SECTION 403(B) TAX-DEFERRED ANNUITY PLANS

The 403(b) plan is another specialized plan that is available to some employers as an alternative or supplement to a qualified plan. The 403(b) plan was provided as a result of Congress's concern that employees of tax-exempt organizations might not have adequate qualified plan coverage. Tax-exempt employers may have relatively little money available for employee benefits, and the tax deductibility of a qualified plan does not act as an incentive because the tax-exempt employer pays no federal income taxes. As a result, Congress enacted Code Section 403(b), which, within limits, allows employees of certain tax-exempt organizations to have money set aside for them by salary reductions or direct employer contributions in a tax-deferred plan somewhat similar to a qualified plan.

Section 403(b) plans are an important consideration in designing the benefit program for any tax-exempt employer. However, today many tax-exempt employers have regular qualified plans for their employees, with the Section 403(b) plan being made available as a supplemental retirement or savings program. Tax-exempt, but not government, employers can adopt 401(k) plans as well as 403(b) plans, so such employers may be in a position to choose between the two approaches for salary savings. For most tax-exempts, the 403(b) plan is somewhat more advantageous than a 401(k) plan.

Section 403(b) plans are sometimes referred to as tax-deferred annuity (TDA) plans or tax-sheltered annuities, but because these terms also can refer to annuities not covered under Section 403(b), the term Section 403(b) plans will be used here to avoid confusion.

Eligible Employers

Employees of the following two types of organizations are eligible to adopt Section 403(b) plans:

1. A tax-exempt employer described in Code Section 501(c)(3)—an employer "organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes, or to foster national or international amateur sport competition ... or for the prevention of cruelty to children or animals." Section 501(c)(3) also requires that the organization benefit the public rather than a private shareholder or individual and that the organization refrain from political campaigning or propaganda to influence legislation.

2. An educational organization with a regular faculty and curriculum and a resident student body that is operated by a state or municipal agency—in other words, a public school or college. This is the only type of government employer that can adopt a 403(b) plan.

Thus, Section 403(b) plans are available to a wide range of familiar nonprofit institutions such as churches, private and public schools and colleges, hospitals, and charitable organizations.

To participate in a Section 403(b) plan of an eligible employer, the participant must be a full- or part-time employee. This is significant because tax-exempt organizations often have ties with persons who are independent contractors rather than employees. For example, many physicians on a hospital staff technically are not employees but rather independent contractors. A person is an employee when the employer exercises control or has the right to control the person's activities as to what is done and when, where, and how it is done. The question of employee status also affects federal income tax withholding, employment taxes (Social Security and federal unemployment), and participation in other fringe benefit plans of the employer. If the employer wishes to cover a person under a Section 403(b) plan, it must at least treat that person consistently as an employee for all these purposes.

To be eligible for a Section 403(b) plan, a public school employee must perform services related directly to the educational mission. The employee can be a clerical or custodial employee, as well as a teacher or principal; a political officeholder is eligible only if the person has educational training or experience.

Coverage and Participation Tests

Section 403(b) plans to which the employer makes contributions are subject to relatively complicated nondiscrimination requirements. Employer matching contributions are also subject to the tests described in the discussion of savings and thrift plans. However, if the plan is funded entirely through employee salary reductions, as many plans are, these requirements do not apply. There is a simpler nondiscrimination requirement for salary reductions, however: if the plan permits salary reductions for any employee, then it must permit salary reductions of more than $200 for any other employee, except for those covered under a Section 457 plan or Section 401(k) plan or under another 403(b) plan. Certain part-time and student employees can be excluded.

A Section 403(b) plan (except for a church-related, public school, or public college plan) is covered under the age and service provisions of ERISA Section 202, which are the same as the analogous age and service code provisions for qualified plans. Thus, if a Section 403(b) plan uses age or service eligibility, these can be no greater than age 21 and one year of service. However, age and service requirements are rarely used in Section 403(b) plans.

The Limits on the Employee's Annual Contributions

Determining the maximum amount that can be contributed for an employee under a 403(b) plan is quite complicated. There are at least three steps in the computation, and if the plan is based on employee salary reductions, as most plans are, there are five basic steps summarized following.

1. The 403(b) annual exclusion allowance. The starting point in the computation is a provision unique to 403(b) plans, the annual exclusion allowance. The formula for the annual exclusion allowance for an employee is

   • 20 percent of the participant's includable compensation from the employer multiplied by

   • the employee's total years of service for the employer, minus

   • amounts contributed to the plan in prior years that were excluded from the employee's income.

   Includable compensation in general is gross compensation including salary reductions. For example, if a participant has a salary of $30,000 and elects a salary reduction of $5,000 to the 403(b) plan, his includable compensation for purposes of this formula is $30,000, even though his taxable compensation is only $25,000.

   The third item—the amount subtracted from the 20 percent times years of service amount—must include contributions by the employer to regular qualified plans on behalf of the employee. If the qualified plan is a defined-benefit plan, the amount deemed to be contributed for the employee is to be determined under recognized actuarial principles or under a formula provided in the regulations.

2. The Section 415 annual additions limit. The determination of the maximum 403(b) contribution for higher-income employees is complicated by the fact that although a Section 403(b) plan is not a qualified plan, the Section 415 limitation for defined-contribution plans applies. Thus, the annual addition to any participant's account cannot exceed the lesser of 25 percent of compensation or $30,000, even if the exclusion allowance would produce a higher figure.

   
   

   Doctor Staph is an employee of the Tibia Hospital and has annual compensation of $200,000 this year. She has four prior years of service for Tibia Hospital, during which the hospital has contributed $5,000 to her account in a Section 403(b) plan. No amounts have been contributed to any qualified plan on her behalf. Her exclusion allowance for the Section 403(b) plan this year is 20 percent of her includable compensations of $200,000 times her five years of service, or a total of $200,000, less contributions for prior years of $5,000, or $195,000. However, since this exceeds the applicable Section 415 limit of $30,000 is the most that can be contributed to the Section 403(b) plan for Doctor Staph this year.

   If the participant has more than one employer, all Section 403(b) plans of all employers must be combined for purposes of the Section 415 limit. However, if the employee participates in a regular qualified plan or plans as well as the Section 403(b) plan, it usually is not necessary to combine the qualified plans and the 403(b) plan for purposes of the Section 415 limit [Section 415(g) and Regulations Section 1.415-8].

   
   

3. Section 415 catch-up alternatives. The third step relates to a special feature in applying the Section 415 limit to a 403(b) plan. The Section 415 limit (25 percent/$30,000) may not be exceeded in any year, while the regular exclusion allowance is increased by prior service. This works a hardship on long-service employees who have had relatively low Section 403(b) contributions in prior years. Under the regular exclusion allowance, their prior service would otherwise permit large contributions to catch up for past years. For employees of educational institutions, hospitals, and home-health service agencies—but not other employers—the Code contains catch-up alternatives to the regular Section 415 limitation that are aimed at long-service employees. Under the catch-up alternatives, the 25 percent of compensation limit under Section 415 is not always applied, thus permitting Section 403(b) contributions in excess of 25 percent of the current year's compensation. However, in no event can the $30,000 limitation be exceeded, even under the catch-up alternatives.

4. Salary reduction limitation. The fourth step in determining the maximum 403(b) contribution applies to salary reduction plans. For such plans, there is a limit of $9,500 on annual salary reductions for each participant. This limit applies to the total (for each employee) of Section 403(b) salary reductions, SIMPLEs, and 401(k) salary reductions under plans of all the employee's employers. The $9,500 is indexed for cost-of-living increases (2000: $10,500). The $9,500 limit does not apply to direct employer contributions to the participant's account; thus, the total can be more than $9,500, as long as the exclusion allowance and the Section 415 limit are not exceeded.

   The amount contributed to the plan by a salary reduction will not be subject to income taxes if the salary-reduction election is made properly. For these amounts to avoid taxation, the salary reductions must be made under the same rules discussed in connection with 401(k) plans concerning the timing of the election. As with 401(k) salary reductions, although the amounts are not currently subject to income tax to the participant, they are subject to Social Security and federal unemployment (FICA and FUTA) taxes.

5. Salary reduction catch-up. As a final step in the process of determining the maximum 403(b) annual contribution, there is a further catch-up provision to raise the $9,500 salary reduction limit for employees having at least 15 years of service with the employer. The catch-up limit [Code Section 402(g)] allows additional salary reductions above the $9,500 limit (as indexed) equal to the least of

   • $3,000;

   • $15,000 less prior catch-up contributions; or

   • $5,000 times the employee's years of service with the employer, less all prior salary reductions with that employer.

Types of Investments for 403(b) Plans

Section 403(b) plan funds must be invested in either

• annuity contracts purchased by the employer from an insurance company or

• mutual fund shares held in custodial accounts [referred to as 403(b)(7) accounts].

Many different types of annuities may be used for Section 403(b) plans. Thus, the annuities can be individual or group contracts, level or flexible premium annuities, and fixed dollar or variable annuities. Face-amount certificates providing a fixed maturity value and a schedule of redemptions are also permitted. In addition, the annuity contract may provide incidental amounts of life insurance for the employee; however, the value of such insurance is taxable to the employee each year under the PS 58 table. The annuity contracts can provide the employee a choice of broad types of investment strategy—for example, a choice between investment in a fixed-income fund and an equity-type fund. However, if the contract gives the employee specific powers to direct the investments of the fund, the IRS will regard the employee as in control of the account for tax purposes and the employee will be currently taxed on the fund's investment income.

Annuity contracts used in Section 403(b) plans must be nontransferable. This means that they cannot be sold or assigned as collateral to any person other than the insurance company issuing the contract. However, the employee is permitted to designate a beneficiary for death benefits or survivorship annuities. Because similar restrictions apply to annuities transferred to participants from qualified plans, most insurance companies use the same standard provisions for both types of annuity contracts.

Mutual fund accounts [403(b)(7) accounts] are used in 403(b) plans much as they are in 401(k) plans, and can give participants the opportunity to allocate their accounts according to their own investment strategies by providing a family of funds with different investment approaches.

Distributions and Loans from Section 403(b) Plans

Distributions from Section 403(b) plans are subject to rules similar to those applicable to qualified 401(k) plans; however, there are differences in detail. Withdrawal restrictions are quite complicated. In general, withdrawals are not permitted from 403(b)(7) custodial accounts (mutual funds) or from any salary-reduction 403(b) account except for withdrawals after age 59½, or upon death, disability, separation from service, or financial hardship. These withdrawal restrictions technically do not apply to annuity-type 403(b) accounts funded by direct employer contributions rather than salary reductions. However, this "loophole" is of limited usefulness because all early withdrawals are subject to the 10 percent early distribution penalty of Code Section 72(t). This penalty applies to most distributions prior to age 59½ from qualified plans, IRAs, and Section 403(b) plans. The penalty applies even to distributions that are permitted; for example, many hardship distributions from Section 403(b) plans will be subject to the penalty.

Other qualified plan distribution rules also apply to Section 403(b) plans. Distributions must begin by April 1 of the calendar year following the attainment of age 70½ or actual retirement, if later. The minimum annual distribution thereafter is a level amount spread over the participant's life expectancy or over the joint life expectancies of the participant and beneficiary.

Loans

Section 403(b) plans with either annuity or mutual-fund accounts may permit loans on the same basis as regular qualified plans. Because of the restrictions on Section 403(b) distributions, plan loan provisions are particularly important to employees and should be considered in any Section 403(b) plan.

Taxation of Section 403(b) Plans

A Section 403(b) plan provides the same general tax advantages as a qualified plan. Thus, plan contributions within the limits of the exclusion allowance are not currently taxable to the employee. Investment earnings on plan funds are also not currently taxable.

However, the taxation of distributions from Section 403(b) plans is some-what less favorable than for qualified plans. The full amount of any distribution from a Section 403(b) plan, whether during employment or at termination of service, is fully taxable as ordinary income to the participant, except for any cost basis the participant has in the distribution. A cost basis could result if the employee paid tax previously on any amount contributed to the plan or reported PS 58 costs if the plan provides incidental life insurance. There are no averaging or capital-gain provisions for the taxable amount of a distribution from a Section 403(b) plan. The bad tax effect of having all of the income taxable in a single year can be alleviated only by having a periodic form of payout from the plan. A periodic distribution from a Section 403(b) plan is taxed under the annuity rules the same as an annuity from a qualified plan.

Death benefits are also subject to somewhat less favorable income tax treatment than death benefits from qualified plans. The averaging and capital gain provisions are not available to the beneficiary. Section 403(b) death benefits are included in the gross estate of the deceased participant for federal estate tax purposes. However, if they are paid to a spouse, they escape estate taxation under the unlimited marital deduction. In other cases, there may be no estate tax because the tax applies only to relatively large estates (those over about $600,000, subject to increase to $1,000,000 by 2007).

Regulatory and Administrative Aspects

A Section 403(b) plan is considered a pension plan, rather than a welfare benefit plan, for purposes of the reporting and disclosure provisions. The reporting and disclosure requirements applicable are similar to those applicable to qualified plans. However, as with qualified plans, Section 403(b) plans of government units and churches that have not elected to come under ERISA are exempt from these requirements, unless mutual funds rather than annuity contracts are used for funding. If a Section 403(b) plan is purely of the salary reduction type and does not include any direct employer contributions, the reporting and disclosure and other regulatory requirements are greatly reduced.