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What’s My Limit? Contributions to both a 403(b) and a governmental 457(b) plan

“One of my clients participates a 403(b) plan and a governmental 457(b) plan (through a state university). Her accountant is telling her that she, potentially, could contribute $41,000 of deferrals between the two plans for 2022.  How can that be so?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings plans, including nonqualified plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Illinois is representative of a common inquiry related to the maximum annual limit on employee salary deferrals.

Highlights of Discussion

Generally speaking, it may be possible for her to contribute more than one would expect given the plan types she has and based on existing plan contributions rules, which are covered in the following paragraphs. Your client should rely on her tax advisor in order to determine what amounts she can contribute to her employer-sponsored retirement plans because this is an important tax question that is best answered with the help of professionals.

For 2022, 457(b) contributions (consisting of employee salary deferrals and/or employer contributions combined) cannot exceed $20,500, plus catch-up contribution amounts ($6,500) if eligible [Treasury Regulation Section (Treas. Reg. §1.457-5)]. Since 2002, contributions to 457(b) plans no longer reduce the amount of deferrals to other salary deferral plans, such as 401(k) or 403(b) plans. A participant’s 457(b) contributions need only be combined with contributions to other 457(b) plans when applying the annual contribution limit. Therefore, contributions to a governmental 457(b) plan are not aggregated with deferrals an individual makes to other types of deferral plans.

Consequently, an individual who participates in both a governmental 457(b) plan and one or more other deferral-type plans, such as a 403(b), 401(k), salary reduction simplified employee pension plan, or savings incentive match plan for employees has two separate annual deferral limits. Here’s an example.

Example

For 2022, 32-year-old Toni is on the faculty at the local state university and participates in its 457(b) and 403(b) plans. Assuming adequate levels of compensation, Toni can defer up to $20,500 in her 403(b) plan, plus another $20,500 to her 457(b) plan—for a total of $41,000.

Also, keep in mind the various special catch-up contribution options depending on the type of plan outlined next.

 

403(b) 457(b)
15-Years of Service with Qualifying Entity Option:[1]

 

402(g) limit, plus the lesser of

 

1) $3,000 or

2) $15,000, reduced by the amount of additional elective deferrals made in prior years because of this rule, or

3) $5,000 times the number of the employee’s years of service for the organization, minus the total elective deferrals made for earlier years.

 

Age 50 or Over Option

 

Employees age 50 or over can make catch-up contributions of $6,500 beyond the basic 402(g) limit.

 

Note:  Must apply the 15-year option first

Age 50 or Over Option

 

Employees age 50 or over can make catch-up contributions of $6,500 beyond the basic 457 deferral limit of $20,500.

 

Special “Last 3-Year” Option

 

In the three years before reaching the plan’s normal retirement age employees can contribute either:

•Twice the annual 457(b) limit (in 2022, $20,500 x 2 = $41,000),

 

Or

 

•The annual 457(b) limit, plus amounts allowed in prior years but not contributed.

 

Note:  If a governmental 457(b) allows both the age-50 catch-up and the 3-year catch-up, one or the other—but not both—can be used.

 

Another consideration when an individual participates in more than one plan is the annual additions limit under IRC Sec. 415(c),[2] which typically limits plan contributions (employer plus employee contributions for the person) for a limitation year [3] made on behalf of an individual to all plans maintained by the same employer. However, contributions to 457(b) plans are not included in a person’s annual additions (see 1.415(c)-1(a)(2).

 

Conclusion

Sometimes individuals who are lucky enough to participate in multiple employer-sponsored retirement plan types may be puzzled by what their maximum contribution limits are. This is especially true when a person participates in a 403(b) and 457(b) plan. That is why it is important to work with a financial and/or tax professional to help determine the optimal amount based on the participant’s unique situation.

[1] A public or private school, hospital, home health service agency, health and welfare service agency, church, or convention or association of churches (or associated organization) and it is allowed by the terms of the plan document

[2] For 2022, the limit is 100% of compensation up to $61,000 (or $67,500 for those > age 50).

[3] Generally, the calendar year, unless the plan specifies otherwise

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Check Your Plan for ACA Notice Requirements

“My client’s 401(k) plan has an automatic contribution arrangement (ACA) with immediate plan eligibility. How can the notice and plan entry requirements for this plan be satisfied?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with an advisor in Wisconsin addressed a question on an ACA.

Highlights of the Discussion

The notice requirements for an ACA are that an eligible employee have an “effective opportunity” to make or change an election at least once during each plan year [see Treas. Reg. Section 1.401(k)-1(e)(2)(ii)]. Effective opportunity is based on a “facts and circumstances” test.  Consequently, determining effective opportunity when a plan has immediate eligibility can be tricky.

According to IRS Revenue Ruling 2000-8, an effective opportunity occurs if the employee receives notice of the availability of the election and the employee has a “reasonable” period before the cash is currently available to make the election.  Here again, reasonable, is based on facts and circumstances. For a plan that provides for immediate entry—the notice will still be considered timely, provided the employer gives it as soon as possible after the employee’s eligibility date, and the employee may elect to defer on any compensation earned beginning on the date he or she becomes eligible. But be aware of plan document provisions that may address notice and deferral timing and/or recordkeeping platforms that may impose a “30-90 days prior” timing requirement.

IRS Notice 2009-65 contains sample plan document language that can be used for adding automatic enrollment to plans.  The notice specifies, “At least 30 days, but not more than 90 days, before the beginning of the Plan Year, the Employer will provide each Covered Employee a comprehensive notice …”  An IRS Issue Snapshot points out that

“… if the plan document has specific language describing annual notice and election requirements, compliance in operation is required. For example, Notice 2009-65, 2009-39 I.R.B. 413, includes sample language for an ACA plan that is neither a QACA[1] nor an EACA[2]. The sample language includes a mandatory annual notice to participants that must be distributed at least 30 days but not more than 90 days before the beginning of a plan year. It is common for plans to adopt the IRS’ sample plan language.”

Further, some recordkeeping systems will not allow a new plan participant to be added until after 30 days from date of hire as that is their set internal process tied to the safe harbor for notice distribution.

Conclusion

Under an ACA, an eligible employee must receive notice of the availability of the deferral election and be given a reasonable period before the cash is currently available to make the election. A reasonable period is based on facts and circumstances, but be sure to check the plan document for specific language or recordkeeper internal processes that may affect the timing.

[1] Qualified Automatic Contribution Arrangement

[2] Eligible Automatic Contribution Arrangement

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Making a “1042” Election

“My client has an ESOP and several employees have inquired about making a ‘1042 election.’  Can you explain what a 1042 election is and how it is made?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with an advisor in Illinois involved questions on stock exchanges under IRC Sec. 1042.

Highlights of the Discussion

How to make a proper 1042 election is a very important tax and legal question. That is why my first response is to say that an individual contemplating such a move should work with an experienced tax or legal advisor to ensure proper filing of the 1042 election. What follows is for informational purposes only and should not be construed or relied upon as tax or legal advice.

Basically, a 1042 election allows qualifying individuals and entities to defer capital gains tax on “qualified securities” sold to an Employee Stock Ownership Plan (ESOP) if the proceeds of the sale are reinvested in “qualified replacement property” (QRP) as defined in IRC Sec. 1042(c)(4). For a general overview of qualified securities and QRP, please see an earlier Case of the Week ESOP Tax Advantaged 1042 Exchange.

Treasury Regulations Section 1.1042-1T prescribe the requirements of a proper 1042 Election. Also, see IRS Publication 550, Investment Income and Expenses  page 62 for filing details as well as Part II of IRS Form 8949, Sales and Other Dispositions of Capital Assets  and the instructions, along with Schedule D of Form 1040  and the accompanying instructions.

The IRS guidance states a taxpayer that meets the qualifications for a 1042 election, must attach three statements to his or her tax return filed with the IRS to successfully communicate his or her intent to make a 1042 election to defer capital gains tax (See Pub. 550 page 63 and PLR 200019002).

  1. Statement of Election: The filer must demonstrate his or her express written intent to elect not to recognize capital gains with respect to the sale of C corporation stock to an ESOP under IRC Sec. 1042. A very detailed description of the sale must accompany the election.
  2. Notarized Statement of Purchase: The filer must provide a signed and timely notarized statement that he or she has completed the sale of stock to the ESOP. The statement must also describe the QRP, date of purchase, the cost of the property and declare the property to be QRP for the qualified stock sold to the ESOP.
  3. Statement of Consent: The company sponsoring the ESOP must provide written consent to allow the filer to defer taxes on the sale. It must also consent to the application of certain IRS penalties under IRC Secs. 4978 and 4979A if the company sells shares purchased by the ESOP within three years or allocates them to the selling shareholder(s) and/or their families.

According to Publication 550, the filer must also attach to his or her tax filing an appropriately completed IRS Form 8949.

Conclusion

As this general description alludes, making a 1042 election to defer capital gains tax on a sale of qualified securities to an ESOP is highly nuanced. Anyone contemplating such a transaction should work with an experienced tax or legal advisor to ensure proper execution.

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“What is the ’20 percent rule’ when defining highly compensated employees?”

“I’m familiar with the IRS’s standard definition of highly compensated employee (HCE) for retirement plans, but recently I overheard another advisor talk about applying the “20 percent rule” when determining HCEs for plan purposes. What is the 20 percent rule?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with an advisor in New Jersey addressed a question on the definition of highly compensated employee (HCE).

Highlights of the Discussion

In lieu of using the IRS’s standard definition of HCE, a plan sponsor has the option of applying the 20 percent rule, otherwise known as a “Top Paid Group” election. This election allows the plan to limit the number of HCEs based on compensation to only those who are in the top 20 percent of all employees when ranked by pay.

Employers with many HCEs as determined under the standard definition of HCE, sometimes make Top Paid Group elections to limit the overall number of HCEs for plan testing purposes if the election will help them satisfy nondiscrimination requirements. Plan sponsors should work with their TPAs and recordkeepers to determine if a Top Paid Group election makes sense for their plans.

The definition of HCE for a plan is contained in the governing plan document. Generally, under IRC Sec. 414(q)(1), an HCE for a plan is a participant who either

1. Owns more than five percent of the company at any time during the current year, or the immediately preceding year; or
2. Received compensation exceeding the IRS-prescribed limit for the immediately preceding year (look back) ($130,000 for 2021 and $135,000 for 2022). [See IRC Sec. 414(q)(1)(A) and (B)]

Under the Top Paid Group election [IRC Sec. 414(q)(1)(B)(ii)], a plan participant is an HCE if he or she

• Earns over the income limit for the look-back year (as mentioned above) and
• Is within the top 20 percent of all individuals at the company when they are ranked by compensation during the look-back year.

More than 5% owners would also be HCEs if a Top Paid Group election is made.

A Very Simple Example:
Participant   % Owner   Look-Back Comp   HCE Standard   HCE Top Paid Group
Alpha            50               $750,000                Yes                        Yes
Bravo              0               $650,000                Yes                        Yes
Charlie           0               $600,000                Yes                         No
Delta              0               $130,000                 Yes                         No
Echo             50                $125,000                Yes                        Yes
Foxtrot           0                $  95,000                 No                        No
Golf                0                $  60,000                  No                        No
Hotel              0                 $   45,000                No                        No
India               0                $   35,000                 No                        No
Juliet              0                $   30,000                 No                        No

As the chart illustrates, under the standard HCE definition, HTK Inc., has five HCEs (i.e., Alpha, Bravo, Charlie, Delta and Echo). If HTK Inc., makes a Top Paid Group election, there are three HCEs (i.e., Alpha, Bravo and Echo). Charlie and Delta are no longer considered HCEs because they are not in the top-paid group, and they do not own more than 5% of HTK.

Conclusion

HCEs in a plan can be determined under the IRS’s standard or Top Paid Group definition. Plan sponsors should always check the terms of their plan document to see which definition applies, and work with their TPAs and recordkeepers to ensure proper application.

 

 

©2022 Retirement Learning Center, LLC

 

 

 

 

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Applying a QACA Election

“My client is implementing a QACA in her 401(k) plan. Does she have to apply the default election provision to all participants?”

Highlights of the Discussion

In general, according to IRS rules, your client would not have to apply the QACA default election to any employee who is eligible to participate in the 401(k) plan prior to the effective date of the QACA and has a previous salary deferral election in place or has affirmatively elected not to defer at all [ Treas. Reg. § 1.401(k)-3(j)(1)(iii)].

However, your client should check the terms of the plan document for the precise application of the default election. Sometimes a plan can be designed to apply the default election to those participants whose current deferral percentages are less than the QACA default deferral percentage.

Also, it could be possible for a plan to contain a provision where a participant’s current election expires after a set amount of time. In that case, the plan could then apply the QACA default percentage unless the affected participant executes another affirmative deferral election or opts out.

Conclusion

In a 401(k) plan with a QACA, there are exceptions to applying the QACA default deferral percentage. The best source to turn to is the plan document for the precise application of the QACA default election.

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When a Governance Review Reveals Something is Missing

“What should a plan committee include in its governance process?”

The Retirement Learning Center works with plan committees to help assess the effectiveness of their plan governance process. This process, known as a governance review, consists of reviewing various plan related documents to help assess how well the plan committee is satisfying its ERISA obligations. Recently, RLC completed a review for an organization in the Midwest and it was clear- something was missing.

We had requested and received the prior three years of agendas, meeting minutes and handouts, service agreements, the investment policy statement (IPS) and the plan document.

The documentation we reviewed was good. The meeting minutes were clear and well done; the investment review and assessment process was thorough and it appeared the IPS was followed appropriately. A solid array of investment options was maintained for the benefit of the participants.

Our concern was not what we saw but what was absent in meeting minutes and other materials.

The committee’s documentation only addressed investment-related issues and was devoid of any consideration or issues other than the investment process. Pursuant to the plan committee meeting minutes, no non-investment topics were ever discussed. RLC’s view is that  such an omission is problematic.

Good governance goes beyond oversight of the investment options. A good governance process should include ongoing

  • Fiduciary education,
  • Reviews of service agreements and standards,
  • Evaluations of plan documents and amendments,
  • Analyses of annual plan audits,
  • Checks on payroll remissions and
  • Participant notices and communication and
  • Government reporting.

Those are just a few of the key elements that a governance committee should evaluate, document and reflect in the agenda and meeting minutes.

A good governance process extends beyond oversight of the investment menu. We encourage plan officials to ensure their governance process is holistic and covers all aspects of plan operations, communications, and overall plan effectiveness.

 

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Brokerage Windows–A Matter of Prudence

“Several of my plan sponsor clients are considering adding a brokerage window to their plans’ investment line ups. Is that a good idea?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with an advisor in Georgia is representative of a common inquiry related to 401(k) plan investments.

Highlights of Discussion

Adding a brokerage window to a plan’s investment menu is not a question of good or bad, but of prudence and loyalty under ERISA’s best interest standards. As clearly stated in Q&A 39 of Field Assistance Bulletin 2012-02R, plan sponsors that utilize brokerage windows that enable participants and beneficiaries to select investments outside of their plans’ designated investment alternatives (DIAs) have a statutory and ongoing fiduciary duty to evaluate whether such options are prudent investment alternatives for their plans under ERISA Sec. 404(a).

Further, with respect to participant disclosures related to brokerage windows, a plan sponsor must provide a(n)

  1. General description of the brokerage window (or like arrangement) sufficient enough to enable participants and beneficiaries to understand how the window works;
  2. Explanation of any fees and expenses that may be charged against the individual account of a participant or beneficiary on an individual, rather than plan-wide, basis in connection with the window; and
  3. Statement of the particular service and dollar amount of fees and expenses that actually were charged during the preceding quarter against the participants’ accounts in connection with the window.

While the DOL, clearly, does not prohibit the use of brokerage windows within self-directed plans, neither has it given much regulatory guidance on the matter. The ERISA Advisory Council confirmed the lack of solid guidance in a December 2021 study, “Understanding Brokerage Windows in Self-Directed Retirement Plans.”  However, most Council members did not believe that additional guidance in this area was needed. “In this regard, the Council observed that the marketplace seemed to be functioning well.”  The Council did recommend the DOL consider further fact finding related to brokerage-window-only (BWO) plans (i.e., plans that have no DIAs and brokerage accounts are the sole investment option) out of a concern “… that those types of plans may not incorporate the spirit of ERISA’s intent and protections for financially inexperienced employees and may need the Department’s attention …”

With respect to brokerage windows, the question for plan officials is whether such an arrangement, as a whole, is a prudent option for a plan and its participants (not each of the investment alternatives within the window).  That said, it seems the DOL may begin peeking inside the window a bit further. In Compliance Assistance Release No. 2022-01,  the DOL commented to the effect that if plan participants can access investments the agency deems “risky” through a brokerage window, “… plan fiduciaries responsible for … allowing such investments through brokerage windows should expect to be questioned about how they can square their actions with their duties of prudence and loyalty in light of the risks  …”

Conclusion

The DOL will hold plan fiduciaries and other officials to the ERISA standards of prudence and loyalty with respect to offering brokerage windows within self-directed plans. Such individuals and their advisors should be prepared to offer documentation in defense of their decisions and actions.

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IRS as Creditor

Is the account balance of a 401(k) plan participant protected from an IRS tax levy?

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with an advisor in Alabama is representative of a common inquiry involving 401(k) plans and IRS tax levies.

Highlights of Discussion

Unfortunately, no it is not. If the participant has an unpaid tax liability the IRS has the authority to levy against his or her 401(k) plan account balance [ Reg. § 1.401(a)-13(b)(2)].  In fact, any qualified retirement plan or IRA [including traditional, Roth, savings incentive match plan for employees (SIMPLE) or simplified employee pension (SEP) plan IRAs] may be subject to an IRS tax levy.

11.6.3 of the IRS’s Internal Revenue Manual (IRM) provides instructions and strict procedures when an IRS tax levy involves assets in retirement plans (as opposed to retirement income under 5.11.6.2 of the IRM). The IRM instructs agents to levy on retirement accounts only after considering the following questions.

1) Does the taxpayer have property other than retirement assets that may be available for collection first?

2) Has the taxpayer exhibited “flagrant” conduct? (See example next.)

EXAMPLE:  Jake, who has an outstanding tax liability with the IRS, continues to make voluntary contributions to retirement accounts while asserting his inability to pay the amount he owes to the IRS.   The IRS could deem this conduct as flagrant.

3) Are the retirement plan assets  necessary to cover the tax payer’s essential living expenses?

4) Does the taxpayer have “present rights” to receive the retirement plan assets?

EXAMPLE:  Amanda has money in a 401(k) plan, but cannot withdraw it until she experiences a distribution triggering event as listed in the plan document. An IRS levy may identify her 401(k) plan balance, but the money cannot be paid over until Amanda can withdraw it under the terms of the plan.

Logistically, the IRS will use Form 668-R, Notice of Levy on Retirement Plans for levying retirement plan assets.  When money is withdrawn from a retirement account to satisfy an IRS levy the taxpayer would include any pre-tax amounts in his or her taxable income for the year. Fortunately, an exception to the 10% additional tax on early distributions for taxpayers under age 59 ½ applies if the money was withdrawn because of a notice of levy served on the retirement account.

Conclusion

In most cases, 401(k) plan assets are protected from creditors—unless the creditor is the IRS.  However, IRS agents are instructed to levy against retirement plan assets only as a last resort.  Any taxpayer addressing an IRS tax levy should seek guidance from an experienced tax professional or attorney experienced in this area.

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Lead Employer Leaves MEP

“If the lead employer in a MEP wants to leave the arrangement, does that mean the MEP is terminated?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with an advisor in Massachusetts is representative of a common inquiry involving multiple employer plans (MEPs).

Highlights of Discussion

If the Lead Employer (a.k.a., the Controlling Member or Plan Sponsor) wants to leave a MEP, that does not mean the MEP is automatically terminated. Check the terms of the governing plan document to see if there is a process for a Lead Employer or Participating Employer (i.e., any employer who participates in the MEP) to leave the arrangement.

For example, a review of one plan document revealed the Lead Employer has some options as to how to leave the MEP.

  1. The Lead Employer could terminate the MEP.  In this case, the document states: “The Lead Employer may terminate this Plan at any time by delivering to the Trustee and each Participating Employer a written notice of such termination.” If the entire MEP is terminated, all participants become 100% vested in their assets (if a vesting schedule applies).
  2. The Lead Employer could withdrawal from the MEP.  The document states: “Upon thirty (30) days written notice to the other party, either the Lead Employer or Participating Employer may voluntarily withdraw from the Plan.”

Under a withdrawal, the MEP is not terminated. The MEP could remain intact but would have to be amended to designate a new Lead Employer. If none of the Participating Employers wanted to take on the role of the Lead Employer, each could withdraw from the MEP and set up its own individual plans and transfer assets to their respective new plans.

Conclusion

A Lead Employer may have options for leaving the MEP aside from plan termination. Be sure to check the terms of the plan document to see what alternatives—such as withdrawal—may be available.

 

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