Need to Know: Top 5 Operational Errors of 403b Plans


The IRS correction program, the Employee Plan Compliance Resolution System (EPCRS), provides pre-approved ways to correct common 403b operational errors. The program gives employers a road map to effectively and efficiently put the participants in the position they would have been had the error not occurred. The program has three components: Self Correction Program (SCP), Voluntary Correction Program (VCP), and Audit CAP, the Closing Agreement Program.


Through SCP, insignificant errors can be self-corrected at any time. Significant errors can be self-corrected within a three-year time frame from the time of the error, Otherwise, the employer must pay a fee to go through VCP and to request IRS approval to correct the long-standing significant error or to correct an insignificant error in a way that is not pre-approved by EPCRS. VCP is only available before the plan is selected for audit. Errors discovered during an audit are corrected through the Audit CAP, through which the employer pays a sanction to avoid disqualification.


Not surprisingly, the list of common mistakes financial statement auditors find is nearly identical to the list of common errors published by the IRS. Whether you have a large plan or a small plan, you should perform frequent self-reviews to ensure that you are not systematically making the following top five common mistakes.


Mistake # 1: Failure to Operate the Plan in Accordance with its Terms

Just because it could be legal doesn't mean it's the right thing to do.

Often, plan officials operate the plan how they think the plan should be written without checking the actual options that were chosen on the adoption agreement-in other words, what was done operationally would be legal if the plan permitted it, but it doesn't.


A common example is the failure to withhold on non-cash taxable compensation. Unless it results in a discriminatory definition of compensation, it is possible to exclude from contribution calculations taxable earnings such as holiday gift cards, taxable awards and prizes, moving expenses, and even other taxable compensation that the employee does receive in a paycheck such as bonuses or overtime. However, it is not an option to disregard earned income that is not specifically excluded in the plan's definition of compensation.


The failure to follow the plan document is an operational violation that is a qualification error.


Mistake #2A: Improper Exclusion-Universal Availability Failure

Plans often exclude employees who are not excludible. The universal availability rules do not allow 403(b) plans to exclude employees by job classification: part-time, seasonal, temporary, substitute teachers, adjunct professors and collectively bargained employees. These types of employees may be able to be excluded under the statutory exclusion rules, but not because of their employment classification. The statutory exclusions are often misinterpreted and misapplied. Statutory exclusions include:

  • employees who will contribute $200 or less;

  • employees eligible to participate in a 401(k), 457(b) or other 403(b) plan of the same employer;

  • nonresident aliens; and

  • employees who do not accumulate 1,000 hours in a year because they normally work less than 20 hours per week.

Additionally, there must be effective opportunity for employees to defer into the plan through eligibility notification.


Mistake # 2B: Improper Exclusion-Other

Universal availability errors are only one way to improperly exclude individuals or wages from contribution computations. Other improper exclusion examples include:

  • Failure to observe a deferral election

  • Failure to automatically enr_oll

  • Failure to use the correct definition of compensation

  • Failure to inform participant of contribution opportunity

  • Violation of the Once-In, Always-In Rule

When eligible employees or eligible compensation are improperly excluded from contribution computations, EPCRS assumes that the employee would have chosen to contribute, regardless of the industry, age, income level or other demographic. Universal availability errors and other improper exclusion corrections can be very costly because the IRS expects the employer to fund a restitution to the participant account.


Mistake #3: Failure to Follow Applicable IRC Limits: 402(g), 415, 401(a)(17), etc.

Automation can be both a blessing and a curse. Employers rely on technology for plan administration, but this only works when the software settings are accurately updated. Constant legislative changes make it impossible to "set it and forget it." In many instances, limits are exceeded because the plan sponsor fails to code the payroll software to stop the computation after a legal or plan limit is reached. Sometimes, 403(b) plans have such a generous employer contribution formula that is it not mathematically possible for participants to contribute the maximum elective deferral permitted under the plan without exceeding the Internal Revenue Code (IRC) maximum annual addition limit. The most relevant contribution limits applicable to 403(b) plans are:


Limit

2022

2021

Elective Deferral — IRC Sec. 402(g)

$20,500

$19,500

15-Year 403(b) Catch-up Limit

$3,000

$3,000

Age 50 Catch-up Limit

$6,500

$6,000

Maximum Annual Addition - IRC Sec. 415 (c)

$61,000

$58,000

Maximum Compensation - IRC Sec. 401 (a)(17)

$305,000

$290,000

Contrary to popular belief, recordkeepers are not automatically in charge of monitoring limits. It's important to know the terms of your contracts with service providers. Regardless of who is at fault for allocations to participant accounts in that exceed the relevant limits, the excess deposits must be removed from participant accounts by the appropriate deadlines:

  • Excess deferrals plus earnings must be withdrawn by April 15.

  • Excess deferrals not withdrawn by April 15 are subject to double taxation, in the year contributed and in the year distributed. Under EPCRS, excess deferrals are still subject to double taxation.

  • Excess deferrals not distributed by April 15 are subject to the 10% additional tax, which is not correctible under EPCRS.

  • Earnings are taxed in the year distributed.

  • 415( c) excess contributions must be transferred to a 403( c) account or to the participant by the end of the year in which the excess occurred; if transferred later, they must be corrected under EPCRS.

  • Distribute excess contributions from the Roth account source first, then the elective deferral accounts, then from the employer contributions.

  • IRS and financial statement auditors are likely to verify that excess deposits to participant accounts are properly handled.

Maximizing retirement savings is good, but failure to observe the limits is too much of a good thing.


Mistake #4: Incorrect Computation of the Special 403(b) Catch-Up Limit

Participants with 15 years of service with the same 403(b) employer are eligible to contribute an additional $3,000 per year up to a lifetime maximum of $15,000 if their average contributions for their entire eligibility period are less than $5,000 per year. The amount of the special 15-year catch-up and the underused amount is equal to the lesser of:

  • $3,000;

  • $15,000 reduced by the sum of prior years' 15-year catch-up deferrals; or

  • $5,000 x years of service with the employer, minus the total of all elective deferrals made to a 403(b), 401(k), SARSEP or SIMPLE IRA plan maintained by the employer, including the 15-year catch-up, but excluding the age SO catch-up.

Contributions in excess of the 402(9) limit count toward the special 403(b) catch-up first and then towards the age 50 catch-up. A participant eligible for both types of catch-ups may contribute up to $3,000 extra for the 15-year catch-up, along with an extra $6,500 for the age 50 catch-up in 2020, 2021 and 2022 ($6,000 in 2015, 2016, 2017, 2018 and 2019).

Determining years of service can be complicated because the definition of full-time may be different for each position and for each employer and may be expressed in days, weeks, months, or semesters and can span more than one calendar year. Additionally, determining years of service are with the same employer may require data from separate institutions and payroll systems. For example:


  • If an employee works for the same public school district, but at different schools within that system, the rules consider the employee to be employed by the same employer.

  • If an employee works for a hospital system, but works at different hospitals within that system, the rules consider the employee to be employed by the same employer.

  • If a minister is a self-employed minister, the rules consider all those years of service as a self-employed minister as working for the same employer.

An employer planning to use the 15-year catch-up should review IRS Pub. 571 for a more detailed look at this calculation. This also may be an area to ask for the input of a benefits professional such as a third-party administrator.


Excess contributions plus earnings must be distributed to the participant. The timing of the corrective distribution will determine the taxation to the employee. For example, excess deferrals must be withdrawn by April 15, or they will be subject to double taxation on the year of the contribution excess and the year of the distribution.


For a person in the highest tax bracket, this could mean over 80% taxation including federal and state income taxes, plus Social Security and Medicare taxes. Earnings on excess deferrals are taxed in the year distributed. The taxation will be determined by how the corrective distribution is reported on Form 1099-R:

  • Excess deferrals and earnings distributed during the year the excess occurred should be reported on one Form 1099-R (Code 8).

  • Excess deferrals and earnings distributed between Jan. 1 and April 15 of the following year may have to be reported using two Form 1099-Rs: one Form 1099-R (Code P) for the excess deferral; and one Form 1099-R (Code 8) for the earnings.

  • Excess deferrals and earnings distributed after April 15 should be reported on one Form 1099-R (Code 8) for the year they are distributed.

Mistake #5: Missed or Insufficient Required Minimum Distributions (RMDs)

"But my record keeper takes care of that!" The most common errors often result from the most common misconception: that the TPA and/or the recordkeeper take care of everything.


In the case of RMDs, recordkeepers' responsibilities often stop at informing the participant that they should take their distribution. Owners of 403(b) contracts can calculate the RMD separately for each 403(b) contract they own, and then take the full RMD from only one or some of the 403(b) contracts. For that reason, recordkeepers are seldom responsible for verifying that the participants computed their RMD amount accurately, and participants often fill out the distribution forms using only one of their several 403(b)contracts; resulting in an insufficient RMD.


An onerous excise tax of 50% is imposed on the amount of the RMD not received by the participant and is paid with the participant's individual federal tax return for the year the RMD was not taken, through Form 5329, Additional Taxes on Qualified Plans (Including IRAs} and Other Tax Favored Accounts. Under SCP, the participant-owed excise tax under IRC Section 4974 is not automatically waived. In certain situations, the IRS may waive the penalty if the taxpayer attaches a letter explaining that the RMD failure or shortfall was due to reasonable cause and that steps are being taken to catch up the payments. If the administrator determines that the failure to make RMDs was not a minor error, the failure can be corrected through the IRS VCP. Under VCP, the plan sponsor would pay a fee to submit a suggested correction method to the IRS for approval, including a request to forgive the affected participant's excise tax. The submission is made on Form 14568-H, Schedule 8: Failure to Pay Required Minimum Distributions Timely.


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