Employer-sponsored plans play an increasingly significant role in retirement planning as individuals worry about the future of Social Security and their ability to finance the kind of retirement they envision. They also help employers attract and retain better employees, cutting the costs of having to find and train new hires.
For certain tax-exempt institutions, one option is to offer a 403(b) plan. These defined contribution plans are similar to 401(k) plans, allowing money in the account to grow tax-deferred until the funds are withdrawn at retirement.
Some plans also offer a Roth 403(b) option, in which employee contributions are taxed, but all growth and withdrawals are tax-exempt, so the employee’s retirement income is tax-free if certain requirements are met.
Broadly, there are two types of 403(b) plans:
1. Employee-only contribution accounts that generally aren’t subject to the Employee Retirement Income Security Act (ERISA). From a sponsor’s perspective, the plans offer the advantages of not being required to undergo period discrimination testing and they don’t require special account or due process for being fully funded by the organization.
2. Double contributions plans, where employees and the employer both put money into the account. These are subject to ERISA.
It’s in your organization’s best interests to consult with a professional advisor to determine whether ERISA applies to the plan your group is offering or considering.
For 2018, employee contributions are limited to $18,500 (up from $18,000 in 2017). Designated Roth or 401(k) contributions to other plans count toward that limit. Employees can contribute an additional $6,000 in “catch-up” contributions every year once they turn age 50 (unchanged from 2017). In addition, certain individuals with 15 or more years of service can contribute another $3,000 a year.
Employer contributions are tax deductible and automatic in most 403(b) plans. With 401(k) accounts, vesting periods of as long as three years are common.
Elective deferrals in a 403(b) plan are not subject to nondiscrimination testing (the ADP test). So there is no need to refund contributions to highly compensated employees because of a failed test. Such refunds are common where the deferrals among most employees are low. Instead of the test, the 403(b) plans must make elective deferrals universally available to all employees except those whose deferrals would not be more than $200 or who:
- Can participate in another employer-sponsored 401(k) or 403(b) plan, or in an eligible governmental 457(b) plan that permits elective deferrals.
- Are students performing a service for a school, college or university.
- Are nonresident aliens.
- Work fewer than 20 hours a week.
The rules and regulations governing 403(b) plans are complex, particularly when it comes to employee deferrals, nondiscrimination rules and after-tax employee contributions.
If there are any “No” answers, there may be a problem with the plan. Bear in mind, however, that even if you answer “Yes” to all the questions, your group’s plan might still not meet all the requirements. Your tax advisor can help determine compliance and correct any errors that pop up. Many problems can be easily fixed without penalty and without having to contact the IRS.
Loans and Hardship
Sponsors can set up 403(b) defined contribution plans that allow for loans and hardship withdrawals.
Loans are not taxable to the employee if they are made as part of a written loan program maintained by the employer and:
- Total no more than $50,000 or 50% of the employee’s vested balances, whichever is less.
- Are repaid within five years unless the money is used to purchase the employee’s main residence.
- Are repaid in substantially level payments, at least quarterly, over the life of the loan.
Money can be withdrawn from a plan for hardship if the money is needed to meet an immediate and heavy financial need. A distribution may be treated as necessary to satisfy an immediate and heavy financial need if the money is used to help:
- Pay for or obtain medical care for employees, spouses or dependents.
- Buy a principal residence.
- Cover post-secondary education tuition, room and board and fees for the next 12 months for employees, spouses, dependents or children (even if they are no longer dependent).
- Prevent eviction or foreclosure on the employee’s primary residence.
- Cover funeral expenses.
- Pay for certain repairs to the employee’s principal residence.
Most withdrawals from a 403(b) plan taken before age 59 1/2 face a 10% penalty plus income tax, including hardship distributions.
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