, it requires a:

  • Basic plan document containing non-elective provisions, which also explains the elections made in the adoption agreement
  • Trust agreement that describes requirements for plan asset segregation and management in a separate document –and–
  • Adoption agreement in which the employer adopting the plan selects elective provisions

Alternatively, the plan can take the form of a single plan document plus a trust or custodial account document.

For either type of plan, the following additional documents are also required:

  • SPD. In the case of an ERISA plan, the SPD must conform with the requirements of ERISA §§ 101(a), 102(a)(1) and 104(b), and 29 C.F.R. §§ 2520.104b-1 and 2520.107. While a non-ERISA plan is not required to have an SPD, most do in order to provide a simplified method for participants to understand the basic terms of the plan.
  • Resolution. Corporate resolution by which the employer adopts the plan.

The plan Provider will also need to provide each adopting employer with a copy of the opinion letter applicable to the pre-approved plan.

Additional requirements for these documents are provided below.

Basic Plan Document or Single Document

A Provider’s document system will generate the basic plan document or specimen plan, and a copy of the opinion letter by which the IRS approved the written form of the plan. (See below regarding IRS approval.) Neither document allows for customization, but both are essential to the plan.

A basic plan document reflects the regulatory requirements for all plans that are covered by the pre-approved plan document, even if all the features discussed in the basic plan document are not elected in the adoption agreement. For example, a basic plan document may incorporate both profit sharing and 401(k) plan statutory requirements, even a specific employer elects in the adoption agreement to provide only profit sharing features but not 401(k) features. Essentially, the basic plan document reflects all the regulatory basis for every possible election in the adoption agreement.

Alternatively, a plan can elect to use a single plan document that incorporates only those features that a specific adopting employer elects. In the case of a plan with this form, all references to the adoption agreement below should be read as referring to the single plan document.

General Information Required Of All Adopting Employers

All document systems require certain information about the employer adopting the plan, the plan itself, and the document being generated. General information includes:

  • Employer name, address, fiscal year, Employer Identification Number, NAICS I.R.C. that identifies industry subtypes;
  • Plan design type (i.e., DC or defined benefit), employer’s plan number (because employers may have multiple plans), plan name, effective date;
  • Pre-approved document type (profit-sharing only, 401(k))
  • The preferred style of document (such as a “check-the-box” style adoption agreement, or a single plan document that emulates an individually designed plan)

After drafting the adoption agreement or the single plan document, the system user must register the document in the Provider’s system. Registration enables the Provider to notify adopting employers when plan revisions are required by law, or simply to adopt such revisions itself. Without such automated “upkeep” of implemented plans, the plan’s pre-approval can essentially expire for failure to have updated the plan as laws, regulations, or other guidance changes.

Shared Information for Plan Documents, Administration, Reporting and Disclosure

Often, companies that provide plan document systems also offer plan administration and plan reporting systems. Such systems work together, culling data from one system for use in the others. For example, the information provided to the document system about the adopting employer will be reflected in the plan’s annual tax return. Such shared information includes:

  • Plan trustees and contact information (captured in SPD);
  • Adopting employer information (captured in the plan’s annual tax return for which the employer is responsible);
  • Whether the plan employer is part of “commonly controlled group” of corporations, or an “affiliated service group” of corporations (captured by plan administration system for nondiscrimination testing purposes).

Since the same information has multiple applications, there is inherent risk that erroneous information may compromise related plan service systems. In practice, such risks may be minimized before the plan goes into operation—via diligent review by Providers, plan administrators, and adopting employers.

Adoption Agreement

Eligibility and Service Provisions

Every plan must define when an employee will become eligible to participate. The selection of eligibility and service provisions, including eligibility exclusions, is often a function of the demographics of the employer’s workforce (provided the selected eligibility and service requirements adhere to I.R.C. requirements, and ERISA requirements in the case of an ERISA plan, and are applied consistently). For additional information on coverage and minimum participation requirements see ERISA § 202 (29 U.S.C. § 1052); I.R.C. § 410; 26 C.F.R. § 1.401(a)(26)-6(b). Governmental and church plans are exempt from statutory eligibility and participation rules, but plan documents for them must still specify what eligibility and participation rules will apply.

Eligible Employees

An employer may exclude from the definition of “eligible employee” any employee who:

  • Does not meet the plan’s minimum age and/or service requirements
  • Is a nonresident alien who receives no earned income from sources within the United States –or–
  • Is covered by a collective bargaining agreement between that employer and a union

I.R.C. §§ 401(a)(26)(B) and 410(b); 26 C.F.R. §§ 1.401(a)(26)-6(b) and 1.410(b)-6.

However, the employer may elect in the adoption agreement to include nonresident aliens and collectively bargained employees described above, provided the inclusion is consistently applied. 26 C.F.R. §§ 1.401(a)(26)-6(a) and 1.410(b)-6(b)(3).

In a non-standardized plan, an employer may choose to exclude certain classifications of employees based upon the plan’s design. Such “design-based” exclusions include:

  • Leased employees (defined in I.R.C. § 414(n))
  • Key employees (defined in I.R.C. § 416(i))
  • Highly compensated employees (HCEs) defined in I.R.C. § 414(q)
  • HCEs who are key employees
  • Self-employed individuals defined in I.R.C. § 401(c)
  • Employees paid solely in commissions
  • Employees paid on an hourly basis
  • Employees paid on a salaried basis, regardless of the number of hours they work
  • Employees ineligible for employer-provided health and welfare benefits
  • For collectively bargained plans, and if applicable to the collective bargaining agreement, employees whose compensation does not include prevailing wage payments –and–
  • Other exclusions designed for the employer, provided that such exclusions do not cause the plan to cover only those non-HCEs who are the lowest paid or who have the shortest periods of service, and who represent the minimum number of non-HCEs necessary for the plan to pass annual coverage testing under I.R.C. § 410(b)

Some large employers sponsor different plans for different employment classifications, i.e., hourly, salaried, commissioned salespeople, collectively bargained employees and partners/owners. Employees may also be excluded on the basis of being employed by a separate line of business (as defined in I.R.C. § 414(r)) for the purpose of nondiscrimination testing under I.R.C. § 410(b)(6)(C).

Employers often permit their entire full-time workforce to participate after satisfying the plan’s age and/or service requirements – but may wish to exclude part-time employees. Part-time employees cannot be excluded based solely on their part-time status: if they satisfy the plan’s service requirements they must be permitted to enter the plan. I.R.C. § 410(a). Conversely, the adoption agreement may allow exclusions based on other criteria that may also apply to part-time employees (such as ineligibility for employer-paid health and welfare benefits).

Service Requirements and Entry Date

ERISA covered plans reference YOS to determine much about an employee’s rights in a plan. YOS serves many purposes, including as:

  • A requirement to participate in the plan
  • The measure by which a participant’s employer-funded contributions (i.e., profit sharing or matching contributions) vest and become non-forfeitable –and–
  • The basis for determining whether a break in service has occurred that may cause the participant to forfeit benefits previously earned

In a non-ERISA plan, service can be based on years of employment, years of participation, or other creditable years of service as defined in the plan document.

To apply service requirements consistently, the plan must also define the terms used to calculate plan service, including:

  • The required amount of service. This must be based on YOS, defined as a maximum of 1,000 hours of service (HOS) either in the first year of employment, or by the end of a defined computation period.
  • Service-counting. Counting service can be accomplished by counting the hours actually worked during a year (known as “counting/actual hours method”) and extrapolating whether a YOS has been satisfied by assuming a certain number of HOS for every day, week, two-week or month worked, or by determining YOS based on the years of service (YOS) and fractional YOS (known as “elapsed time method”).
  • Variation. YOS definitions will vary for different plan purposes – such as service for eligibility purposes, versus, service for vesting purposes.
  • Prior service recognition. Whether service with a prior employer or predecessor plan will be counted must be clear, and the purposes for which such service will be considered. This election often arises as the result of corporate acquisitions of other employers.

Each type of contribution permitted in a plan can be subject to uniform or varied eligibility requirements. Examples of varied eligibility requirements include:

  • Elective deferrals (funded by employees) that have no requirement other than employment
  • Employer-funded profit sharing and matching contributions that require one YOS
  • Age requirements (up to age 21) –and–
  • Eligibility requirements less restrictive than the statutory maximum waiting periods

After satisfying the plan’s eligibility requirements, the eligible employee becomes a plan participant on the plan’s “entry date.” Like eligibility requirements, entry date can vary for different types of contributions. Entry dates may be:

  • After the eligibility requirements are satisfied, whether semiannually, quarterly, monthly, or the next plan year
  • The first or last day of the plan year nearest satisfaction of eligibility requirements
  • The plan’s defined anniversary date –or–
  • Immediate upon satisfaction of the requirements

For more information about participation requirements generally, see I.R.C. §§ 401(a)(26), 410(a) and 410(b); for 401(k) plans see I.R.C. § 401(k)(2).

Plan Date Provisions

ERISA and I.R.C. compliance is often date-driven. Dates that are crucial to plan administration (but of little interest to employers and participants) include:

  • “Anniversary date” which is often defined as the first or last day of the plan year, but any day of the plan year may be elected in the adoption agreement
  • “Valuation date” to determine the value of the assets in plan accounts and the plan’s trust or custodial account, which may be the last day of the plan year, semiannual on the last of each six month period, the last day of each quarter or month
  • “Limitation year” which is used to determine compliance with maximum allocations under I.R.C. § 415, and which may be the plan year, the calendar year coinciding with or ending within the plan year; a 12-consecutive month period ending on a specified date; the employer’s fiscal year ending with or within the plan year; or a designated 12-month period

Because these dates impact plan administration, the employee benefits practitioner is advised to consult with the plan administrator, the third-party plan administrator (if any) and/or the plan’s actuary to determine an appropriate dates and periods.

The dates of greatest interest to employers and participants involve retirement. Except in the case of a governmental plan, “normal retirement age” (NRA) although not a calendar date, must be elected in the plan. A pre-approved can, for example, provide NRA options of:

  • Age 65 or the 5th anniversary of participation in the plan (the statutory NRA, which is also the latest NRA permitted by ERISA for ERISA plans)
  • A younger age (but not less than 55)
  • Age between 55 and 65, plus a selected number of YOS or years of participation (YOP)
  • Combined age and YOS or YOP that equals a fixed number
  • Age and the sum of age and YOS or YOP equaling a fixed number
  • Age and a defined anniversary of employment or participation in the plan –or–
  • Another formula, provided it does not result in NRA later than the statutory NRA.

Whatever NRA is selected must be applied consistently. Additional information about retirement ages can be found at 26 C.F.R. § 1.401(a)-1(b); ERISA § 3(24) (29 U.S.C. § 1002(24)); I.R.S. Notice 2012-29, 2012-1 C.B. 872.

The normal retirement date (NRD) is the date on which a participant who has terminated employment can begin taking unreduced retirement distributions. In some instances, the plan will also permit in-service distributions beginning on NRD, or permit a participant to delay distributions beyond NRD until they are mandated (soon after the later of termination of employment or turning age 70½). Except in the case of a governmental plan, the adoption agreement must designate the NRD because rights and obligations toll from that date. The employer designates the plan’s NRD by reference to the NRA:

  • Actual date NRA is attained; month in which NRA is attained; month following NRA
  • Anniversary date of plan year in which NRA is attained; anniversary date nearest NRA; anniversary date following NRA
  • Last day of month NRA is attained; last day of month nearest NRA; last day of month coincident with or next following NRA.

A plan may, but is not required, to permit an “early retirement age” (ERA) – and corresponding “early retirement date (ERD),” at which an employee who has terminated employment can receive actuarially reduced benefits. If selected by the employer, ERA can be:

  • A designated age that does not exceed NRA
  • An age, plus a YOS or YOP requirement
  • A number of years before NRA
  • Sum of age and YOS or YOP that equals a designated number
  • Age and the sum of age plus YOS or YOP equaling a selected number
  • A number of YOS or YOP, without an age requirement
  • An age and a designated anniversary of employment or plan participation

For large employers, ERA/ERD may be used to promote succession, or to provide early retirement windows when a company finds itself top-heavy with senior employees. Early retirement benefits are relatively rare among small employers, and if permitted, are typically in plans that cover few employees other than the business owner and his immediate family.

Some plans elect to provide retirement benefits in the event the participant becomes disabled before attaining retirement age. If so, the adoption agreement must define “disability” that permits payment of benefits before ERA or NRA is attained. Disability retirement options include:

  • Suffering from a medically determinable impairment expected to result in death or last for at least 12 or more months
  • Determination by the Social Security Administration that the participant is eligible to receive Social Security disability benefits –or –
  • The participant has begun to receive payments under the employer’s long term disability program

Compensation Provisions

Compensation is among the most complex topics under ERISA and the I.R.C. Like service provisions, compensation is a concept used for several plan purposes, including:

  • Contribution allocations – to determine the amount contributions that will be allocated to participants’ accounts
  • Maximum benefit limitations – to ensure that plan allocations do not exceed maximum allocation limitations (I.R.C. § 415) and additional allocations will be required if higher paid and key employees disproportionately benefit under the plan (I.R.C. § 416)
  • Safe harbor contributions – to ensure that requirements of this feature (which enables employers to avoid complex nondiscrimination testing) have been satisfied.

In a non-standardized plan, compensation can also be variously defined. Nevertheless, a non-standardized plan must give the adopting employer the option to select total compensation as the compensation to be used in determining allocations or benefits. The differences between types of compensation are subtle when read, but significant in application. The adoption agreement should designate a compensation definition that is appropriate to how compensation is paid to plan participants. Optional compensation definitions include:

  • W-2 compensation, which is wages, tips and other compensation entered on Box 1 of Form W-2
  • I.R.C. § 3401(a) compensation, which is used for FICA purposes
  • I.R.C. § 415(c)(3) compensation
  • Simplified I.R.C. § 415(c)(3) compensation, as defined in 26 C.F.R. § 1.415(c)-2(d)(2)

The compensation definition can be further modified by applying certain exclusions from compensation. Generally, employee deferrals to other plans sponsored by the employer can be excluded from the definition of compensation. Possible exclusions include deferrals to:

  • Simplified Employee Pensions under I.R.C. § 402(h)(1)(B);
  • Cafeteria plans under I.R.C. § 125;
  • Transportation plans under I.R.C. § 132(f)(4);
  • I.R.C. §§ 401(k) and 403(b) plans;
  • I.R.C. § 457(b) plans;
  • Simple Retirement Accounts under I.R.C. § 402(k).

In a non-standardized plan an employer can also choose to exclude types of pay from the plan’s definitions of compensation, including overtime, commissions, discretionary bonuses, bonuses, taxable employee benefits, compensation in excess of a specified dollar amount, and a designated exclusion that does not discriminate in favor of HCEs. Other possible inclusions/exclusions can be selected for salary paid in the first few weeks of the next limitation year; for salary continuation during military leave or for disabled participants; or for post-severance compensation.

The adoption agreement must also designate the “computation period” for compensation, for each purpose to which the compensation definitions apply. Computation periods can be an entire plan year; the plan’s limitation year; the calendar year ending with or within the plan year; a pay period, monthly, bi-monthly, quarterly, semi-annually, bi-weekly, or weekly; or a 12-month period ending on a designated date.

As with any administrative provisions, the employee benefits practitioner should consult the plan administrator before selecting compensation definitions.

For a further discussion on permissible definitions of plan compensation, see Compensation Definition Rules for Qualified Retirement Plans.

Contributions and Benefits

For a defined contribution plan, the adoption agreement must specify the type of contributions allowed. For example, in a 401(k) plan, there might be any or all of elective deferrals, matching contributions, and profit-sharing, Roth contributions, employee after-tax contributions, deemed IRA contributions. The employer’s contribution may be required at a specified rate under the terms of the plan, or may be determined by the employer each year. Safe harbor contributions may be provided in order to ensure than a 401(k) plan satisfies the ADP and ACP tests. Elective deferrals may be limited to the statutory limitations that apply to elective deferrals under I.R.C. §§ 402(g), 415, 401(k)(3) and 416, or the plan may permit catch-up contributions to the extent permitted by law. (401(k) plans permit catch-ups under I.R.C. § 414(v)). The plan must set forth special contribution rules in case the plan becomes top-heavy.

A defined contribution plan must also specify how contributions are allocated. For example, are profit-sharing contributions allocated strictly in proportion to compensation, or are they coordinated with Social Security under the I.R.C. § 401(l) permitted disparity rules? Are matching contributions allocated in proportion to all employee contributions, or do they match just elective deferrals? Are there maximum limits on the contributions that will be matched?

A defined benefit plan (including a cash balance plan) must specify the benefit formula to be applied. For example, a defined benefit plan might provide that the benefit is X% of final average compensation times years of service. The rate of contributions would then not be specified under the plan, but determined based on actuarial computations of what contributions were necessary to fund the benefits.

Vesting Provisions

“Vesting” refers to the extent to which portions of employer-funded contributions become nonforfeitable over time. Most often, a designated percentage becomes vested in each year of the stated vesting period. The unvested portion of employer contributions can be forfeited, i.e., removed from the participant’s account balance, if the participant terminates employment before satisfying the vesting schedule (although certain service reinstatement rules can prevent forfeiture). In contrast, employee-funded contributions are always fully vested and can never be forfeited by the participant.

Vesting Schedules and Events

If the plan provides employer contributions, the adoption agreement must specify their vesting periods. A plan can designate a single vesting schedule for all employer-funded contributions, or individual vesting schedules for each type of employer contribution. ERISA and the I.R.C. limit the time over which employer contributions can vest. For an ERISA plan, the longest permissible graded vesting period is six years. Cliff vesting cannot require more than three vesting YOS. For additional information on minimum vesting requirements, see I.R.C. § 411(a)(2); 26 C.F.R. § 1.411(a)(1); 26 C.F.R. §§ 1.411(a)-3T.

Permissible vesting schedules in an ERISA plan include:

  • Cliff vesting – 100% vesting upon completion of designated years of vesting service
  • Immediate vesting – 100% upon participation in the plan
  • nother vesting schedule designated by the employer – provided that 100% vesting occurs not later than completion of the sixth year of vesting service

Top-heavy contributions to an ERISA plan are subject to special vesting requirements. Foremost, the vesting schedule for top-heavy contributions must be at least as favorable as the vesting schedule for other employer contributions. In practice, plans that provide a vesting schedule for non-safe harbor employer contributions often designate the same vesting schedule for top-heavy contributions.

Certain contributions are also subject to statutory vesting schedules. For example:

  • Employee contributions (including employee deferral contributions after-tax contributions) must vest immediately, never to be forfeited by the participant.
    •Safe harbor nonelective (SHNE) contributions (contributions designed to help a 401(k) plan to meet ADP requirements) and safe harbor matching (SHM) contributions (contributions designed to help a 401(k) plan other than a nonelecting church plan to meet ACP requirements) must also vest immediately.
  • Plans that require two years of service before a participant can enter the plan must immediately and fully vest employer contributions.

For a governmental plan, the IRS provides a safer harbor for vesting at least as favorable as the following schedule:

  • Fifteen year cliff vesting. 100% vesting upon 15 years of creditable service (service can be based on years of employment, years of participation, or other creditable years of service).
  • Twenty year graded vesting. A participant is fully vested based on a graded vesting schedule of five to 20 years of creditable service (service can be based on years of employment, years of participation, or other creditable years of service).
  • Twenty year cliff vesting for qualified public safety employees. A participant is fully vested after 20 years of creditable service (service can be based on years of employment, years of participation, or other creditable years of service). This safe harbor would be available only with respect to the vesting schedule applicable to a group in which substantially all of the participants are qualified public safety employees (within the meaning of I.R.C. § 72(t)(10)(8)).

The plan’s selected vesting schedule notwithstanding, the employer can choose whether to “accelerate” vesting upon a participant’s attainment of early retirement age, death, or disability. The employer can also choose to count a participant’s time of disability toward their vesting service (as though s/he was still employed). Like all adoption agreement provisions, however, the administrator must apply vesting acceleration on an equal and nondiscriminatory basis.

Prior and Transferred Assets Vesting Schedules

After a corporate merger, acquisition or spin-off, an employer may require a new plan or amendment of its existing plan, to provide plan coverage to employees of the entity that was the subject of the corporate transaction. For example, an employer that acquires another business can cover the acquired employees in the employer’s existing plan, or may sponsor a new plan for the acquired company. If the acquired company has a pre-existing plan, the employer may become the sponsor of the acquired plan, may sponsor a new plan for the affected employees, or may merge the prior plan into an existing plan.

ERISA’s provisions relating to mergers and acquisitions exceed the scope of this note. But in relevant part, affected employees may not lose the benefits allocated to them under a prior employer’s plan: each affected participant is entitled to receive a benefit after a corporate transaction that is at least equal to the benefit the participant would have received before the transaction. I.R.C. §§ 401(a)(12) and 414(l); 26 C.F.R. §§ 1.401(a)-12, 1.414(l)-1. For additional information on ERISA’s requirements regarding retirement plans involved in mergers & acquisitions, see Retirement Plan Issues in Corporate Transactions.

When implementing (or amending) a pre-approved plan that will cover acquired employees, the adoption agreement must indicate:

  • Whether a prior vesting schedule exists for affected participants prior account balances
  • Whether the vesting schedule that applied to prior account balances (“old money”) is more or less generous than the vesting schedule for new contribution allocations (“new money”) –and–
  • The vesting schedule under the prior plan

In summary, old money must vest at least as quickly as it would under the prior plan, but new money can vest at the existing plan’s schedule, whether slower or faster than the former plan’s vesting schedule.

Similarly, if two plans merge and assets are transferred from the acquired plan into a new or existing plan, the transferred assets must continue to vest at the same or faster rate as they would have under the former plan. The adoption agreement will require you to designate each account type that is the source of transferred assets, i.e., non-elective contribution account or matching contribution account, and the vesting schedule that applied to the transferred assets.

Breaks in Service and Reemployment

An account balance in an ERISA plan that becomes forfeitable is not immediately forfeited: the participant must attain a designated number of years of “breaks in service” before the balance is deducted from the participant’s employer contribution account. If the participant returns to service before the maximum break in service is completed, then the participant’s account balance attributed to unvested employer contributions can be reinstated. (But compare employer contributions that are fully and immediately vested, which can never be forfeited.)

In order to permit forfeitures, an adoption agreement must indicate the service rules that apply to forfeitures, including how breaks in service are counted (by incorporating HOS and YOS – both of which are defined in “Service Requirements and Entry Date” above under “Eligibility Requirements”). The most typical break in service and reemployment provisions are:

  • A “one-year break in service” is a plan year during which the participant failed to complete a designated number of HOS up to 500 hours –and–
  • YOS completed after a break in service can be disregarded for vesting purposes unless the participant is reemployed within five years

Some plans (more typically defined benefit plans) apply a “rule of parity” that allows a plan to disregard YOS completed before a break in service, if the number of consecutive one-year breaks equals or exceeds the greater of five, or the participant’s years of service before the break began. In contrast, although relatively rare, employers can choose to count all service toward vesting, including service completed after a break in service, regardless of the length of the break in service.

Governmental plans are not subject to statutory rules regarding forfeitures, but must nevertheless specify what forfeiture rules are being used.

Forfeitures

Forfeitures are the result of a participant’s failure to complete the plan’s vesting schedule. For example, if a plan has three-year cliff vesting, employer contributions will vest when the participant completes three years of service, but if the participant terminates employment after two years, the account balances become forfeitable.

The adoption agreement must reflect the plan’s rules for how forfeitures will be deducted from participants’ accounts. A plan can permit forfeitures to occur at:

  • Various dates tied to other plan definitions (such as valuation date, the designated number of consecutive breaks in service)
  • Upon certain distribution events (such as distribution of the entire vested interest, or pro-rata as the vested interest is distributed over time)

Consult the trustee (or trust custodian charged with valuing account balances) before electing these provisions. For additional information on forfeitures, see I.R.C. §§ 411(a)(6).

Forfeited assets cannot revert to the employer; therefore the adoption agreement must detail when and how forfeitures of employer contribution accounts will be applied in the plan. Once forfeited, unvested employer non-elective and matching contributions can be used by the employer to:

  • Reduce administrative expenses (to pay permissible plan expenses)
  • Restore forfeited account balances of rehires (to replace forfeitures previously taken from an account if the participant is reemployed by the employer)
  • Reduce employer contributions (to fund current employer contributions with forfeited balances)
  • Supplement employer contributions (to give additional contributions to participants)

Asset Distribution Provisions

End-of-Service Distributions

Plans must permit distribution of benefits (if requested by the participant or beneficiary) as the result of retirement, termination of employment or death. If elected in the adoption agreement, a plan may treat a participant’s full disability (as defined in the plan) as a distribution event.

In all cases, the adoption agreement must designate the forms of distribution permitted by the plan. Options include:

  • Lump sum in cash (the minimum form required of all DC plans)
  • Partial non-periodic ad hoc distributions paid at times and in amounts requested by the participant or beneficiary
  • Installment payments made in substantially equal annual, quarterly or monthly installments over a number of years designated in the adoption agreement, or over a period of years selected by participant that is less than her life expectancy, or another schedule designated in the adoption agreement
  • Annuities (payments made by purchasing an annuity contract providing for equal periodic payments for the life of participant, and possibly after participant’s death for the life of a designated beneficiary or spouse)

For additional information on permitted distribution types, see I.R.C. §§ 401(a)(15), 401(a)(11), 411(d)(6). More varied distribution types are permitted in governmental and nonelecting church plans, which are not subject to those I.R.C. sections.

If permitted by the employer’s election (and if later elected by the participant) a plan can provide joint and survivor annuities, which pay for the life of the participant, and at participant’s pre-death election, continue payments to a designated beneficiary a fixed proportion of the annuity contract value for a specified period.

Pre-approved plans may permit various annuity options, and those provided in support of annuity products often provide extensive ones. In a defined benefit plan, the normal form of benefits must be a qualified joint and survivor annuity for the participant and spouse if the participant is married, and otherwise a life annuity for the participant. A preretirement survivor annuity in favor of the spouse must also be provided if the participant dies before termination of employment. If a married participant wants to elect a different form of benefits, the election is possible only if the spouse consents.

Depending on the annuity options provided by the pre-approved plan’s provider, the adoption agreement may require decisions on:

  • The periods permitted for annuities
  • Whether they will carry over from the participant’s life to another’s life
  • The designated percentage payable to the non-spouse beneficiary or surviving spouse
  • Whether payments will be guaranteed for a period of years

For additional information on statutory annuity requirements, see I.R.C. §§ 401(a)(11), 417; 26 C.F.R. § 1.401(a)(20).

In-Service Distributions

Plans are not required, but may in some circumstances permit, participants to access portions of their account balances while still employed by the adopting employer. For participants, the availability of in-service distributions is a double-edged sword: they calm employees’ fears that money saved for retirement will be inaccessible until retirement, but removing assets and losing investment income reduces retirement readiness. Notably, although a plan can permit premature distributions (taken before the plan’s earliest retirement date) a 10% penalty tax will be deducted from the premature distribution.

Once elected, the ability to remove in-service distributions is limited. The availability of in-service distributions are “protected benefits”: once provided, they must always be available for account balances that exist before the removal of the protected benefit. Although subsequent allocations are not subject to an eliminated protected benefit, the plan will incur additional administration costs to administer a protected benefit for portions of participants’ account balances. See I.R.C. § 411(d)(6) for additional information on protected benefits.

In-service distributions can be provided only if the adoption agreement provides for them. Distributions of employee deferrals under a 401(k) plan can be permitted only on or after a participant’s attaining an age specified by the employer that is no earlier than 59½, or upon hardship (see below).

The adoption agreement may also apply non-age requirements to access account balances that would be used for in-service distributions. Additional requirements can include:

  • The participant’s attainment of early or normal retirement age under the plan
  • Assets having been allocated for at least two years
  • Participation in the plan for at least five years –or–
  • A combination of both allocation and participation requirements

In a defined benefit plan, in-service distributions can be permitted only upon attainment of the earlier of age 62 or normal retirement age under the plan. Various rules limit the normal retirement age that can be specified for this purpose.

The adoption agreement must also specify the accounts from which in-service distributions can be deducted. If elected, in-service distributions of 401(k) elective deferrals can be made from accounts holding:

  • Employee non-elective contributions (i.e., employee deferrals)
  • Matching contributions
  • SHNE and SHM contributions
  • Various types of rollover accounts (in which employees place distributions from a prior employer’s plan)
  • Employee voluntary contribution accounts

For additional information on in-service distributions, see I.R.C. §§ 401(k)(2)(B)(i)(III), 401(k)(10).

Hardship Distributions

For a 401(k) plan, another permissible in-service distribution is the hardship distribution. Hardships distributions must be granted on the basis of immediate and heavy financial need, which must be defined in the plan. The single plan document or adoption agreement must designate the accounts from which hardships can be paid. Like in-service distributions, the availability of hardships is a protected benefit. Hardship distributions are also subject to the 10% premature distribution penalty.

Most pre-approved plans define “hardship” as meeting the “safe harbor hardship” standards of 26 C.F.R. § 1.401(k)-1(d)(2)(iv). If a safe harbor hardship is elected in the single plan document or adoption agreement, the safe harbor’s “deemed hardship” criteria cannot be changed, and any distribution paid on this basis will be deemed necessary to satisfy the participant’s immediate and heavy financial need. Safe harbor distributions can be used to pay:

  • Deductible medical expenses
  • A down payment on the purchase of a principle residence
  • Tuition and related educational needs
  • Amounts required to prevent eviction or foreclosure
  • Funeral or burial expenses –and–
  • Significant repair costs arising from a catastrophic event

In addition, before obtaining a safe harbor hardship, a participant must have obtained all other distributions and plan loans that are available under the plan and must have ceased elective deferrals and voluntary employee contributions for six months.

Although atypical in a pre-approved plan, in lieu of the safe harbor standards, an employer can define its own non-safe harbor criteria for hardship distributions. However, a unique definition must be consistently applied, and the employer should expect the plan’s review, approval and recordkeeping processes to invite stricter scrutiny in a financial or agency audit of the plan. See I.R.C. § 401(k)(2)(B)(i)(IV) for additional information on hardship distributions.

Plan Loans

Although not technically an in-service distribution, a defined contribution plan can permit plan loans that enable participants to access their account balances before terminating employment. Plan loans are paid from the participant’s accounts, and must be repaid with interest. Plan loans that have not been repaid are deducted from the participant’s accounts; there is no premature distribution penalty associated with plan loans. For a plan covered by ERISA, married participants must provide their spouse’s consent to obtain plan loans.

If plan loans are permitted, the adoption agreement must specify the number, frequency, minimum and maximum amounts permitted, applicable interest rate and default provisions relating to plan loans. For information on plan loans see I.R.C. § 72(p)(2).

Other Administrative Provisions

Besides statutory and design options, the adoption agreement must specify how plan asset and trust or custodial account provisions will apply. These include:

  • The date as of which earnings on contributions will be credited to a participant’s account
  • Whether the plan’s forfeiture account will be subject to trust earnings
  • Whether plan participants may make their own investment choices from a slate of investment alternatives that have been vetted by the plan trustees
  • If the plan permits participant-elected investments, to which accounts a participant’s investment control will apply
  • Whether life insurance can be purchased as a form of benefit
  • The extent to which the plan will accept rollover contributions from other plans (if at all) –and–
  • How many trustees are required to take action on behalf of all trustees

Additional Documents Required to Implement a Pre-Approved Plan

Other documents required to generate a pre-approved plan may also require some additional information.

Trust Agreement

If plan assets are held in trust (as opposed to an annuity contract), either the basic plan document or a separate trust agreement must set forth the trust provisions. The trust agreement enumerates ERISA’s fiduciary requirements that apply to trustees’ management of plan assets. “Named trustees” are generally employees of the adopting employer, who exercise some discretion in the administration of the plan. Most typical in pre-approved plans, named trustees select the plan investments that a participant can apply to his individual accounts. Conversely, some pre-approved plans require trustees to make all investment decisions for the plan’s aggregated accounts. For additional information on trust requirements, see ERISA § 403 (29 U.S.C. § 1103).

In either case, the trust agreement must specify the names of the plan’s trustees, and since circumstances (such as retirement) cause trustees to change, the trust agreement will require periodic amendment.

Summary Plan Description

In brief, the SPD describes the plan’s benefits and participant rights in “plain English” intended to be understood by the average plan participant, including eligibility, contributions, vesting/forfeiture, distributions, where to get additional information about the plan.

Choices elected in the adoption agreement will also be captured in the system-generated SPD. However, additional plan policies may need to be completed to enable the document system to generate a complete (and ERISA compliant, in the case of an ERISA plan) SPD. Additional policies that would impact the SPD include the plan’s:

  • Loan policy (if the plan permits loans)
  • Expense policy (denoting administrative expenses charged to participant accounts, such as to apply for a plan loan) –and–
  • Insurance policy (describing how contribution accounts can be applied to life insurance premiums)

Detailed information about ERISA’s requirements for SPDs is located at ERISA § 102 (29 U.S.C. § 1022); 29 C.F.R. § 2520.102-3. While non-ERISA plans are not subject to statutory or regulatory requirements for SPDs, they will nevertheless typically provide a plan summary to inform employees of the essential plan terms.

Corporate Resolution

The corporate resolution is the instrument with which the employer adopts the plan and approves the plan documents. The information required for the resolution is usually captured from the employer’s general information that was entered into the adoption agreement.

However, some situations will require either unique or multiple resolutions. Besides allowing you to select certain routine resolutions (i.e., appointing and/or removing a plan trustee), the resolution module should allow you to draft unique resolutions that are not pre-programmed as a module option (such as allocating contributions to specified ineligible employees to correct cross-testing failures under 26 C.F.R. § 1.401(a)(4)-11(g)).

Notices to Participants and Beneficiaries

Many plan provisions that can be elected by the employer also require special disclosures to plan participants. For example, SHNE and SHM contributions, as well as automatic deferral contributions, each require the administrator to provide annual notice to participants. Certain events, such as plan mergers, cause a transfer of investments between investment platforms and a “blackout period” during which participants cannot access their accounts or change their investments. The plan administrator must provide detailed blackout notices to participants and beneficiaries well before the blackout begins.

Some document systems generate such participant notices but only after you provide relevant event-specific information. When the notice relates to plan features, the relevant information is captured from the adoption agreement. But when a notice relates to an event that isn’t a plan feature – such as a plan merger – additional information is required to generate a compliant notice.

Obtaining IRS Opinion Letters

The IRS issues opinion letters on pre-approved plans. The opinion letter explains the:

  • Scope of the IRS’s pre-approval of the plan that is being used by the employer
  • Body of law and certain assumptions that are basis for the pre-approval –and–
  • Extent to which the adopting employer is protected by pre-approval of plan

The IRS announces the date by which employers must adopt pre-approved plans for each six-year cycle.

For instructions on how to apply for an opinion letter, see Pre-Approved Plan Submission Procedures. For a detailed discussion on determination letter applications (including information on how to apply), see Determination Letter Application Procedures.

If a mass submitter files on behalf of a flexible plan, it must bracket and identify the optional provisions when submitting such plan, and must also provide the IRS a written representation describing the choices available to Providers and the coordination of optional provisions. Thus, such a representation must indicate whether a Provider’s plan may contain only one of a certain group of optional provisions, may contain only a specific combination of provisions, or may exclude the provisions entirely. Similarly, if the inclusion (or deletion) of a specific optional provision in a Provider’s plan will automatically result in the inclusion (or deletion) of any other optional provision, this must be set forth in the mass submitter’s representation.

Adopting employers that have made minor modifications to the terms of the pre-approved plan may request a determination letter using Form 5307. Examples of minor changes include: changing the effective date of a provision, adopting IRS model or sample amendments, the adoption of an interim or discretionary amendment in accordance with Revenue Procedure 2007-44, or the adoption of amendments to obtain reliance for §§ 415 and 416 given the required aggregation of plans. Adopting employers that have not made any changes to the terms of the pre-approved plan (except to select among options under the plan) should not submit Form 5307. These employers may rely on the opinion letter issued for the plan.

This excerpt from Lexis Practice Advisor®, a comprehensive practical guidance resource providing insight from leading practitioners, is reproduced with the permission of LexisNexis. Reproduction of this material, in any form, is specifically prohibited without written consent from LexisNexis.

Substantial Risk of Forfeiture Definition Comparison Chart
(Posted on May 29, 2018 by )


The chart that follows compares the circumstances in which a person’s rights to compensation are subject to a substantial risk of forfeiture (SRF) for purposes of income taxation under each of sections 83, 409A, 457, and 457A of the Internal Revenue Code (I.R.C.), Social Security and Medicare (FICA) taxation under I.R.C. § 3121(v)(2), and excise taxes under I.R.C. § 4960. As a practitioner drafting or advising on compensation arrangements—especially arrangements involving non-qualified (or ineligible), unfunded deferred compensation (referred to herein as NQDC)—you must be able to correctly interpret these I.R.C. sections and distinguish the concepts of SRF expressed therein to ensure that an employer understands and achieves the tax goals for which its arrangements’ are designed. Read more.

New chart: Pre-approved Plan Eligibility Checklist
(Posted on January 5, 2018 by )


Lexis Practice AdvisorThe IRS maintains pre-approved plan programs (1) for retirement plans described in I.R.C. § 401(a) (qualified plans), and (2) for annuity contracts or custodial accounts described in I.R.C. § 403(b) (403(b) plans). A new chart shows what types of plans are and are not eligible to use the pre-approved plan program.

Read more.

Pre-approved Plan Eligibility Checklist
(Posted on January 2, 2018 by )


Use this checklist to determine which retirement plans can use pre-approved plan documents to satisfy the requirements for preferential tax treatment under the Internal Revenue Code (I.R.C.). The IRS maintains pre-approved plan programs (1) pursuant to Rev. Proc. 2017-41, 2017–29 I.R.B. 92, for retirement plans described in I.R.C. § 401(a) (qualified plans), and (2) pursuant to Rev. Proc. 2013–22, 2013–18 I.R.B. 985, as modified by Rev. Proc. 2014–28, 2014–16 I.R.B. 944, for annuity contracts or custodial accounts described in I.R.C. § 403(b) (403(b) plans). The programs available for pre-approved plans are different depending on the type of plan and the type of employer. Read more.

Employers Need to Adopt Pre-Approved 403(b) Plans by March 31, 2020
(Posted on January 30, 2017 by )


Internal Revenue ServiceWith the IRS no longer issuing rulings or determination letters on individually designed qualified plans or § 403(b) plans under most circumstances, the importance of pre-approved plans (master, prototype, and volume submitter plans) has been vastly increased. Adoption of a pre-approved plan is now the sole method for an employer to have assurance that its plan meets IRS requirements. While § 403(b) plans cannot take the form of master plans, they can be structured as prototype or volume submitter plans.

Reflecting this, Revenue Procedure 2013-22 established a program for issuing opinion and advisory letters for § 403(b) pre-approved plans. Starting June 28, 2013, sponsors of plans intended to qualify as pre-approved § 403(b) plans were permitted to apply for such letters. The first letters have not been issued under that program yet, but the expectation is that they will be issued soon.

The IRS has now announced in Rev. Proc. 2017-18, 2017-5 I.R.B. 743, that the last day of the remedial amendment period for employers to adopt pre-approved § 403(b) plans will be March 31, 2020. After that date, adoption of a pre-approved § 403(b) plan will no longer give an employer retroactive relief for qualification defects which arose since 2010. Revenue Ruling 2013-22 indicated that a six-year cycle would apply to pre-approved § 403(b) plans. While it is not clear whether the second cycle would also end on exactly March 31, there will likely not be another opportunity to adopt a pre-approved plan to fix past errors until about 2025 or 2026. And even then, adoption of a pre-approved plan would likely not provide retroactive relief for periods before 2020.

Obtaining an IRS advisory or opinion letter is not legally required, so long as a plan (in form and operation) complies with § 403(b). However, as a practical matter, an employer will typically want to adopt a pre-approved § 403(b) plan with an IRS letter verifying its status, since one of the major advantages of a pre-approved plan is the opportunity to get IRS blessing on the plan.