Very Serious Business: Sense and Nonsense under Section 403(b) of the Internal Revenue Code of 1986

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I. INTRODUCTION II. DEVELOPMENT OF SECTION 403(b) III. WHAT IS A 403(b) ARRANGEMENT? IV. WHICH EMPLOYERS MAY SPONSOR A 403(b)

ARRANGEMENT?

A. In General

B. Eligible Employers

C. Ineligible Employers

D. Suggested Changes V. WHO MAY PARTICIPATE IN A 403(b) ARRANGEMENT? VI. FUNDING VEHICLES VII. SALARY REDUCTION CONTRIBUTIONS VIII. LIMITATIONS ON CONTRIBUTIONS TO A 403(b)

ARRANGEMENT

A. Dollar Limit on Elective Salary Reduction

Contributions

1. General Rule

2. Higher Limit for Certain Employees

3. Coordination with Other Plans

4. Excess Deferrals

B. Limitations Under Section 415

1. General Rule

2. Special Elections

a. The A Election

b. The B Election

3. Special Section 415 Rules for 403(b)

Arrangements

4. Effect of Excess Contributions

C. The Exclusion Allowance

1. General Rule

2. Includible Compensation

3. Years of Service

4. The "C Election"

5. Other Rules

D. Vesting

E. Excise Tax

F: Conclusion and Comments IX. TAX TREATMENT OF 403(b) ARRANGEMENT

PARTICIPANTS X. ROLLOVERS AND TRANSFERS XI. DISTRIBUTION REQUIREMENTS

A. Minimum Distribution Rules

B. Restrictions on Distributions

1. Salary Reduction Contributions

2. Custodial Accounts

3. Plan Termination

4. Exceptions XII. NONDISCRIMINATION REQUIREMENTS

A. Salary Reduction Contributions

1. General Rule

2. Employees Who May Be Disregarded

3. Results of Noncompliance

B. Other Employer Contributions XIII. COMPLIANCE WITH SECTIONS 410(b), 401(a)(26)

AND 401(a)(4)

A. In General

B. The Safe Harbors Under Notice 89-23

1. The Maximum Disparity Safe Harbor

2. The Lesser Disparity Safe Harbor

3. The No Disparity Safe Harbor

C. Definition of Employer

D. Excludable Employees

E. Compensation

F. The Plan Year

G. The Testing Method XIV. APPLICABILITY OF ERISA

A. In General

B. Consequences of ERISA Coverage XV. CONCLUSION

I. INTRODUCTION

Until 1958, employees of certain tax-exempt organizations could defer all or part of their income from the organization through the use of a tax-sheltered annuity arrangement.(1) In 1958, Congress added section 403(b) to the Internal Revenue Code (IRC),(2) restricting the amount of compensation that could be deferred for tax-purposes.(3) Under the legislation, an employee's deferral for tax-purposes was limited to the "exclusion allowance," a calculation based on the employee's compensation and length of service with the employer.(4) From these modest beginnings, section 403(b) has become an integral part of the benefit packages of eligible employers.(5)

A 403(b) arrangement has, until recently, been easier to design and administer than a plan which is qualified under section 401(a). In addition, since the Tax Reform Act of 1986 (TRA 1986) prohibits the adoption of new 401(k) plans by governmental and tax-exempt employers,(6) a 403(b) arrangement is clearly the best vehicle available to employees of tax-exempt employers who wish to make tax-deductible salary deferrals into a retirement plan. The only alternative, an eligible deferred compensation plan under section 457,(7) is clearly less satisfactory, as (1) the employee simply becomes a general creditor of the employer with respect to amounts deferred, and income thereon,(8) and (2) in order to comply with both the requirements of section 457 and the requirements of the Employee Retirement Income Security Act of 1974 (ERISA),(9) as amended, a private tax-exempt employer must generally limit participation in its section 457 plan to a select group of management or highly compensated employees. …