Understanding 403(b) Contribution Limits

Complex, but Critical

Copyright 1995 The Variable Annuity Life Insurance Company (VALIC). Reprinted on BenefitsLink by permission of VALIC. All Rights Reserved.

Since 1955, VALIC has specialized in providing retirement savings programs for employers and employees nationwide. Because we helped pioneer the legislation which created and shaped 403(b) retirement savings programs, we have a unique understanding of the complex rules and regulations governing such programs.

Based on this expertise, we offer the following information regarding 403(b) programs -- specifically the complex but critical rules involving program contribution limits. This information should provide a broad overview of this subject. This educational article is just one of the ways in which we help our clients conform to the often confusing regulations affecting 403(b) programs.

Evidence of our commitment can be found in both our dedication of significant company resources to training our staff in 403(b) contribution limit compliance as well as our unique guarantee. VALIC's well-trained Retirement Plan Specialists provide detailed Maximum Exclusion Allowance (MEA) calculations for each participant and VALIC guarantees the accuracy of these calculations, assuming that the employer or employee provides accurate data. VALIC also offers administrative expertise and services to employers to ensure that their retirement savings programs meet federal guidelines, and comply with contribution limits.

For more information about VALIC's services relating to 403(b) contribution limits, call your local VALIC office at 1-800-44-VALIC (1-800-448-2542).

Introduction

Since 1992, the Internal Revenue Service ("IRS") has been conducting audits of tax-exempt universities and health care organizations through its Coordinated Examination Program (CEP). During the past year the IRS, has indicated in several press releases, that it has uncovered numerous compliance problems with the 403(b) arrangements of these audited employers. In particular, the IRS has been focusing on the problems it has been encountering regarding the 403(b) contribution limits. These limits are extremely complex and warrant careful consideration. This article is intended to provide you with a "roadmap" to help you in understanding these limits and the interplay among them.

In 1958, Congress enacted section 403(b)(2) setting the first of the annual limits on the maximum amount that can be excluded from taxable income under a section 403(b) tax deferred annuity. In 1974, Congress enacted the Employee Retirement Income Security Act of 1974 ("ERISA"), imposing additional limits under section 415(c). Finally, the Tax Reform Act of 1986 added the third of the limits under section 402(g), governing salary reduction contributions.

It is important to understand how a 403(b) arrangement works. All pre-tax contributions, whether made directly from the employer or via a salary reduction agreement, are considered to be made by the employer on behalf of the employee. Regardless of the actual source of the contributions, an employee may not exceed his or her maximum limit for any taxable year. For purposes of employees participating in a 403(b) program, a taxable year usually means a calendar year.

There are three forms of permissible contributions to a 403(b) program. The most common is a salary reduction contribution (which usually is treated as an elective deferral), another form is a non-salary reduction contribution, constituting the employer's basic or matching contribution (which usually is not treated as an elective deferral), and the third form is an employee after-tax contribution (which is subject to only one of the contribution limits: section 415(c)).

Section 403(b)(2) Limit

The first limit, under Section 403(b)(2) of the Internal Revenue Code of 1986, as amended (the "Code"), is commonly referred to as the "maximum exclusion allowance" or "MEA." Basically, the limit is 20% of includible compensation times years of service minus untaxed amounts contributed or deferred in prior years to qualified plans, section 403(b) programs, and section 457 plans with the current employer. Only "vested" 403(b) contributions are subject to this limit, however, salary reduction contributions are 100% vested immediately upon contribution.

Includible Compensation

There is much confusion among employers concerning the meaning of "includible compensation." Includible compensation is taxable compensation from the 403(b) sponsoring employer over the last full year of service. Usually, for full-time employees, the last full year of service means the full calendar year. However, for part-time and separating employees, the last full year of service may mean includible compensation received over two or more calendar years.

Includible compensation does not include 403(b) contributions (either salary reduction or non-salary reduction), and it does not include salary reduction contributions to: 401(k) plans, 457 plans, "top hat" deferred compensation plans, 414(h) pick-up, 125 cafeteria plans, and non-125 fringe benefit plans.

Unfortunately, excluding salary reduction 403(b) contributions from includible compensation causes a "catch-22" problem. You can't figure out the maximum salary reduction amount without first subtracting it from includible compensation, and you need the includible compensation amount to be able to figure out the maximum salary reduction amount. The Treasury Regulations illustrate a computation of the exclusion allowance using a "trial and error" method for arriving at the correct salary reduction figure.

However, this is a very unwieldy method for deriving such amounts and most 403(b) providers prefer to use a uniform method for calculating the maximum 403(b) salary reduction amount. They use a formula which is algebraically equivalent to, but not the same as, the statute. A 403(b) provider using such a formula should be able to provide an algebraic proof substantiating the correctness of the formula. When solving for the maximum 403(b) salary reduction contribution, a sample formula might be:

     [ 0.20 x Salary x Years of Service ] - Prior Years' Contributions
       - Current Year 403(b) Non-Salary Reduction Contributions
      ---------------------------------------------------------------
                   1 + [ 0.20 x Years of Service ]

Salary under this formula would exclude all salary reduction amounts except the 403(b) salary reduction amount you are solving for under the equation.

Years of Service

Years of service includes full-time and fractional years of service with the current 403(b) employer through the end of the current calendar year. However, an employee never has less than one year of service. Whether an employee has a full year of service depends upon the normal workload for a full-time position. For instance, if all teachers who work 10 months in a calendar year are considered full-time, then a teacher will receive one year of service for each 10 month period worked.

Prior Years' Contributions

Prior years' contributions are all pre-tax contributions or deferrals to defined benefit and defined contribution qualified plans, all pre-tax contributions to 403(b) programs, and all pre-tax deferrals to section 457 plans with the current employer, with one exception. The exception is all deferrals to a section 457 plan by any employer must be included in prior years' contributions to the extent they are made in a year (or portion of a year) that is credited as years of service with the current employer.

Prior years' qualified plan contributions are counted regardless of vesting, but prior years' 403(b) contributions are counted only upon vesting. After-tax employee contributions to qualified plans, 403(b) programs, or section 457 plans are not counted as prior years' contributions.

For determining prior years' contributions to a defined benefit plan, if you do not know the actual employer contributions made to fund the plan, then a benefit may be attributed to the employer by a formula described in the Treasury Regulations governing section 403(b). These contributions may also be determined under any other reasonable method using recognized actuarial principles consistent with the provisions of the plan under which such contributions are made and the method adopted by the employer for funding the benefits under the plan. Many 403(b) providers use the method found in the Treasury Regulations.

Oftentimes, states or municipalities have enacted statutes or ordinances to allow the employer to "pick-up" an employee's contribution to either the employer's defined benefit plan or defined contribution plan. Picked-up contributions are pre-tax employer contributions to either of these types of qualified plans which are sponsored by a governmental employer. These picked-up contributions are accounted for as part of prior years' contributions.

Special Church 403(b)(2) Limit

There is a special MEA limit for church employees. For a church employee whose adjusted gross income does not exceed $17,000, this special MEA is the lesser of $3,000 or the actual amount of includible compensation. Any elective deferral amounts contributed under this special MEA remain subject to the applicable 402(g) limit, as discussed below.

Exceeding the 403(b)(2) Limit

What happens if an employee's contribution exceeds the MEA limit? It does not cause disqualification of either the 403(b) plan or the 403(b) contract. It causes only tax liability to that employee and to the employer. The employee must include the "overmax" amounts in income in the year of deferral. Further, if the section 403(b)(11) withdrawal restrictions or plan restrictions apply, the "overmax" amount may not be removed. The employer must pay employment taxes (i.e., FICA and FUTA) and must pay statutory tax penalties and interest for underwithholding on taxable wages.

Section 415(c) Limit

The second limit is governed by section 415(c). All 403(b) arrangements are treated as defined contribution plans for purposes of the section 415 limits. Section 415(c) imposes a limitation on contributions to such plans in a given limitation year equal to 25% of taxable compensation up to $30,000. Generally, the section 415(c) limitation year is the calendar year unless the employee owns or controls an outside employer whose plan has another limitation year or elects to change the section 415(c) limitation year to another 12-month period.

The section 415(c) limit is imposed on annual additions, which are the sum of (1) employer contributions (either salary reduction or non-salary reduction), (2) employee after-tax contributions, and (3) forfeitures from other employees that are allocated to the account of an employee. The section 415(c) limit applies to 403(b) contributions regardless of vesting.

Compensation

As with includible compensation under the MEA, compensation under the section 415(c) limit cannot be calculated unless you know the 403(b) salary reduction contribution (i.e., it is taxable compensation), although it is compensation received during the current year, not over the last full year of service. Consequently, many 403(b) providers use a formula for this limit which is algebraically equivalent to the statute. When solving for the maximum 403(b) salary reduction contribution that will be permitted under section 415(c), a sample formula might be:

The lesser of:

  (1)  [ 0.20 x Salary ] -
       [ 0.80 x Current Year 403(b) Non-Salary Reduction Contributions ]
  or
  (2)  $30,000 - Current Year 403(b) Non-Salary Reduction Contributions

Salary under this formula would exclude all salary reduction amounts except the 403(b) salary reduction amount you are solving for under the equation.

Section 415 Aggregation

Under section 415(c), all defined contribution plans of an employer are treated as one defined contribution plan, subject to one set of section 415(c) limits (i.e., 25% of taxable compensation up to $30,000). However, there is an exception for 403(b) arrangements. The employee under the 403(b) contract -- not the actual employer -- is deemed to maintain the 403(b) contract regardless of the form of contribution or the degree of control maintained by the employer. This means contributions to other plans of the 403(b) employer are not ordinarily combined with the contributions to the 403(b) plan under the section 415 limits. However, if the employee owns or controls more than 50% of another business that maintains another plan or the employee elects the special alternative limit under section 415(c)(4)(C), the contributions to the 403(b) contract must be "aggregated" with the contributions to the outside plan or the 403(b) employer's other plans under the section 415(c) or (e) limits. Also, if the empl oyee has another 403(b) annuity contract with another employer, contributions to all 403(b) contracts must be aggregated for purposes of the section 415(c) limit.

Special Alternative Limits

There are three special alternative limits under section 415(c)(4)(A),(B), and (C) which allow an employee who has been undercontributing to "catch-up" on his or her contributions. However, the election of one of these special limits is irrevocable, and once made, prohibits the employee from electing one of the other special limits over the employee's lifetime. Nonetheless, an employee may return to the general limits under sections 403(b)(2) and 415(c) at any time. These special alternative limits are not as useful as they once were because elective deferrals contributed pursuant to these special limits remain subject to the limits under section 402(g), as discussed below.

These special alternative limits are available to employees of nonprofit educational institutions, hospitals, home health service agencies, certain churches, and health and welfare organizations. An employee is considered to have made an election of a special alternative limit when the use of one of the special alternative limits is necessary to support the exclusion from gross income reflected on the employee's income tax return for that year.

• Special alternative limit "A" allows an employee to disregard the section 415(c) percentage limit and contribute up to the MEA limit, but only 10 years of service are counted. This limit may be used only once, regardless of employer -- upon separation from service. And, as mentioned before, elective deferrals contributed under this limit remain subject to the applicable section 402(g) limit.
• Special alternative limit "B", the most popular alternative, also allows an employee to disregard the section 415(c) percentage limit and contribute the least of: (1) the MEA limit, (2) 25% of taxable compensation, plus $4,000, or (3) $15,000. Again, elective deferrals contributed under this limit remain subject to the applicable section 402(g) limit. As with the section 403(b)(2) and section 415(c) limits, 403(b) providers may use a formula for this "B" alternative which is algebraically equivalent to 25% of compensation, plus $4,000. When solving for the maximum salary reduction contribution that will satisfy special alternative "B," a sample formula might be:

  The least of:

    (1)  [ 0.20 x Salary x Years of Service ] - Prior Years' Contributions
           - Current Year 403(b) Non-Salary Reduction Contributions
         --------------------------------------------------------------------
                   1 + [ 0.20 x (Years of Service) ]
    (2)  [ 0.20 x Salary ] + $3,200 - [ 0.80 x Current Year 403(b) Non-Salary
         Reduction Contributions ]
    or
    (3)  $15,000 - Current Year 403(b) Non-Salary Reduction Contributions

  Salary under this formula would exclude all salary reduction amounts except the 403(b) salary reduction amount you are solving for under the equation.

• Special alternative limit "C" allows an employee to disregard the MEA limit and contribute 25% of taxable compensation, up to $30,000. This limit requires the employee to aggregate contributions to all plans of the employer under the 415 limits. Once again, elective deferrals contributed under this limit remain subject to the applicable section 402(g) limit.

Special 415(c) Church Limit

There is also a special section 415(c) limit for church employees. The limit is the lesser of $10,000 or the MEA, with a lifetime limit of $40,000. An employee may not elect alternative limit "A" when using this special section 415(c) limit. Any elective deferrals contributed under this special church section 415(c) limit remain subject to the applicable section 402(g) limit.

Exceeding the 415(c) Limit

What happens if a contribution exceeds the section 415(c) limit? Unlike qualified plans, 403(b) contributions in excess of the 415(c) limit do not cause disqualification of either the 403(b) plan or contract. Exceeding this limit can only cause tax liability to that employee and/or the employer.

Under Treasury Regulation section 1.415-6(b)(6), some 415(c) excesses can be corrected if, as a result of the allocation of forfeitures, a reasonable error in estimating a participant's annual compensation, a reasonable error in determining the amount of elective deferrals under section 402(g) that may be made, or under other limited facts and circumstances, a participant's annual additions exceed the section 415(c) limit. They will not be treated as annual additions if they are corrected as follows:

• If the plan permits, elective deferrals and employee after-tax contributions (and earnings thereon) which exceed the section 415(c) limit may be corrected by distributing them to the employee pursuant to Revenue Procedure 92-93.
• Contributions in excess of the section 415 limits which cannot be corrected are generally treated as taxable income to the employee in the tax year which ends with or within the limitation year. Additionally, any 403(b) contributions which exceed the section 415 limits are treated as prior years' contributions for purposes of future MEA calculations.

Section 402(g) Limit ($9,500 Cap)

The section 402(g) limit applies to all 403(b) contributions which are treated as elective deferrals. This usually means salary reduction contributions. However, non-salary reduction contributions may be treated as elective deferrals and thus be subject to the section 402(g) limit if they are made pursuant to an individual negotiation with the employer. In other words, if the employee makes a "deal" with the employer to have the employer make non-salary reduction contributions for him in an effort to circumvent the 402(g) limit, the 402(g) limit will apply.

Some salary reduction contributions are not treated as elective deferrals and are not subject to the section 402(g) limit. Salary reduction contributions which are made pursuant to a one-time irrevocable election, at a stated percentage or dollar rate, by the employee at the time of initial eligibility to participate in the salary reduction agreement are not treated as elective deferrals. If the participant must make salary reduction contributions as a condition of employment, the one-time irrevocable election requirement is met. Even if it is not a condition of employment, it is crucial that an employee not have the right to revoke the election, once made, until he or she leaves the service of the employer. If the employee has the right to make a revocable election, but does not do so, this causes the salary reduction contribution to be treated as an elective deferral subject to the applicable section 402(g) limit.

The section 402(g) limit applies to an individual on a calendar year basis regardless of employer. In other words, it follows him from plan to plan and employer to employer. Section 403(b) elective deferrals must be coordinated annually with 401(k), 408(k)(6), and 501(c)(18) deferrals. Once the 401(k)/408(k)(6) limit reaches $9,500, the section 402(g) limit applicable to 403(b) deferrals will be indexed and will be the same limit.

15-Year Cap Expansion ($12,500 cap)

Certain employees may expand their section 402(g) limit. Basically, an employee who has at least 15 years of service with the current employer sponsoring the 403(b) arrangement by the end of the current calendar year and is an employee eligible to elect one of the special alternative limits under Section 415(c)(4), may expand the basic section 402(g) limit applicable to section 403(b) arrangements. This "15 year cap expansion" adds the least of (1) $3,000, (2) $15,000 minus cap expansion amounts used before, or (3) $5,000 times years of service minus prior years' elective deferrals (including prior years' section 457 deferrals) to the $9,500 limit (indexed). However, there is a $15,000 lifetime limit on this 15-year cap expansion and once depleted, the $9,500 limit (indexed) applies thereafter.

Exceeding the 402(g) Limit

What happens if an employee's elective deferrals exceed the applicable 402(g) limit? Unlike the section 403(b)(2) and 415(c) limits, elective deferrals under the section 402(g) limit must be observed. If elective deferrals do exceed the 402(g) limit, they become excess deferrals. If they are not timely corrected (generally by April 15 of the year after the year of deferral), the excess deferrals of that employee are subject to double taxation -- once in the year of deferral and again in the year of actual distribution.

Coordination of Deferrals and Contributions

In no event may a participant's elective deferrals exceed the lesser of the $9,500/$12,500 limits or the general limits under the MEA or section 415(c) (with or without the use of one of the special alternative limits under section 415(c)(4)).

If an employee has more than one 403(b) annuity contract with an employer, these contracts are treated as one annuity contract. However, if amounts are contributed by two or more 403(b) eligible employers, then a separate MEA is calculated for each employer. The section 415(c) limit applies to all contributions and the section 402(g) limit applies to all elective deferrals regardless of employer.

The section 402(g) limit on 403(b) elective deferrals applies to the employee on a calendar year basis, regardless of the employer or section 403(b) provider. However, salary reduction contributions under a section 125 cafeteria plan or section 414(h) pick-up are not defined as elective deferrals and are not counted against the limits under section 402(g).

If an employee participates in a section 457 plan and a 403(b) arrangement in the same year, all contributions (salary reduction and non-salary reduction) to the 403(b) arrangement are subject to the section 457 limit of $7,500 (or up to the $15,000 higher 457 limit, if applicable).

As previously mentioned, the rules governing the 403(b) limits are extremely complex. This "roadmap" is designed to provide you with a basic overview of these rules and to promote better compliance of 403(b) programs.

Assuring that Your Contributions Comply with the Limits

Providers should be able to calculate contribution limits for every participant using either a computer software program or a printed worksheet. And most important, look for providers that can guarantee the accuracy of their calculations. Consider excluding any TDA provider that asks you to complete the worksheet alone.

About the Author

This article was written by Janet M. Anderson, senior counsel and assistant secretary of The Variable Annuity Life Insurance Company (VALIC), who is the author of Chapter 2, "403(b) Contribution Limits" in the 403(b) Answer Book by Panel Publications.

Revised July 28, 1995