COMPARING 403(b) AND QUALIFIED PLANS

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1 PensionPrimer COMPARING 403(b) AND QUALIFIED PLANS A Topic of Interest to Retirement Plan Administrators Perhaps the most important decision that an institution will need to make when establishing a retirement program is whether to choose a qualified plan that is, a plan meeting the requirements of Section 401(a) [including 401(k) plans] or 403(a) of the Internal Revenue Code (the Code) or a Section 403(b) plan. It s a decision that will affect your plan in several important ways, including who can contribute, how much can be contributed, and government reporting requirements. Although most institutions with plans funded with TIAA-CREF annuities have 403(b) plans, some institutions adopt qualified plans to meet their specific requirements. And there are a few institutions that adopt both a qualified plan and a 403(b) plan. Regardless of which type of plan (or plans) an institution chooses, 403(b) and qualified plans both offer the same basic advantage: tax-deferral. Contributions to the plan, as well as any earnings, aren t taxable to employees until they begin receiving them as retirement income. This allows employees to enjoy the dual benefits of tax-deferral and compound growth.

2 Operating Two Plans If an employer operates two plans, a qualified basic retirement plan for employer contributions and a 403(b) supplemental plan for employee contributions, an employer and an employee may be able to contribute up to $54,000 in 2004 ($57,000, if age 50 or over). But doesn t $54,000 exceed the 2004 Section 415 dollar limit of $41,000? No, because when an employee participates in both a qualified plan (such as a 401(k) plan) and a 403(b) plan, contributions to each plan are generally not added together when calculating an employee s 415 limit. A notable exception occurs when the employee owns more than 50% of the organization that maintains the qualified plan (or otherwise controls the entity maintaining the qualified plan), for example, a Keogh. Then the 403(b) contributions and the qualified plan contributions are aggregated when calculating the 415 limit. An employee can seemingly exceed the 415 limit because the 415 limit is applied on a per-employer basis. And with 403(b) plans, the employee is considered to be the employer for purposes of the 415 limit. This is true regardless of the number of plans an In this Pension Primer, we ll explore some of the major differences between a 403(b) plan and a qualified plan as they apply to most employers, concentrating on their differences in the areas of contributions, administration, and vesting. Although this Pension Primer is designed to give you general guidance on which type of plan is more likely to fit the needs of your institution, we strongly recommend that your institution consult with legal counsel before establishing the plan. This Primer reflects the legislative changes that affect retirement plans under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) that are effective in GENERAL DESCRIPTION 403(b) Plans Section 403(b) plans were established specifically for organizations that are tax-exempt under Code Section 501(c)(3) and for public educational organizations. Institutions eligible for a 403(b) plan include colleges and universities, independent schools, research organizations, teaching hospitals, churches, and charitable organizations. Public teaching institutions, such as state universities and community colleges and K-12 public school systems, can also adopt 403(b) plans. With a 403(b) plan, contributions can be made one of three ways: 1) by the employer only (a noncontributory retirement plan); 2) by the employee only (a salary reduction plan); or 3) by both the employer and the employee (a contributory retirement plan). Employer contributions can be matching contributions, i.e., contributions made by the employer only if the participant elects to make contributions. Employee contributions to a contributory 403(b) plan can be made on a before-tax (salary reduction) basis or an after-tax (salary deduction) basis. Contributions (except salary deduction amounts), as well as any earnings, are not subject to federal income tax until the employee receives them as benefits. continued on next page 2 PensionPrimer TIAA-CREF Individual and Institutional Services, Inc. distributes securities products. For more complete information, call , for the prospectuses or read or download them at the TIAA-CREF Web Center: Read them carefully before you invest. TIAA (Teachers Insurance Annuity Association), New York, NY issues annuities.

3 Qualified Plans Section 401(a) or 403(a) qualified plans are available to any employer for profit and nonprofit alike. (For plans funded with TIAA-CREF annuities, there s no difference between 401(a) and 403(a) plans.) Employers with a qualified plan can usually deduct the amount they contribute to the plan, within the limits set by the Internal Revenue Code. Since employers eligible for TIAA-CREF annuities are nonprofit Section 501(c)(3) organizations or public schools, the ability to tax-deduct employer contributions is irrelevant they re already tax-exempt. Like a 403(b) plan, employer contributions and earnings to a qualified plan are exempt from current taxation. While all 403(b) plans can accept salary reduction contributions, only certain qualified plans, i.e., 401(k) plans, can accept salary reduction contributions.* Governmental institutions are not permitted to sponsor new 401(k) plans. For this reason, a governmental institution that wants a single retirement plan that accepts both employee salary reduction contributions and employer contributions will want to select a 403(b) plan. Although the inability to accept employee salary reduction contributions is a constraint on governmental institutions, they can overcome this problem by adopting two plans: a qualified plan for employer contributions and a separate 403(b) plan for employee salary reduction contributions. Although operating two plans is certainly more time-consuming and complicated than running a single plan, it does provide employees with a potential benefit (please see side bar: Operating Two Plans ). For this reason, certain private institutions also choose to sponsor both a qualified plan and a 403(b) plan. And, under the changes made by EGTRRA, governmental employers can offer salary reduction under a 457(b) plan in addition to deferrals to a 403(b) plan. continued from previous page employee participates in during the year or how many plans an employer operates. For example, an employer might have two 403(b) plans, a base plan and a supplemental plan. The employee is considered to be the sole employer for both plans and thus subject to a single 415 limit. An employee who had three employers during the year, each with its own 403(b) plan, is still limited to one 415 limit because he or she is considered the employer for all three plans. With qualified plans, an employee who works for two employers during the year, each with its own qualified plan, would be subject to two 415 limits. If a single employer operates two qualified plans, the employee would be subject to a single 415 limit. CONTRIBUTION LIMITS Tax-deferral is a fundamental benefit offered by both 403(b) and qualified retirement plans. However, the Internal Revenue Code limits the amount of money an employer and employee can contribute on a tax-deferred basis to both types of plans. Here s a brief explanation of each limit: * Note: A 401(k) plan is a special type of qualified plan that permits salary reduction contributions and has a number of other features similar to those of 403(b) plans. For a discussion of 401(k) plans, see the Pension Primer entitled: Taking a Closer Look at 401(k) Plans. You can obtain a copy from your Institutional Consultant or by calling , extension PensionPrimer 3

4 Section 402(g) Limit on Salary Reduction Contributions THE MAXIMUM AMOUNT EMPLOYEES CAN GENERALLY CONTRIBUTE TO A 403(b) PLAN IN 2004 THROUGH VOLUNTARY SALARY REDUCTION CONTRIBUTIONS IS $13,000. THE SAME LIMIT APPLIES TO SALARY REDUCTION CONTRIBUTIONS TO A 401(k) PLAN. The maximum amount employees can contribute to a 403(b) plan in 2004 through voluntary salary reduction contributions is $13,000. (The $13,000 amount is scheduled to increase $1,000 a year until it reaches $15,000 in After 2006, the amount will be adjusted for inflation in $500 increments.) How does the 402(g) limit affect qualified plans? The same limit applies to salary reduction contributions to a 401(k) plan. The $13,000 limit is the maximum an employee may contribute on a salary reduction basis to all 403 (b) and 401 (k) plans. So if an employee made salary reduction contributions to a 403(b) plan (or 401(k) plan) of another employer, those amounts must be included in the $13,000 limit. It s important to keep in mind that some employees will be limited to less than $13,000 because the maximum amount an employee can contribute cannot exceed the smallest limit calculated under Sections 402(g) and 415. Section 415 Annual Additions This section of the Code applies to both 403(b) and qualified plans and specifies the maximum contribution employer plus employee (before-tax and after-tax) that can be made to a retirement plan in a calendar year. This amount is the lesser of $40,000 or 100% of compensation. The indexed amount is $41,000 in Section 403(b)(2) Limit EGTRRA repealed the Section 403(b)(2) Maximum Exclusion Allowance (MEA). As a result, 403(b) plan contributions are no longer subject to this limit. EGTRRA also repealed Alternative Limits A, B, and C, which previously allowed some employees to make additional contributions. 15-Year Rule 4 PensionPrimer The 15-year rule allows employees to exceed the 402(g) limit ($13,000 in 2004) if they have at least fifteen years of service with certain nonprofit organizations (teaching institution, hospital, church, home health care

5 organization, or health and welfare service agency), assuming an employee s salary reduction amount would be more than $13,000 but for the 402(g) limit. Additional contributions made under the 15-year rule cannot exceed $3,000 per year, up to a $15,000 lifetime cap. This 15-year rule is available only under 403(b) plans not 401(k) plans. This appears to be in addition to the Age 50+ Catch-Up discussed on page 9. Catch-up Elective Deferrals EGTRRA included a new provision that allows employees age 50 and older to make additional elective deferrals to 401(k), 403(b), and public/governmental 457(b) plans. More details are provided on page 9. Nondiscrimination Tests Section 401(m) provides for a special nondiscrimination test (ACP test) that applies to 403(b) and 401(k) voluntary after-tax salary deduction amounts and employer matching contributions made to the plans of certain private institutions. (Matching contributions are contributions that the institution makes only if the participant elects to make salary reduction or salary deduction contributions.) This test compares the amount of salary deduction and matching contributions for highly compensated employees to the amounts contributed for non-highly compensated employees. If the plan fails this test, amounts contributed for highly compensated employees may have to be reduced or additional contributions will need to be made for non-highly compensated employees. Unlike contributory 403(b) plans, Section 401(k) plans are also subject to a special nondiscrimination test limiting elective deferrals for highly compensated employees. This special test, called the Actual Deferral Percentage test, or ADP, must generally be performed annually. Elective deferrals consist of employee before-tax contributions made on a voluntary basis. The ADP test is virtually identical to the ACP test applicable to both 401(k) plans and contributory 403(b) plans, except that it applies to different types of contributions. The ADP test applies only to employee elective deferrals, while the ACP test applies to employee after-tax and employer matching contributions. Depending on the design of the plan, the employer may need to satisfy both tests. SOME EMPLOYEES WILL BE LIMITED TO LESS THAN $13,000 BECAUSE THE MAXIMUM AMOUNT AN EMPLOYEE CAN CONTRIBUTE CANNOT EXCEED THE SMALLEST LIMIT CALCULATED UNDER SECTIONS 402(g) AND 415. PensionPrimer 5

6 Form 5500 Annual Report The Employee Retirement Income Security Act of 1974 (ERISA) generally requires private institutions to file an annual report each year to the Department of Labor for each plan. (Note: For some supplemental salary reduction plans, it may not be necessary to file a Form 5500 report.) The report must generally be filed by the last business day of the seventh month following the end of the plan year. For qualified plans, the information requested can be very extensive, including financial statements and detailed nondiscrimination information. Qualified plans with more than 100 employees filing Form 5500 must also obtain an accountant s opinion on the report. In comparison, completing Form 5500 for a 403(b) plan is a simple process, since the financial and nondiscrimination information are not required. And an accountant s opinion isn t required when filing Form 5500 for a 403(b) plan. continued on next page 6 PensionPrimer ADMINISTRATION Determination Letter A determination letter is a letter issued by the Internal Revenue Service for a qualified plan stating whether or not the plan meets the requirements of the Code. By obtaining a favorable determination letter meaning that, in the opinion of the IRS, the provisions of the plan conform to the Code s qualification requirements an employer is assured that deductions for plan contributions will be permitted by the IRS and that contributions and earnings thereafter will be tax-deferred for employees. Even if a 401(k) plan receives a favorable determination letter, however, it must still meet the operational requirements of the ADP and ACP tests. The determination letter process does not apply to 403(b) plans. While it s not a requirement for an employer to obtain a determination letter when adopting a qualified plan, virtually all employers, including nonprofit employers, get one. The reason? Without a determination letter, the IRS could determine later (say, after an audit) that the plan was never qualified and thus not exempt from income tax. If that were to happen, the employer and its employees would be subject to income tax on all past contributions, as well as withholding and other employment taxes. Both parties would also be liable for penalties on overdue taxes. To avoid this possibility, most employers obtain a determination letter from the IRS soon after the plan is adopted. If during the determination letter filing process the IRS finds a feature of the plan unacceptable, the employer can generally amend the plan on a retroactive basis. Obtaining a determination letter from the IRS can be a lengthy and expensive process, and is usually done with the help of an attorney. To get a letter, an employer must provide the IRS with several items, including a copy of the retirement plan document, copies of the trust agreement (if any), and the appropriate IRS application forms. The IRS charges a fee, typically $700 $1,250, for a determination letter. The amount will depend on the scope of the letter requested, i.e., whether it covers certain nondiscrimination tests. The institution will also need to distribute a Notice to Interested Parties generally to all employees eligible to participate in the plan, notifying them that a request for a determination letter will be made.

7 Although the determination letter process doesn t apply to 403(b) plans, an institution can submit its plan for review to the IRS, through a private letter ruling, to ensure that the plan meets all requirements. Because the IRS charges a user fee for a private letter ruling and the process requires the services of an attorney, most institutions establishing a 403(b) plan normally don t request a ruling unless there s something unusual about the plan s design. VESTING continued from previous page Regardless of whether an institution adopts a 403(b) or qualified plan, TIAA-CREF provides step-by-step instructions for completing Form In addition, TIAA-CREF provides each institution the data it needs with respect to TIAA-CREF annuities to complete the questions on the form. Vesting occurs when an employee s right to receive retirement benefits is no longer dependent on continued employment. Vesting schedules apply only to employer contributions and earnings. Employee contributions (as well as any earnings attributable to employee contributions) are always immediately vested. Vesting can be either immediate or delayed. With immediate vesting, after an employee has met the participation requirements and joins the plan, all contributions and earnings made into the plan are his or hers to keep. Participation requirements are the conditions an employee must fulfill before participating in the plan. For example, a plan may require an employee to work one year and be at least age 21 before participating in the plan. The maximum participation requirements for a plan with immediate vesting are generally two years of service and the attainment of age 21, or for educational institutions, one year of service and the attainment of age 26. * The maximum participation requirements for a plan with delayed vesting are one year of service and the attainment of age 21. With delayed vesting, even after meeting the participation requirements, the employee doesn t have an immediate right to the contributions (and any earnings on those contributions) made for him or her by the employer under the plan. The purpose of a delayed vesting schedule is twofold: to reward employees with longer service and to reduce the cost of providing benefits to employees who leave after only a few years of service. An employee may be required to work several years before he or she is 100 percent vested in the plan. This type of vesting schedule, where the employee is 100 percent vested after working several years, is called cliff vesting. For *These requirements apply only to plans covered by ERISA. PensionPrimer 7

8 example, none of the employee s accumulation would vest during the first four years of participation. But in the fifth year, the employee s entire accumulation would be 100 percent vested. Vesting can also be gradual, in which case 20 percent of the employee s accumulation might be vested after two years, 40 percent after three years, and so on, until the entire accumulation is 100 percent vested. This type of schedule is known as graded vesting. There are minimum vesting requirements for cliff and graded vesting schedules. * With cliff vesting, the employee s entire accumulation generally must be 100 percent vested after five years of service. With graded vesting, 20 percent of the accumulation must be vested after three years, with the percentage increasing by 20 percent a year until the entire accumulation is vested after seven years of service. The employer can, of course, adopt a more liberal vesting schedule. Faster vesting schedules apply to employer matching contributions, which must vest 100% in three years if cliff vesting is used, or vest 20% a year starting with year two with complete vesting in six years. There is an alternative for employers that want the primary benefit of delayed vesting (namely, avoiding the cost of including short-term employees) but don t want to go through the trouble of administering a plan with a delayed vesting schedule. By adopting a plan with immediate vesting and using the maximum permitted participation requirements two years of service and age 21 the employer can avoid both making contributions for many short-service employees and administrative complications. FORWARD INCOME AVERAGING Ordinarily, retirement income is taxable in the year the employee receives it. This is true whether the employee receives a lifetime annuity, payments for a fixed period, or a lump-sum cash distribution. Under certain circumstances, however, an employee who receives a lump-sum distribution from a qualified plan is permitted to compute the tax as if the distribution were received over several years. By treating the distribution as if it were being received over several years, the employee can reduce the amount of tax owed on the distribution. Participants in 403(b) plans are not eligible for income averaging. 8 PensionPrimer *These requirements apply only to plans covered by ERISA.

9 The Small Business Job Protection Act of 1996 eliminated five-year forward income averaging for distributions made after 12/31/99. Ten-year averaging, however, remains available to employees who attained age 50 before 1986 and who have participated in the plan for at least five years. Eligible employees should consult with a tax advisor to determine the most advantageous tax computations and distribution methods. THANKS TO THE AGE 50+ ELECTIVE DEFERRALS Since 2002, plan participants age 50 and older have been eligible to make larger elective deferrals to 403(b), 401(k) or public/governmental 457(b) plans. These elective deferrals can exceed the statutory 415 or 402(g) limit, or any lower limit applicable under the terms of their plans (but cannot exceed the 100% of compensation limit under Section 415). These employees will be eligible to contribute an additional $3,000 in 2004, with increases in $1,000 increments every year until In 2007, the age 50+ limit will be indexed in $500 increments. Age 50+ contributions are not subject to any other contribution limits, or to any nondiscrimination rules. However, the plan must allow all plan-eligible employees age 50 and older (other than union members) to participate in the same manner. Age 50+ contributions are in addition to any contributions allowed under Section 402(g). Participants have one catch-up for all 403(b) and 401(k) plans and a separate catch-up for all public/governmental 457(b) plans. MINIMUM DISTRIBUTION REQUIREMENTS Federal law normally requires participants in tax-favored plans, including qualified and 403(b) plans, to begin receiving benefits (e.g., annuity payments) or making withdrawals by a specific date. For most participants, whether they re in a 403(b) plan or a qualified plan, this date is April 1 following the year they reach age Participants who continue working ECONOMIC GROWTH AND TAX RELIEF RECONCILIATION ACT OF 2001, PLAN PARTICI- PANTS AGE 50 AND OVER WILL BE ELIGIBLE TO MAKE ADDITIONAL CONTRIBUTIONS TO THEIR 403(b), 401(k) OR PUBLIC/GOVERNMENTAL 457(b) PLAN IN PensionPrimer 9

10 A PARTICIPANT MUST RECEIVE THE REQUIRED MINIMUM DISTRIBUTION BY THE APPROPRIATE DUE DATE. IF NOT, THE PARTICIPANT MAY HAVE TO PAY A NONDEDUCTIBLE PENALTY TAX EQUAL TO 50% OF THE AMOUNT after age don t have to withdraw accumulations until April 1 of the year after they separate from service. Under a 403(b) plan, accumulations contributions and earnings credited before 1987 need not be withdrawn until the end of the year the participant attains age 75 or April 1 of the year after he or she retires, if later. The amount of the required minimum distribution varies from year to year, depending on the age of the employee as well as the amount of the remaining accumulation. For 403(b) plans, the minimum distribution requirement is satisfied by withdrawing the required amount from each 403(b) plan or from a single 403(b) plan. For qualified plans, the minimum distribution requirement applies on a per-plan basis. The employee would have to determine the minimum distribution amount for each plan and then withdraw that amount from that plan. It s very important that a participant receive the required minimum distribution by the appropriate due date. If not, he or she may have to pay a nondeductible penalty tax equal to 50 percent of the amount that should have been distributed, in addition to ordinary income tax. In most cases, employees who are receiving lifetime annuity benefits from their TIAA-CREF annuities will satisfy the minimum distribution requirement. TIAA-CREF also offers employees the Minimum Distribution Option (MDO), a payment option that pays just the required annual minimum distribution. This enables employees to preserve as much of their tax-deferred accumulations as possible, while meeting the minimum distribution requirements. THAT SHOULD HAVE BEEN DISTRIBUTED PLUS ORDINARY INCOME TAX. 10 PensionPrimer

11 SUMMARY It s clear that each type of plan has its pluses and minuses. The decision to adopt a qualified or 403(b) plan will largely depend on the requirements of the individual institution. Qualified plans may be appropriate for employers with the following characteristics: UNDER A 403(b) PLAN, The employer sponsors a retirement plan with a relatively high contribution rate. ACCUMULATIONS The employer has many employees who want to contribute as much as possible to a 403(b) supplemental salary reduction plan. The employer is prepared to bear the cost and additional administration of establishing and maintaining a qualified plan. Although qualified plans offer some unique features, many nonprofit institutions adopt 403(b) plans for the following reasons: A Section 403(b) plan like a 401(k) plan enables the employer to establish a single retirement plan accepting both employer and employee contributions on a tax-deferred basis. Section 403(b) plans are easier and less costly to implement and administer, with no need for a determination letter and simpler Form 5500 filings. The higher tax-deferral potential provided by a qualified plan, when combined with a 403(b) supplemental salary reduction plan, affects very few employees at most institutions. No ADP nondiscrimination testing is required for 403(b) tax-deferred annuity plans. For more information about 403(b) or qualified plans, please contact your TIAA-CREF Institutional Consultant. CONTRIBUTIONS AND EARNINGS CREDITED BEFORE 1987 NEED NOT BE WITHDRAWN UNTIL THE END OF THE YEAR THE PARTICIPANT ATTAINS AGE 75 OR APRIL 1 OF THE YEAR AFTER RETIREMENT, IF LATER. PensionPrimer 11

12 COMPARISON OF 403(b) AND QUALIFIED PLANS FEATURE 403(b) RETIREMENT PLAN QUALIFIED RETIREMENT PLAN* 1. Participation Requirements For immediate vesting plan: two years Same as 403(b). and age 21 or one year and age 26 (latter for educational institutions only). For delayed vesting plan: one year and age 21. ** 2. Vesting Immediate or delayed. Immediate or delayed. 3. Employer Contributions Yes. Yes. 4. Employee Salary Reduction Yes. No, except for employees with a 401(k) (before-tax) Contributions 5. Employee Salary Deduction Yes. Yes. (after-tax) Contributions 6. Determination Letter Not applicable Not required, but strongly recommended. plan. (Cost: usually $700 $1,250.) 7. IRS Form 5500 Filing Yes; easy to complete. Yes; more complicated than 403(b). (private institutions only) 8. Employee Salary Reduction Generally $13,000 or less. Governed Generally, $13,000 or less to a 401(k) plan. (before-tax) Contribution Limit by Sections 402(g) and 415 of the IRC. A special nondiscrimination test (the ADP A special 15-year catch-up rule applies test) applies and the Section 402(g) and 415 that may raise the limit to $16,000. limits also apply. 9. Total Contribution Limit Cannot exceed the lesser of $41,000 Cannot exceed the lesser of $41,000 (employer+employee) or 100 percent of compensation. or 100 percent of compensation. Governed by Section 415. Governed by Section 415. Age 50+ Contributions $3,000. Can exceed Sections 402(g) Same as 403(b). or 415, but cannot exceed the 100% of compensation limit under Section Minimum Distribution Requirements Applicable to post-1986 accumulations Applicable to entire accumulation upon upon attaining age or separation attaining age or separation from from service, if later. For pre-1987 service, if later. accumulations, upon attaining age 75 or separation from service, if later. Please note that withdraws may be subject to ordinary income tax and a federal 10% additional tax may apply prior to age While annuities provide most of the same benefits as annuities outside of a tax-qualified retirement plan, they do not offer any additional tax deferred treatment of earings beyond the treatment provided by the tax-qualified retirement plan itself. *Qualified plans include 401(a), 403(a), and 401(k) plans, but only 401(k) plans can accept salary reduction contributions. Under current law, governmental institutions are not permitted to adopt new 401(k) plans. **For plans subject to ERISA. Printed on recycled paper. A9455 C / Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), New York, NY 10017