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Clergy, Church & Law

Should Your Church Consider a 401(k) Plan?

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By Richard R. Hammar

Background

In 2004, the IRS published proposed regulations that provided the first comprehensive guidance on the administration of 403(b) retirement plans in 40 years. The IRS was prompted to act as a result of the massive noncompliance it uncovered in field audits of 403(b) plans. Following publication of the 2004 proposed regulations, they received comments and held a public hearing. The regulations were adopted as final regulations in 2007, and were to take effect on January 1, 2009, for most tax-exempt organizations. However, at the end of 2008, the IRS unexpectedly postponed the regulations for an additional year, meaning that churches and other charities have until December 31, 2009 to comply.

Key point. The Assemblies of God Ministers Benefit Association Select Retirement Plan is a 403(b) plan.

Key point. The new 403(b) regulations state that “in the case of a section 403(b) plan maintained by a church-related organization for which the authority to amend the plan is held by a church convention (within the meaning of section 414(e)), [the final regulations] do not apply before the first day of the first plan year that begins after December 31, 2009.”

The regulations impose new administrative requirements on churches and other providers of 403(b) plans, and this has caused many church leaders to ask if their church should switch its employee retirement plan from a 403(b) to a 401(k) plan. After all, 401(k) plans are by far the most popular employee retirement plan, with nearly 50 million participants and $2.5 trillion in assets. Further, many lay church leaders are familiar with 401(k) plans because of their dominance among for-profit employers, but know little if anything about 403(b) plans. This has caused many lay church leaders to suggest that their church avoid the requirements of the new 403(b) regulations by simply switching to a 401(k) plan. But is this a good idea? What advantages, and disadvantages, would be realized by such a change?

Resource. The application of the new 403(b) regulations to churches and other religious organizations is addressed fully in chapter 10 of Richard Hammar’s 2009 Church & Clergy Tax Guide. To order, call 1-800-222-1840.

403(b) and 401(k) Plans — Similarities and Differences

The Assemblies of God Ministers Benefit Association Select Retirement Plan is a 403(b) plan. In most respects, 403(b) and 401(k) plans are similar. In recent years, the differences between these two kinds of retirement plans have narrowed considerably to the point that many regard 403(b) plans as “401(k) plans for nonprofits.” This perception is especially true for “church plans,” which generally are exempt from the complex administrative requirements imposed by ERISA on 401(k) plans.

However, some important differences remain. The main similarities and differences between these forms of retirement program are summarized in a table.

Key point. There are different kinds of 401(k) plans available to employers, including traditional 401(k) plans, safe harbor 401(k) plans, and SIMPLE 401(k) plans. Different rules apply to each. For tax-favored status, a plan must be operated in accordance with the applicable rules. Therefore, it is important that the employer be familiar with the special rules that apply to its plan to ensure that it is being administered in accordance with those rules. This article will only address traditional 401(k) plans, since these are the most common.

Table: 403(b) and 401(k) Plans — Similarities and Differences

Note:This table contains general comparisons only. For specific information refer to your tax advisor.

Feature

403(b) plan

401(k) plan

Trust requirement

No.

ERISA requires plan assets to be held in trust. Church plans not subject to this requirement unless they elect ERISA coverage.

Eligible employers

Most tax-exempt employers (including schools and churches).

Most for-profit and, since 1997, most nongovernmental nonprofit employers, including churches.

Investment options

Annuities, custodial accounts (mutual funds), church retirement income accounts.

Annuities, custodial accounts (mutual funds).

Employee directed investments

Permitted.

Same as 403(b) plans.

Tax benefits

· Participants do not pay tax on allowable contributions in the year they are made. Taxes are not paid on allowable contributions until a participant begins making withdrawals from the plan, usually after retirement.

· Earnings and gains on amounts in a 403(b) account are not taxed until they are withdrawn.

· Participants may be eligible to take a credit for elective deferrals contributed to a 403(b) account.

Same as 403(b) plans.

Housing allowance available for retirement distributions

Yes, but only if pursuant to “official action taken by the employing church or other qualified organization before the payment is made.”

Same as 403(b) plans.

Contribution limits

The lesser of (1) section 415 the limit on annual additions, or (2) the section 402(g) limit on elective deferrals. For 2009, the limit on annual additions is the lesser of $49,000 or 100 percent of includible compensation for the most recent year of service, and the limit on elective deferrals (a limit on the amount of contributions that can be made through a salary reduction agreement) is $16,500.

Same as 403(b) plans.

Effect of excess contributions

Excess contributions (in excess of the limits on annual additions and elective deferrals) subject to tax.

The entire plan may be disqualified.

Payout method

Lump sum, installments, or annuities.

Same as 403(b) plans.

Rollovers out

Participants may roll over to another employer’s 403(b), 401(k), or 401(a) plan.

Same as 403(b) plans.

Rollovers in

Participants may roll over in from another employer’s 403(b), 401(k), or 401(a) plan.

Same as 403(b) plans.

15-year catch-up provision

For employees with at least 15 years of service with a church, school, or certain other charities, the limit on elective deferrals to a 403(b) plan is increased by the least of :

· $3,000;

· $15,000, reduced by increases to the general limit allowed in earlier years because of this rule; or

· $5,000 times the number of years of service for the church or charity minus the total elective deferrals made by the employer for earlier years.

All years of service by a minister of a church, or a lay person, as an employee of a church, a convention or association of churches, and some church-controlled organizations, are considered as years of service for one employer.

No similar provision.

Additional $5,500 catch-up deferral

Available for participants who are 50 years of age or older.

Same as 403(b) plans.

Distributions without penalty

Generally, a distribution cannot be made from a 403(b) account until the employee:

· reaches age 59 1/2;

· has a severance from employment;

· dies;

· becomes disabled; or

· in the case of salary reduction contributions, encounters financial hardship.

Same as 403(b) plans.

Minimum required distributions

Participants must receive all, or a minimum specified by law, of their interest accruing after 1986 in a 403(b) plan by April 1 of the calendar year following the later of the calendar year in which they become age 70 ½ or the calendar year in which they retire.

Same as for 403(b) plans.

ERISA coverage

No, unless coverage is elected.

Generally yes, but church plans are exempt (churches can voluntarily elect coverage).

Form 5500 filing requirement

Not applicable.

Form 5500 must be filed annually. Church plans not electing ERISA coverage are exempt.

Aggregation

Contributions to a 403(b) plan generally are not combined or aggregated with contributions to a qualified plan in applying the section 415 limit.

Same as 403(b) plans.

FICA taxes

Income taxes not paid on elective deferral (salary reduction) contributions to the plan, up to the allowed limits. But, FICA taxes are paid on elective deferrals into the plan. FICA taxes generally not paid on account earnings, or on permitted distributions.

Same as 403(b) plans.

Self-employment taxes

IRS Publication 517 instructs ministers, when computing self-employment taxes: “Do not include … contributions by your church to a tax-sheltered annuity plan set up for you, including any salary reduction contributions (elective deferrals), that are not included in your gross income.”

Possibly the same as 403(b) plans.

ADP antidiscrimination testing

Church plans exempt from antidiscrimination rules that are designed to prevent discrimination in favor of highly compensated employees.

Annual non-discrimination testing required to ensure the plan does not discriminate in favor of highly compensated employees. Church plans generally exempt.

Section 404 deduction

Not applicable.

For-profit employers can claim a tax deduction (subject to certain limits) on contributions they make to an employee’s plan.

Key point. One possible advantage of a 403(b) plan is that this is the primary retirement program for churches. Some future congressional efforts to enhance church retirement programs may be limited to amendments to section 403(b), since it would make no sense to amend a provision (section 401(k)) that overwhelmingly applies to for-profit employers.

Conclusion

Consider the following points before converting your 403(b) plan to a 401(k) plan:

· As the table illustrates, 403(b) and 401(k) plans are substantially similar. Yes, there are new administrative burdens that will apply to 403(b) plans by the end of 2009. But, there are administrative responsibilities in maintaining a 401(k) plan, too. These include monitoring compliance with participation rules, contributions, vesting, nondiscrimination, investments, disclosures to employees, reporting to the IRS, and distributions. To be sure, many or all of these responsibilities can be transferred to a third party provider, but at a minimum the church (employer) has fiduciary duties that cannot be transferred.

RICHARD R. HAMMAR, LL.M, CPA, serves as legal counsel to the Assemblies of God, and is editor of the Church Law and Tax Report newsletter. He has written more than 50 books on church legal and tax issues, including the third edition of Pastor, Church and Law.

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