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Suspending Plan Loan Repayments

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“Under what circumstances, if any, can a 401(k) plan participant with an outstanding plan loan suspend repayments?”

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 and income plans, including nonqualified plans, 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 a financial advisor from Massachusetts is representative of a common inquiry related to plan loans.

Highlights of Discussion

There are just two scenarios under which the IRS will allow a plan to suspend loan repayments of a participant with an outstanding loan: 1) in the case of a leave of absence of up to one year or 2) for the period during which an employee is performing military service [Treasury Regulation Section 1.72(p)-1, Q&A-9(a) and (b)]. Check the terms of the plan document and loan agreement regarding a participant’s ability to suspend loan repayments.

If a plan permits loan repayments to be suspended during a leave of absence, upon return, the participant must make up the missed payments either by increasing the amount of each monthly payment or by paying a lump sum at the end, so that the term of the loan does not exceed the original five-year term.

EXAMPLE: Leave of Absence

On July 1, 2018, Adrian borrows $40,000 from her 401(k) account balance under the agreement that it will be repaid in level monthly installments of $825 over five years (by June 30, 2023). Adrian makes nine payments and then starts a one-year, nonmilitary leave of absence. When Adrian resumes active employment, she also resumes making her loan repayments. However, the amount of monthly installment is increased to $1,130 in order to repay the loan by the end of the initial five-year term. Alternatively, she could have continued making the monthly $825 installment payment, provided she repaid the full balance due at the end of the five-year term (i.e., make a balloon payment).

A plan may permit a participant to suspend loan repayments during a leave of absence for military service (as defined in Chapter 43 of Title 38, United States Code). In such cases, the participant will not violate the level payment requirement provided loan repayments resume at the end of the military service, the frequency and amount of payments is not less than what was required under the terms of the original loan, and the loan is repaid in full (including interest that accrues during the period of military service) by the end of the loan term, which is five years, plus the period of military service.  Consequently, the suspension could exceed one year and the term of the loan could exceed five years.

Of additional note on suspensions due to military service, the plan is limited on the rate of interest it may charge on the loan during the period of military service to six percent. A loan is subject to the interest rate limitation if the following are true: 1) the loan was incurred prior to the military service; and 2) the participant provides the plan with a written notice and a copy of the military orders within 180 days after the date of the participant’s release or termination from military service [Service Members Civil Relief Act of 2003 (SCRA) Pub. L. No. 108-189]. The plan must forgive any interest that exceeds six percent. For this purpose, “interest” includes service charges, renewal charges, fees, and any other charges (except bona fide insurance).

EXAMPLE: Military Service

On July 1, 2018, Joshua borrows $40,000 from his 401(k) account balance under the agreement that he will repay it in level monthly installments of $825 over five years (by June 30, 2023). Joshua makes nine payments and then starts a two-year, military leave of absence. His service ends on April 2, 2021, and he resumes active employment on April 19, 2021, after which, he resumes making loan repayments in the amount of $825. On June 30, 2025, Joshua makes a balloon payment for the full remaining balance due.

Alternatively, Joshua could have increased the monthly repayment amounts so no remaining balance was due at the end of the term (i.e., June 30, 2025).

Conclusion

Under limited circumstance, plans may suspend loan repayments for participants. Be sure to check the terms of the plan document and loan agreement for specific procedures and requirements.

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SEP and SIMPLE IRA Plans and ERISA Fidelity Bonds

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“Do SEP and SIMPLE IRA Plans Require an ERISA Fidelity Bond?”

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 and income plans, including nonqualified plans, 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 a financial advisor from Florida is representative of a common inquiry related to savings incentive match plans for employees (SIMPLE) IRA plans and simplified employee pension (SEP) plans.

Highlights of Discussion

Generally, yes, but this is a great question with a multi-layered answer depending on the individuals and/or entities that handle the assets of these plans. ERISA Section 412 requires that every fiduciary of an employee benefit plan and every person who handles funds or other property of such a plan be bonded in order to protect the assets of the plan against the risk of loss due to fraud or dishonesty. For this purpose, SEP and SIMPLE IRA plans are considered employee benefit plans. The DOL further explained (albeit somewhat vaguely) its position on the matter in Field Assistance Bulletin (FAB) 2008-4, Q&A 16. With regard to having a fidelity bond, the DOL states: “There is no specific exemption … for SEP or SIMPLE IRA retirement plans. Such plans are generally structured in such a way, however, that if any person does “handle” funds or other property of such plans that person will fall under one of ERISA’s financial institution exemptions” (See DOL Reg. §§ 2580.412-27 and 28).

The logic here is that, typically, employees establish their SIMPLE IRAs and SEP IRAs at banks, trust companies or insurance providers, and such institutions are exempt from the bonding requirement provided they are subject to supervision or examination by federal or state regulators and meet certain financial requirements. The Pension Protection Act added an exemption to the ERISA bonding requirement for entities registered as broker/dealers under the Securities Exchange Act of 1934 if the broker/dealer is subject to the fidelity bond requirements of a self-regulatory organization. Consequently, the employees of qualified financial institutions that hold SEP IRA and SIMPLE IRA plan assets need not be covered by an ERISA fidelity bond.

However, there is no exemption from the ERISA bonding requirement for the fiduciaries of employers who handle SEP and SIMPLE IRA plan assets prior to the assets being held in their respective IRAs. When do SEP and SIMPLE IRA contributions become plan assets? In the case of salary reduction (SAR) SEP and SIMPLE IRA employee salary deferrals, such amounts become plan assets as of the earliest date on which they can reasonably be segregated from the employer’s general assets (DOL Reg. 2510.3-102). In contrast, employer contributions generally become plan assets only when the contributions actually have been made to the plan (FAB 2008-01 and Advisory Opinion 1993-14A).

Court cases provide evidence that this is indeed how the DOL enforces the bonding requirement for SAR-SEP and SIMPLE IRA plans. In Chao v. Smith, Civil Action No. 1:06CV0051, the employer failed to remit employee contributions to a SIMPLE IRA plan. In addition to restoring the salary deferrals to the plan, as part of the settlement the employer was required to secure a fidelity bond and keep it active throughout the life of the plan “as required by the Employee Retirement Income Security Act.”  Similarly, in Chao v. Harman, Civil Action Number 4:07cv11772,  the DOL sued business executives and trustees of a firm’s SIMPLE IRA plan in Jackson, Michigan, for failing to forward employee contributions to workers’ accounts and obtain a fidelity bond. Finally, the DOL sued an employer with a SAR-SEP plan for mishandling of employee deferrals and lack of a fidelity bond (Chao v. Gary Raykhinshteyn, Civil Action No. 01-60056).

In each case, the DOL made a point to state employers with similar problems who are not yet the subject of an investigation may be eligible to participate in the DOL’s Voluntary Fiduciary Correction Program (VFCP) to correct the errors and avoid enforcement actions and civil penalties as well as any applicable excise taxes.

Since some form of employer contribution is required with a SIMPLE IRA plan, employers who fail to make these contributions have an IRS operational failure and may have the ability to correct the error by following the applicable provisions of the Employee Plans Compliance Resolution System in Revenue Procedure 2016-51.

Conclusion

While the DOL offers exemptions from the ERISA fidelity bonding requirement to qualified financial institutions that hold SEP and SIMPLE IRA assets, the agency requires employers who sponsor SEP or SIMPLE IRA plans and other plan fiduciaries who handle plan assets to be covered by an ERISA fidelity bond to prevent against loss as a result of fraud and/or dishonesty.

 

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Distributions from Nonqualified Deferred Compensation Plans

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“With respect to distributions from nonqualified deferred compensation (NQDC) plans, what are the timing requirements?”

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 and income plans, including nonqualified plans, 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 a financial advisor from Texas is representative of a common inquiry related to distributions from Internal Revenue Code Section (IRC §) 409A NQDC plans.

Highlights of Discussion

Sponsors of NQDC plans must enforce strict distribution rules that are dictated by IRC §409A, the terms of the governing plan document and the elections made by participants (if permitted). Regarding the last variable, if a plan permits participants to elect how and when they will take distributions, they must execute their elections before deferring their compensation into the plan. The timing of withdrawals is an important tax consideration that requires advance planning. Once the form and timing of distributions are set (typically when deferral elections are made), there are complex rules that apply if participants want to make changes.

Under IRC §409A, payment events are limited to

  • Separation from service (as defined by the plan);
  • Death;
  • Disability;
  • A specified time or according to a fixed schedule;
  • An unforeseeable emergency; or
  • A change in the ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation (as defined by the plan) (see Treasury Regulation 1.409A-3).

Sponsors can elect to include all or a subset of the above listed distributable events in their plans. A person must look at the specific plan document in order to know which payment events apply to a particular plan and whether participants are allowed any discretion in selecting from among them.

A NQDC plan may allow employee elections regarding the timing and method of payment; or it can dictate the payment regime with no elections allowed. If participants have options, they record their distribution choices when they make their deferral elections. They must elect 1) when they will receive distributions from the NQDC plan, and 2) in what form the distributions will take (lump sum withdrawal or installment payments). The deadline for these elections is typically by December 31 of the year prior to the year for which salary is deferred or for which nonelective (employer) contributions are made to the plan; or within 30 days of becoming eligible to participate in the plan. If participants fail to make distribution elections when permitted, plan terms will dictate a default.

Like the timing for distributions, the methods of payment vary for each NQDC plan. The plan may allow for lump sum withdrawals, installment payments (e.g., over five or 10 years) or both, and participants may be allowed to select the payment type. The plan document will specify the available methods of payment.

With rare exception, distributions may not be accelerated. However, there is a mechanism by which participants may delay receipt of payments beyond which they initially elected [see Treas. Reg.§409A-2(b)]. In general, a participant is allowed to change the timing and method of the payment if an election is filed with the employer at least 12 months prior to the date the first payment would be due; and the payment is postponed for at least five years. Again, it is important to review the plan document to see if the plan allows for distributions to be delayed and, if so, whether distributions are treated as a series of payments or as a single payment for this purpose.

The penalties for noncompliance with these withdrawal rules are severe. The IRS will consider any compensation deferred under an errant plan as taxable income to the participant, plus it will assess a 20 percent excise tax, including accruing interest. Taxes, penalties and interest are payable by the recipient of the deferred compensation, not the employer [see IRC §409A(a)(1)(B)].

Conclusion

The form and timing of payments from IRC §409A NQDC plans is an important consideration because of the potential for income tax liability. Depending on the terms of the governing plan, participants may have flexibility in selecting when payments are due and what form they take and, therefore, have more control over when the amounts become taxable income to them. Understanding the terms of each plan and advance planning are the keys to mitigating the share Uncle Sam will take.

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Safe Harbor Validation of Rollovers

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“What responsibility does a plan sponsor have in validating whether an incoming rollover contribution is legitimate?”

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 and income plans, including nonqualified plans, 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 a financial advisor from Texas is representative of a common inquiry related to rollover contributions.

Highlights of Discussion

A qualified retirement plan isn’t required to accept rollover contributions from other plans or IRAs, but if it does under the terms of its governing plan document, the incoming assets must consist of valid rollover amounts. In order for the plan to retain its tax-preferred status, the plan sponsor must reasonably conclude that an amount is a valid rollover contribution as defined in Treasury Regulation Section (Treas. Reg. §) 1.401(a)(31)–1, Q&A–14(b)(2) and retain documentation. The IRS has provided examples of what would constitute proof of a valid rollover, including safe harbor options detailed in IRS Revenue Ruling 2014-9 .

Historically, plan sponsors followed the guidance of Treas. Reg. 1.401(a)(31)-1, Q&A-14(b)(2) for acceptable forms of documentation, which include a participant providing the sponsor of the receiving plan with a letter from the plan sponsor of the distributing plan that states the distributing plan has received a determination letter from the IRS or that the plan, to the best of the sponsor’s knowledge, is qualified. Further guidance from IRS Form 5310, Application for Determination for Terminating Plan, states a sponsor  who is filing this form is required to “… submit proof that any rollovers or asset transfers received were from a qualified plan or IRA.” The instructions to the form indicate that a copy of the distributing plan’s determination letter and timely interim amendments is one example of acceptable proof.

For an indirect rollover where a plan participant has received the assets from a distributing plan or IRA and, within 60-days, rolls over the amount to the receiving plan the individual can certify that the distribution is eligible for rollover and was received not more than 60 days before the date of the rollover. Many plans use a type of standard rollover certification form for this purpose. If the rollover contribution is late, the plan sponsor can accept the contribution if the individual has a waiver from the IRS or self-certifies under Revenue Procedure 2016-47.

In addition to the methods listed in the regulations, IRS Revenue Ruling 2014-9 provides additional streamlined safe harbor due diligence procedures described below that, in the absence of evidence to the contrary, will allow the sponsor of the plan receiving the rollover to reasonably conclude that the amount is a valid rollover contribution.

Plan-to-Plan Rollovers

The sponsor of the receiving plan can confirm the previous employer’s plan is intended to be qualified by looking up the plan on the DOL’s EFAST2 website. If Code 3C appears on the plan’s most recent Form 5500 filing, then the plan IS NOT intended to be qualified under IRC Code §§ 401, 403, or 408, indicating that a distribution from the plan would not be eligible for rollover.

If the receiving plan receives a check made payable to the trustee of the plan for the benefit of the participant from the trustee of another qualified plan, it is reasonable for the receiving plan sponsor to conclude that the plan that initiated the rollover determined the distribution is an eligible rollover distribution.

IRA-to-Plan Rollovers

When a receiving plan gets a check that is made payable to the trustee of the plan from the trustee of an IRA for the benefit of an employee, the recipient plan administrator may reasonably conclude that the source of the funds is a traditional IRA and not an inherited IRA and, therefore, eligible for rollover.

Keep copies of documentation

As proof rollover amounts were valid, plan sponsors should keep copies of the following items:

  • Checks or check stubs with identifying information;
  • Confirmations of wire or other electronic transfers; and
  • Participant certifications.

Special considerations for RMDs

Required minimum distributions (RMDs) are not eligible rollover distributions. A qualified plan is responsible for ensuring that any RMDs are paid to plan participants. Therefore, the IRS has indicated it is reasonable for the receiving plan to conclude that the distributing plan has already paid to the participant any RMDs and remaining amounts are eligible for rollover.

In contrast, IRA trustees and custodians are not responsible for automatically distributing RMDs to IRA owners. Therefore, a plan sponsor may not reasonably conclude that an IRA rollover consists only of eligible rollover funds. The plan administrator should seek additional documentation to confirm that the IRA owner has satisfied any RMD that may be due.

Conclusion

When rollovers to a qualified plan are permitted, plan sponsors must ensure such incoming amounts are, indeed, eligible for roll over. Validation can be done through employee certification of the source of the funds for a 60-day rollover; verification of the payment source (via information on the incoming rollover check or wire transfer) from the participant’s IRA or former plan; or, if the funds are from a plan, looking up that plan’s Form 5500 filing for assurance that the plan is intended to be a qualified plan.

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Medicare Part B Premium Protection

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My client will be 65 this fall and has begun the Medicare application process. We were planning to delay her Social Security filing until age 70 to maximize her benefits. She contacted me because she heard that Medicare Part B premiums will be more expensive if she doesn’t file for Social Security sooner. Are Medicare Part B premiums affected by a person’s Social Security filing?

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 and income plans, including nonqualified plans, 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 a financial advisor from California is representative of a common inquiry related to Medicare Part B premiums.

Highlights of Discussion

Potentially, yes. Medicare Part B premiums may be affected by Social Security filing status. Medicare Part B premiums, generally, increase each year. However, if an individual’s Medicare Part B premiums are “protected,” then premium increases may be less than if the premiums were not protected. Medicare Part B premiums are protected if the individual is receiving Social Security benefits. If the Medicare Part B premiums are protected then Part B premium increases may be no more than the Social Security cost of living adjustment (COLA) for the year.

As background, most Medicare eligible people pay the standard premium amount. The standard Part B premium amount for 2018 is $134. For some, it may be higher, depending on the individual’s income. If a person’s modified adjusted gross income (MAGI) is above a certain amount, then he or she will pay an “Income Related Monthly Adjustment Amount” (IRMAA). Refer to Part B costs on Medicare’s Web site for more details. Medicare uses the MAGI reported on your IRS tax return from two years ago (2016 return for 2018).

However, many people (70 percent) who receive Social Security benefits pay less than the standard Medicare Part B premium ($130 on average) as a result of the law’s “hold harmless” rule that protects the premium from rising more than the Social Security COLA for the year. To qualify for reduced premiums under the hold harmless provision, individuals must receive Social Security benefits, cannot be subject to premiums based on IRMAA, they must have had their Part B premiums paid out of those Social Security benefits for at least two months in the previous year; and they do not receive a COLA large enough to cover the increased premium.[1]

Example

Jill pays the standard amount ($134 per month) in Medicare Part B premiums and receives Social Security benefits from which the premiums are deducted. Her Medicare Part B premium is protected. In 2019, Jill’s Social Security COLA increase is $15 and the Medicare Part B premium increases $25. Because of the protected status, Jill’s Part B premium will increase by only $15. Her Part B increase is limited to no more than the Social Security COLA increase of $15. If Jill had not been receiving Social Security benefits, her Part B premium would have increased by $25.

Conclusion

Protecting Medicare Part B premiums is one consideration among many that individuals should weigh when determining when to begin Social Security benefits. It may make sense to file for Social Security benefits at 65 to protect the individual from Medicare Part B premium increases. Keep in mind that even if the premium is protected, it can increase, but the increase cannot be greater than the annual Social Security COLA.

 

[1]medicareinteractive.org, Increases in Part B premiums and the hold harmless provision

 

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Form 5500 Limited-Scope Audit

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“What is a Form 5500 limited-scope audit, and how does a plan qualify for one?”

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 Massachusetts is representative of a common inquiry related filing Form 5500, Annual Return/Report of Employee Benefit Plan.

Highlights of Discussion

Generally, ERISA requires administrators (the plan sponsors in most cases) of employee benefit plans  with 100 or more participants to have full scope audits of their plans, conducted by an independent qualified public accountant (IQPA), as part of their obligation to file an annual Form 5500 series of reports with the Department of Labor (DOL) and IRS. The IQPA is tasked with conducting an examination of all financial statements of the plan, and of other books and records of the plan as may be necessary, to enable him or her to form an opinion as to whether the financial statements and schedules conform to generally accepted accounting principles and standards.

Under ERISA Section 103(a)(3)(C) and DOL Reg. 2520.103–8, plan sponsors may instruct the IQPA not to perform any auditing procedures with respect to investment information prepared and certified by “qualified institutions.”  A qualified institution could be a bank, trust company or similar institution, or an insurance company that is regulated, supervised, and subject to periodic examination by a state or federal agency that acts as trustee or custodian for the investments. This option is referred to as a “limited scope audit,” and is available only if the certification by the qualified institution includes a statement that the information is complete and accurate. Limited-scope audits are typically less expensive that full scope audits.

Brokerage firms and investment companies generally would not meet the eligibility requirements for a limited scope audit. However, if those types of firms have established separate trust companies, such trust companies, potentially, could meet the requirements to be a qualified institution for this purpose. A 2002 DOL information letter provides more insight into what constitutes a qualified institution. It is the responsibility of the plan sponsor to determine whether the conditions for limiting the scope of an IQPA’s examination have been satisfied, and only the plan sponsor can request the IQPA to limit the scope of the audit. The American Society of Certified Public Accounts has put together a “Limited Scope Audits Resource Center” to help plan sponsors satisfy their fiduciary responsibility in this area.

The DOL attributes the overall increase in noncompliant plan audits with the corresponding increase in the number of limited-scope audits performed.[1] According to a DOL report, “Assessing the Quality of Employee Benefit Plan Audits,” of the plans studied, 81 percent had limited scope audits and of those limited-scope audits, 60 percent contained major deficiencies. In fact, as a result of the study, the DOL recommended that Congress amend ERISA to repeal the limited-scope audit exemption.

Conclusion

While Form 5500 limited-scope audits may be less costly and time consuming up front, if inappropriately used or incorrectly done, they could result in a greater expenditure of money and time in the long run.

[1] DOL, “Assessing the Quality of Employee Benefit Plan Audits,” 2015

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Rollover of Plan Loan Offsets and 402(f) Notices

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“Has the IRS issued an updated model plan distribution notice to reflect the changes related to rollovers of plan loan offset amounts?”

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 special tax notice required for plan distributions under Internal Revenue Code 402(f).

Highlights of Discussion

The IRS periodically issues model plan distribution notices, also referred to as a “special tax notice,” “rollover notice” or the IRC Sec. “402(f) notice,” in order to incorporate any changes to the language as a result of law changes. As of this posting, the IRS had not issued updates to its model 402(f) notice to reflect changes in the information as a result of the Tax Cuts and Jobs Act of 2017 (TCJA-2017), effective January 1, 2018. The last model notice was issued in 2014 (Notice 2014-74).

Plan sponsors are required to provide up-to-date 402(f) notices to convey important tax information to plan participants and beneficiaries who have hit a distribution trigger under a qualified plan and may receive a payout that would be eligible for rollover (Treasury Regulation 1.402(f)-1). A 402(f) notice, in part, explains the rollover rules and describes the effects of rolling—or not rolling—an eligible rollover distribution to an IRA or another plan, including the automatic 20 percent federal tax withholding that the plan administrator must apply to an eligible rollover distribution that is not directly rolled over. Plan administrators must provide the 402(f) notice to plan participants no less than 30 days and no more than 180 days before the distribution is processed. A participant may waive the 30-day period and complete the rollover sooner.

A plan may provide that if a loan is not repaid (is in default) the participant’s account balance is reduced, or “offset,” by the unpaid portion of the loan. The value of the loan offset is treated as an actual distribution for rollover purposes and, therefore, may be eligible for rollover. In most cases, participants (or beneficiaries) who experience a loan offset can rollover an amount that equals the offset to an eligible retirement plan. Instead of the usual 60-day rollover deadline, effective January 1, 2018, as a result of TCJA-2017, if the plan loan offset is due to plan termination or severance from employment, participants have until the due date, including extensions, for filing their federal income tax returns for the year in which the offset occurs to complete a tax-free rollover (e.g., until October 15, 2019, for a 2018 plan loan offset).

Conclusion

Even though the IRS has not updated its model 402(f) to reflect the extended rollover period for certain loan offsets as a result of TCJA-2017, plan sponsors and administrators must ensure the distribution paperwork and 402(f) notices that they are currently using include language that reflects the new rollover timeframe. For those that rely on plan document providers, ask if the new 402(f) notice is available.

 

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Maximum contributions to 403(b), 401(k) and 457(b) plans

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“One of my clients participates in a 401(k) plan [her own “solo (k)”], plus a 403(b) plan and a 457(b) plan (through the public school system). Her accountant is telling her that she, potentially, could contribute twice the $18,500 deferral limit for 2018. 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 Massachusetts is representative of a common inquiry related to the maximum annual limit on employee salary deferrals.

Highlights of Discussion

First off, kudos to your client for working with you and a tax advisor in order to determine what amounts she can contribute to her employer-sponsored retirement plans as this is an important tax question based on her personal situation that is best answered with the help of professionals. 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 contribution rules, which are covered in the following paragraphs.

For 2018, 457(b) contributions (consisting of employee salary deferrals and/or employer contributions combined) cannot exceed $18,500, plus catch-up contribution amounts 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) 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 457(b) plan are not aggregated with deferrals an individual makes to other types of plans.

In contrast, the application of the maximum annual deferral limit under Internal Revenue Code Section (IRC §) 402(g) (the “402(g) limit”) for an individual who participates in both a 401(k) and a 403(b) plan requires the individual to aggregate deferrals between the two plans [Treas. Reg. §1.402(g)-1(b)]. Consequently, an individual who participates in both a 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. Let’s look at an example.

Example #1:

For 2018, 32-year-old Erika has an individual 401(k) plan for her business as a self-employed tutor. She is also on the faculty at the local state university, and participates in its 457(b) and 403(b) plans. Assuming adequate levels of compensation, Erika can defer up to $18,500 between her 401(k) plan and her 403(b) plan, plus another $18,500 to her 457(b) plan.

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

Catch-Up Contribution Options by Plan Type

401(k) 403(b) 457(b)
Age 50 or Over Option

 

Employees age 50 or over can make catch-up contributions of $6,000 beyond the basic 402(g) limit of $18,500.

 

 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 $6,000 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 $6,000 beyond the basic 457 deferral limit of $18,500.

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 2018, $18,500 x 2 = $37,000),

 

Or

 

•The annual 457(b) limit, plus amounts allowed in prior years 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.

 

415 Annual Additions Limit

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). With respect to 403(b) plans and the 415 annual additions limit, there are special plan aggregation rules that apply.

Generally, the IRS considers 403(b) participants to have exclusive control over their own 403(b) plans [Treas. Reg. Section 1.415(f)-1(f)(1)]. Therefore, in many cases, contributions to a 403(b) plan are not aggregated with contributions to any other defined contribution plan of the individual (meaning two 415 annual additions limits in some cases). An exception to this rule, however, occurs when the participant is deemed to control the employer sponsoring the defined contribution plan in which he or she participates. In such case, a participant must aggregate his or her 403(b) contributions with contributions to any other defined contribution plans that he or she may control [see  IRC § 415(k)(4)].Regarding the treatment of catch-up contributions, the “Age 50 or Over” catch-up contributions [see 1.415(c)-1(b)(2)(ii)(B)] are not included as annual additions, regardless of plan type, whereas the 403(b) “15-Years of Service” catch-up contributions are included as annual additions (IRS 403(b) Fix-It Guide.)

Example #2

Adam is a non-owner, employee of an IRC 501(c)(3) organization that contributes to a 403(b) plan on his behalf. Adam is also a participant in the organization’s defined contribution plan. Because Adam is deemed to control his own 403(b) plan, he is not required to aggregate contributions under the qualified defined contribution plan with those made under the 403(b) plan for purposes of the 415 annual additions test.

 

Example #3

The facts are the same as in Example #2, except that Adam is also a participant in a defined contribution plan of a corporation in which he is more than a 50 percent owner. The defined contribution plan of Adam’s corporation must be combined with his 403(b) plan for purposes of applying the limit under IRC 415(c) because Adam controls his corporation and is deemed to control his 403(b) plan.

Example #4

Dr. U.R. Well is employed by a nonprofit hospital that provides him with a 403(b) annuity contract. Doctor Well also maintains a private practice as a shareholder owning more than 50% of a professional corporation. Any qualified defined contribution plan of the professional corporation must be aggregated with the IRC 403(b) annuity contract for purposes of applying the 415 annual additions limit.

For more examples, please see the IRS’ Issue Snapshot – 403(b) Plan – Plan Aggregation.

Conclusion

Sometimes individuals who are lucky enough to participate in multiple employer-sponsored retirement plan types are puzzled by what their maximum contribution limits are. This is especially true when a person participates in a 401(k), 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 school system, hospital, home health service agency, health and welfare service agency, church, or convention or association of churches (or associated organization)

[2] For 2018, the limit is 100% of compensation up to $55,000 (or $61,000 for those > age 50).

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

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Forms of SEP plan documents and when to use them

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“I have a client that would like to establish a SEP plan. What document options are available and what are the considerations for selection?”

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 New York is representative of a common inquiry related simplified employee pension (SEP) plans.

Highlights of Discussion

Employers that sponsor SEP plans must maintain them pursuant to a written document [Internal Revenue Code Section (IRC §) 408(k)(5). There are three document format options for SEP plans: 1) the IRS model form, which is IRS Form 5305-SEP Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement; a prototype document offered by banks, insurance companies, mutual fund companies and other qualified financial institutions or forms providers; or 3) individually designed documents, which are typically written by attorneys. There are several considerations when selecting a SEP plan document including, but not limited to, cost, whether the sponsor maintains other retirement plans and desired design features.

Regardless of the format used, the deadline for establishing a SEP plan for a particular year is the business’s tax return deadline, plus extensions for that year.

EXAMPLE:

Pete’s Partnership operates on a calendar year, and has a five-month filing extension for its 2017 tax return. If the partnership wants a 2017 SEP plan, it has until September 15, 2018, to sign a document to set up the plan.

Form 5305-SEP

The IRS model Form 5305-SEP is available free of charge from the IRS’ website and there is no need to file a completed copy of it with the IRS. The IRS will consider a SEP plan as established using the model form when the sponsor completes and signs the form without modification; each eligible employee (or, as a last resort the SEP plan sponsor on behalf of an employee) establishes a traditional IRA to receive contributions, and the employer gives required notices to all eligible employees.

A SEP plan sponsor may not use the model Form 5303-SEP if any of the following statements are true. The employer

  • Maintains any other qualified retirement plan (except for another SEP or salary reduction SEP plan);
  • Has any eligible employees for whom traditional IRAs do not exist;
  • Uses the services of leased employees;
  • Wants a plan year other than the calendar-year;
  • Wants to exclude members of a controlled group of employers; or
  • Wants a contribution allocation formula that is other than pro rate (i.e., integrated with Social Security or flat dollar).

Prototype SEP

Prototype SEP plan documents are available for a nominal fee from various prototype document sponsors for use when a model form is not permitted and/or the employer wants more flexibility in plan design. By filing IRS Form 5306-A, Application for Approval of Prototype Simplified Employee Pension (SEP) or Savings Incentive Match Plan for Employees of Small Employers (SIMPLE IRA Plan), and paying a fee, a prototype document sponsor (e.g., a bank, credit union, mutual fund company, etc.) can receive pre-approval of its plan document from the IRS in the form of an IRS opinion letter. An opinion letter states that a SEP agreement is acceptable in form. The IRS has prepared a Listing of Required Modifications (LRMs), or sample language, to assist document sponsors in drafting an acceptable prototype SEP.

An employer using a prototype SEP plan document, rather than a model, can

  • Use the business’s fiscal year as the plan year rather than the calendar year;
  • Use the services of leased employees;
  • Select a pro rata, integrated or flat dollar contribution allocation formula;
  • Maintain another qualified plan in addition to the SEP plan; and
  • Contribute a top-heavy minimum contribution only when the plan is actually top-heavy.

Individually Designed

An employer can engage an attorney to draft an individually designed SEP plan document that is unique to the employer, and request a letter ruling from the IRS as to its acceptability, if desired. While these employer-specific documents can be more flexible than a model or prototype document, an adopting employer will incur higher costs as a result of drafting, establishment and maintenance fees.

Conclusion

The IRS requires businesses that want SEP plans to execute a written plan document containing the terms of the arrangement. There are three general SEP plan document formats from which to choose. Considerations as to the most appropriate form include, but are not limited to, cost, whether the business maintains other retirement plans and desired design features. Business owners should consult a tax and/or legal advisor regarding their particular circumstances.

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