Copyright© 2007 by School Services of California, Inc.

                                      Volume 20                   For Publication Date: July 20, 2007             No. 16

Internal Revenue Service Looks to School District
Retirement Annuity Plans 

SSC:    Why is the Internal Revenue Service (IRS) looking into school district retirement 403(B) plans? 

A:        The IRS conducted a pilot program in three states that revealed wide-ranging noncompliance. This, of course, is leading to the expansion of the pilot program. However, the findings did show that the noncompliance was not intentional, but “due to a lack of understanding about what the law requires regarding the universal availability requirement for 403(b) plans.” So the effort by the IRS is considered to be an outreach activity to ensure that schools know exactly what is required so they can comply with the regulations. 

SSC:    Specifically, what is the IRS looking for in its review? 

A:        The specific portion of the universal availability being reviewed is the nondiscrimination provision on IRS Section 403(b)(12)(A(ii). The rule requires that all employees be treated equitably when districts are offering a 403(b) plan. If one employee is permitted to defer salary amounts, then the offer must be extended to all eligible employees. There are a few employees who may be excluded. They are: 

·                    Employees who will contribute $200 annually or less

·                    Those employee who participate in a 401(k) or 457 plan, or in another 403(b) plan

·                    Nonresident aliens

·                    Employees who normally work less than 20 hours per week

·                    Students performing services described in section 3121(b)(10)

It is also important that employees who would otherwise be eligible based on classification not be excluded inadvertently. Some of the groups may include: 

·                    Nurses

·                    Substitute teachers

·                    Bus drivers

·                    Maintenance workers

·                    Employees who are not full-time, not permanent, and/or noncontract

SSC:    What will happen if a school district is found to be out of compliance? 

A:        If there is noncompliance, the district must satisfy the requirements to “make a fully vested contribution for each eligible employee, for each year the employee was improperly excluded from participating in the 403(b) plan.” In calculating the amount of the contribution, the district has two options, which include a “lost opportunity cost” to the employee: 

The first is the Average Deferral Percentage (ADP) method. First, determine the respective groups (i.e., highly compensated [HC] versus nonhighly compensated [NHC]). An HC employee in a public school is set at $80,000 (adjusted annually). So, an HC employee would be in the grouping that includes those employees who are above the $80,000 annual salary and in the top 20% in employee earnings ranking from highest to lowest compensation (see www.irs.gov/retirement/article/0,,id=171022,00.html). Once the ADP is calculated, each excluded employee is “entitled to a fully vested contribution equal to fifty percent (50%) of the employee’s compensation multiplied by the ADP for that year.” Remember that the ADP must be calculated separately for each year that is found to be out of compliance. If the employer matches the contribution for the deferred salary, then the employee is entitled to 100% of the missed salary deferral.

The second option is in lieu of calculating ADP. An employer may estimate the ADP to be 3% of compensation. Again, the 50% would apply if the salary deferral is not matched by the employer, leading to a 1.5% match. If the salary deferral is matched by the employer, then 100% would apply to the salary deferral, using 3% as the ADP under this methodology. 

SSC:    How will a district know if and when it will be reviewed? 

A:        The answer is when, and not if, you are chosen for a review by the IRS. The IRS will send a notice and questionnaire to be completed by the school district. The questionnaire should be completed as fully and accurately as possible. If the district finds a problem, then corrective action on the part of the school district should occur in a timely manner to reduce the risk of a sanction by the IRS. If you are selected, the school district should use one of the options noted above and communicate it to the IRS in a timely manner. The letter and questionnaire attached are currently being used by the IRS for notification [see Attachment C].

SSC:    Do you have any additional thoughts on this matter? 

A:        The IRS is attempting to correct the practices of school districts, which is contrary to what many would think under this type of activity. The goal of the IRS is to ensure that all school districts are calculating the salary deferrals and contributions associated using the correct methodology. We should applaud the IRS for this concerted effort and training process that is being used to assist school districts across the United States to minimize or eliminate penalties in the area of retirement annuities.  

—Ron Bennett (with Michele Huntoon, CPA, FCMAT)