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403(b) plan sponsors – do you know you must now track outside retirement saving activities of your employees?

Section 403(b) plans, also known as tax-sheltered annuity plans, are retirement vehicles for eligible employees of health care, public education, and other specific tax-exempt organizations. Like 401(k) plans, they allow employees to set aside pre-tax salary deferrals until retirement, when the money is withdrawn from the plan and taxed as income.

However, under a little-known set of rules in the income tax regulations, plan sponsors are required to monitor their employees’ other retirement plan activities when the other plan is sponsored by a company controlled by the employee.

Puzzled? Here’s how it works:

Example #1

Suppose a physician is employed by a not-for-profit hospital that sponsors a 403(b) plan to which the physician contributes salary deferrals. In addition to her employment by the hospital, the physician also owns and maintains a private practice. Note that the hospital and the practice are not affiliated in any way. Yet under the rules, all contributions to the 403(b) plan on behalf of the physician (i.e., her salary deferrals plus any employer contributions) have to be combined with any contributions to any profit-sharing or other plans maintained by the private practice in order to determine whether the physician’s annual addition limit ($49,000 for 2011) has been exceeded.

This result is not intuitive — because generally speaking, defined contribution plans for unrelated employers are not aggregated. What’s going on here?

It turns out that, for this purpose, 403(b) accounts are considered to be maintained by the employee, not the employer. This means that the employee is deemed to be maintaining both her 403(b) account and any other plans sponsored by outside entities that the employee controls — and hence the plans have to be combined for purposes of determining annual contribution limits.

403(b) sponsors – Beware!

The rules go on to say that the employer sponsoring the 403(b) plan has a duty to obtain information from participants about participant-controlled outside entities and plans maintained by the entities. If this information is not obtained, then the employer’s annual 403(b) testing might be inaccurate and some 403(b) participants might end up with excessive aggregate contributions — which could disqualify the participant’s entire 403(b) account.

Here’s how it plays out in more detail:

Example #2

Let’s assume our physician from the example above is under age 50 and contributes $16,500 to her hospital’s 403(b) plan as a pre-tax salary deferral, and the hospital contributes a match of $8,250 — for a total 403(b) plan contribution of $24,750. Meanwhile, the physician’s practice has a great year and contributes $30,000 to the practice’s profit-sharing plan on behalf of the physician. The result? Her annual addition for the year is $54,750 — well in excess of the $49,000 limit for 2011. What to do? The $5,750 excess should be treated as an excess annual addition by the 403(b) plan and as taxable income to the physician for the year to which the contribution relates. And a 6% excise tax on the excess will have to be paid by the physician if her 403(b) account is invested in mutual funds. The hospital must have the 403(b) provider segregate the $5,750 excess contribution within the physician’s 403(b) contract as a separate account and maintain separate accounts going forward. If the excess isn’t segregated, then the physician’s entire 403(b) account could be disqualified.

More broadly, then, what should 403(b) plan sponsors do? Be sure to distribute an annual questionnaire to plan participants, especially if they are highly compensated, asking them if they control unrelated outside entities that sponsor defined contribution plans of their own. If a participant answers yes, then the facts of that case should be scrutinized. Carefully.

At BerryDunn, we know the ins and outs of 403(b) and other retirement plans and can help you avoid pitfalls like the one described above. To learn more, contact BerryDunn’s Roger Prince or Bill Enck. Please note that this article is general in nature and should not be relied upon with respect to any specific case.