403(b)-Specific IQPA Audit Considerations
Let’s start with a little background. Code Section 403(b) came first. In 1958, Congress made available a tax deferred savings device for employees of certain section 501(c)(3) organizations by adding section 403(b) to the Internal Revenue Code. Although deferred compensation plans for municipal employers had already existed for over a decade, Section 457(b) of the Internal Revenue Code was created with the passage of the Revenue Act of 1978, which also added Code Section 401(k) to allow employees to defer taxation on elective deferrals. Although the 401(k) was intended for taxable employers, it was also used by some municipal employers. Later, the Tax Reform Act of 1986 prohibited the establishment of new 401(k)’s for municipal employers, reinforcing the 457(b) as the primary defined contribution savings vehicle for most municipal employers. However, municipal employers with established 401(k) plans were grandfathered.
Retirement Plans Are Like Ice Cream
Like Neapolitan ice cream, 401(k), 403(b), and 457(b) are just three flavors of the same product. Like Baskin Robbin’s 31 flavors are all good in their own way, all the varieties of retirement plans sponsored by different types of employers also do their job well: improving retirement readiness for employees of for-profit, nonprofit, and governmental entities. However, all plans are not created equal, and cannot be audited the same. In this blog, we will focus on audit procedures specific to 403(b) plans.
Only Section 501(c)(3) organizations or public education institutions as defined in IRC Sec. 170(b)(1)(A)(ii) may establish a 403(b) plan. The IRS provides an online tool that auditors can use to obtain information about tax-exempt organizations called the “Tax Exempt Organization Search” (TEOS) tool. The TEOS tool can be used to check information about an exempt organization’s federal tax status and filings. In addition, auditors may verify an organization’s tax-exempt status and eligibility to receive tax-deductible charitable contributions by requesting to see an organization’s IRS letter recognizing it as tax-exempt or by directly calling the IRS at 877.829-5500.
Obtain, Read, and Summarize an Executed Valid Plan Document
The auditor must obtain a copy of the written 403(b) plan that satisfies, both in form and operation, the requirements of the final Section 403(b) regulations. A list of pre-approved prototype and volume submitter plans has been published. Plan sponsors retain document providers for pre-approved, volume submitter, and prototype documents who restate the documents timely in accordance with the IRS restatement cycles. For 403(b) Individually Designed Plans, under Rev. Proc. 2022-40, plan sponsors have been permitted to submit a determination letter application since June 1, 2023. The auditor will request formal amendments to comply with the latest applicable laws and regulations or Board resolutions or other authorization for upcoming changes. The IRS annually publishes a Required Amendments List (RA List). The RA list is an annual list of changes in retirement plan qualification requirements. Additionally, it establishes the amendment deadlines for individually designed plans. The management representation letter includes a statement regarding the intent to amend the plans as required. For example, plans that adopted provisions of SECURE, CARES, and/or SECURE 2.0 have until the last day of the first plan year beginning on or after January 1, 2025 to formally amend the plan.
Once the auditor obtains, reads, and summarizes the plan document, adoption agreement, summary plan description, plan amendments, and representations regarding upcoming amendments, the 403(b) plan audit can begin. Let’s go over the 403(b)-specific audit steps.
Eligibility Testing
Universal Availability, Once-In-Always-In (OIAI), Long-term, Part-time (LTPT) Employees
The auditor will verify compliance with universal availability for elective deferrals in accordance with IRC Sec. 403(b)(12)(A)(ii). Generally, the universal availability requirement is met if all employees of the plan sponsor are allowed to make 403(b) elective deferral contributions. If any employee defers, all employees must be allowed to defer. All for one, and one for all….with a few permitted exclusions.
IRS Reg. 1.403(b)-5(b) includes numerous rules and exclusions related to the universal availability requirement. Some of the permitted exclusions will have a limited lifespan of two years once the Long-term, Part-time (LTPT) rules become effective for 403(b) plans on January 1, 2025. In the meantime, the auditor will verify that the Once-In, Always-In Rule is followed when previously excluded participants become eligible to enter the plan. See our blog titled Are Your Part Time Employees “In or Out” OR “In and Out?” which explains that the OIAI exclusion states that if a Section 403(b) plan excludes part-time employees from making elective deferrals, once an employee becomes eligible to make elective deferrals, the employee cannot be excluded in the future, even if the hours drop to meet the exclusion criteria again.
SECURE 2.0 requires that employees who work between 500 and 999 hours for two consecutive years be permitted to contribute elective deferrals to their 403(b) plans effective plan years beginning in 2025.
Post-Severance Employer Contributions
403(b) plan sponsors have the option of making employer contributions for up to five years after the employee’s severance from employment.
In general, post severance employer contributions must be based on includible compensation for the employee’s last year of service and can be made for up to 5 years after the employee’s employment ends.
Verify that Discrimination Testing was Done and Contribution Limits Observed
Nondiscrimination in Employer Contributions: 403(b) plans do not satisfy the nondiscrimination requirements with respect to salary reduction contributions through compliance with the actual deferral percentage, or ADP, test required of 401(k) plans. Instead, the universal availability requirement applies to salary reduction contributions in a 403(b) plan. The ACP test to ensure that match contributions are not discriminatory does apply. Failure of the ACP test can be corrected after the plan year end by timely recharacterization, distributions, or forfeiture of excess deferrals or contributions, as appropriate. For the mechanics of the ACP test, please refer to our blog titled The Maximum Contribution May Be Lower Than You Thought: ADP and ACP Test Basics for 401(k) and 403(b) Plans. Safe harbor plans are designed to avoid the ACP test. See our blogs titled What are the Available Safe Harbor Plan Formulas? and How to Order a Triple Stack Match for Your Plan for the available safe harbor formulas. Other employer contributions are also subject to discrimination testing if there is disparity in the allocation percentage. The mechanics of those tests are beyond the scope of this blog.
Maximum Employee Contributions: Generally, the maximum annual elective deferral to a 403(b) plan is $23,000 for 2024 and $22,500 for 2023. However, participants who have attained age 50 by year-end may also make catch-up contributions of a maximum of $7,500 for 2024 and 2023. In addition, 403(b) plans may permit employees with at least 15 years of service with the same qualified employer to contribute up to an additional $3,000 for five years for a lifetime limit of $15,000, further limited if the average elective deferrals since the date of eligibility for the relevant participant exceeds $5,000. Please refer to our blog titled How Does the 403(b) Special 15-Year Catch-Up Contribution Work?…for the mechanics of the special 403(b) catch-up computation and the ordering rules of the two match contributions. In my opinion, 403(b) plans that disclaim the audit opinion due to potentially missing pre-2009 contracts should not offer the special catch-up, since lifetime deferral contributions are needed to compute the maximum available special-catch-up. See the Investments section below for more detail.
Maximum Annual Additions: In addition to the employees’ elective deferrals, the employer can make contributions in the form of match contributions or employer profit sharing contributions, even if the nonprofit entities that sponsor 403(b) plans do not have “profits”. The maximum annual addition to a 403(b) plan participant’s account, including all sources, such as elective deferrals, employer contributions, employee after-tax contributions, and allocated forfeitures is the lesser of $69,000 for 2024 and $66,000 for 2023 or 100% of the participant’s includible compensation. However, the catch-up contributions are allocated in addition to these limitations.
Maximum Compensation: The maximum compensation amount that may be taken into account in computing maximum contributions is $345,000 for 2024 and $330,000 for 2023. This amount may be adjusted for inflation each year.
Church Plans: Church plans are beyond the scope of this blog. IRS Pub. 571, “Tax-Sheltered Annuity Plans (403(b) Plans),” provides further guidance on those issues.
403(b) Financial Statement Presentation of Investments
Permitted Investments
SECURE 2.0 amended the Internal Revenue Code to allow 403(b) plans to hold Collective Investment Trusts (CITs) and Separate Accounts. However, 403(b) plans remain unable to maintain these investments due to limitations in existing securities law. The proposed Retirement Fairness for Charities and Educational Institutions Act of 2023, HR 3063 will remove this final roadblock if enacted. 403(b) plans with custodial accounts may soon finally be able to utilize CITs and unregistered insurance company separate accounts but for now, investments in 403(b) plans are limited to annuity contracts and mutual funds held in custodial accounts. Annuity contracts are required to be purchased from a state licensed insurance company. Historically, 403(b) contracts were administered as individual investment account arrangements rather than as a retirement plan. Before 2009, participants were able to move their contracts to a different custodian without the employer’s involvement. Employers are permitted to exclude from plan assets any fully vested pre-2009 contracts from the plan’s accounting if there are no further contributions to the contract and the participant has a right to exercise the rights and obligations of the contract without the employer’s involvement, as permitted by Field Assistance Bulletin (FAB) 2009-02. If pre-2009 annuity contracts are not included in the plan’s financial statements, that omission should be considered a GAAP departure, and the audit opinion will be disclaimed on account of the excluded assets.
Allocated Contracts vs. Unallocated Contracts
The auditor will obtain relevant information about allocated contracts as well as unallocated contracts. Even though allocated contracts are not reported in the plan’s financial statements, purchases of such contracts during the period are recorded, with an offsetting distribution. If the plan has investments in traditional annuities issued by the Teachers Insurance and Annuity Association of America and College Retirement Equities Fund (TIAA-CREF), consider whether the investments are properly reported as plan assets. According to ERISA Opinion Letter 2010-01A, the “Traditional Annuity” investment issued by TIAA-CREF is considered an unallocated insurance contract and should be reported as an investment in a plan’s financial statements.
Participant Loans vs. Plan Loans
Certain 403(b) plan custodians may offer loans directly to plan participants. Such loans, which are generally referred to as plan loans (as opposed to participant loans), are issued directly from the custodian’s funds and not through the plan from a participant’s account. The source of the funds, therefore, distinguishes plan loans from participant loans. Like participant loans, plan loans require adequate security, may be subject to restrictions, and may involve a portion of a participant’s account being set aside or held as collateral. The plan financial statements include participant loan balances but not plan loans. Plan loans should be disclosed if collateralized by participant accounts.
What’s in Store for 2024 and Beyond?
Roth Employer Contributions
Although this provision has been effective for contributions made after enactment of SECURE 2.0, its implementation is likely to increase in the future as more guidance is published. 403(b) plans may allow participants to designate vested employer nonelective and/or matching contributions as Roth contributions.
Hardship Distributions
After December 31, 2023, hardship distribution sources for 403(b) plans will include deferrals, earnings on elective deferrals, qualified nonelective contributions plus earnings, and qualified matching contributions plus earnings, pursuant to SECURE 2.0.
Matching Contributions Based on Student Loan Repayments
Effective for plan years beginning after December 31, 2023, if the 403(b) plan permits, employers can make matching contributions based on eligible employees’ certification that they made qualified student loan payments.
Mandatory Distributions
Effective for distributions made after December 31, 2023, the involuntary cash-out limit will increase from $5,000 to $7,000.
Catch-Up Contributions
Effective for taxable years beginning after December 31, 2023, catch-up contributions for employees with compensation greater than $145,000 (as indexed) must be made on a Roth basis. Effective for taxable years beginning after December 31, 2024, participants ages 60 to 63 may make catch-up contributions up to the greater of (i) $10,000 or (ii) 150% of the regular catch-up amount (as indexed).
New Optional Emergency Withdrawals
403(b) plans have the option to provide for additional withdrawals on account of emergencies, domestic abuse, terminal illness, federally declared disasters, and payments for long-term care contracts. Many of these new withdrawals are exempt from the 10% penalty on early distributions. Plan sponsors who wish to incorporate additional withdrawals in their plan document should discuss the mechanics and the details with their service providers.
Automatic Enrollment/Auto Escalation
Effective for plan years beginning after December 31, 2024, new 401(k) and 403(b) plans must automatically enroll participants when they become eligible; employees may opt out of coverage. The initial automatic enrollment amount must be at least 3 percent but not more than 10 percent. Each year thereafter that amount is increased by 1 percent until it reaches at least 10 percent, but not more than 15 percent.
Long-term, Part-time Employees
Effective for plan years beginning after December 31, 2024, employees who complete two consecutive years of service with at least 500 hours must be allowed to make elective deferrals into the employer’s 403(b) plan. Pre-2021 service is disregarded for vesting purposes. Generally, discrimination testing results will not be affected by LTPT employee deferrals, regardless of whether they are also eligible for employer contributions.
U-Break-It, U-Fix-It
If any of the above 403(b)-specific provisions are administered incorrectly, the IRS website provides a fix-it guide. The IRS Correction Program, the Employee Plan Compliance Resolution System (EPCRS) provides for three ways to correct mistakes:
- Self-correction Program (SCP) – Permits a plan sponsor to correct certain plan failures without contacting the IRS or paying a fee.
- Voluntary Correction Program (VCP) – Permits a plan sponsor to, any time before audit, pay a fee and receive IRS approval for correction of plan failures.
- Audit Closing Agreement Program (Audit CAP) – Permits a plan sponsor to pay a sanction and correct a plan failure while the plan is under audit.
As a starting point, please see the IRS website for an overview of the options under EPCRS, and then collaborate with your service providers and your auditor to bring the plan back into compliance. In my experience, there is no problem that doesn’t have a solution through EPCRS.
