Employer Nonelective Contributions After an Ex-Employee Dies

Linda Segal Blinn

Plans established under Internal Revenue Code Section 403(b) have a unique plan design feature, added to the Internal Revenue Code by the Economic Growth and Tax Relief Reconciliation Act of 2001 and modified by the Job Creation and Worker Assistance Act of 2002. Section 403(b)(3) permits employer contributions to be made to a former employee’s 403(b) participant account for up to five years after retirement, based on the individual’s includible compensation for the last year of service before retirement. In accordance with Treas. Reg. §1.403(b)-4(d)(1), this five-year period is based on the employee’s taxable years, which for individual income tax filers, is the calendar year.

This provision has served as the impetus for public school districts to add an employer nonelective contribution consisting of a terminating employee’s unused sick and/or vacation pay as a post-termination contribution to its 403(b) plan.

As a reminder, employer contributions to governmental plans are deemed to be nondiscriminatory under the Taxpayer Relief Act of 1997. As a result, while the post-termination contribution is an attractive feature for a public school’s 403(b) plan — such a design may not be practical for 403(b) plan sponsored by a 501(c)(3) organization because employer contributions need to satisfy IRS nondiscrimination requirements.

Under a “special pay” or “accumulated leave” plan design, an eligible employer, such as a public school, considers the unused accumulated leave forfeited as direct or indirect cash compensation at the time of the employee’s retirement or severance from employment. The employer must then contribute the unused leave to the former employee’s 403(b) participant account (subject to the Internal Revenue Code Section 415(c) annual additions limits) for up to five years after the year of the employee’s retirement. Note that the employee must not have the option to take the contributions as cash or in any other form of payment.

As with most plan administration, the devil is in the details. That is, the “special pay” feature enables an eligible employer to make employer nonelective contributions for “up to” five years after an individual’s retirement. When applying the 415(c) annual additions limit to a former employee’s contributions, the individual’s includible compensation is deemed to be monthly, rather than annually.

Counting includible compensation on a monthly versus annual basis may create an additional administrative wrinkle that limits an employer’s ability to make post-employment contributions for the entire five-year period. Treas. Reg. §1.403(b)-4(d)(1) provides that if an individual dies during the five-year period post-employment termination, the permissible employer nonelective contribution in the year of death will be based on compensation deemed paid during the months in which the former employee was alive. No further employer contributions can be made to the employee in the year after death, even if the entire five-year post-termination period has not ended.

So, the month in which a former employee dies is the key to determining the amount of the employer nonelective contribution permitted under the 415(c) annual additions limit. For example, if the former employee dies in February, his includible compensation in the year of death (and on which the employer nonelective contribution will be capped) would be prorated by 2/12 — the numerator correlating to the former employee’s death in February. However, if the individual had died in October, then his includible compensation would have been 10/12 of the dollar amount deemed to be paid throughout the year.  

The IRS 403(b) Examination Guidelines describes the administration of an employer nonelective contribution in the year of a former employee’s death in Example 25 of Section 4.72.13.12.2 (“Special Rule for Former Employees”) — also available at https://www.irs.gov/irm/part4/irm_04-072-013-cont01.html#d0e2189 :

Example 25: Public University A maintains an IRC 403(b) plan under which it contributes annually 10 percent of compensation for participants, including for the first five calendar years following the date on which the participant ceases to be an employee. The plan provides that if a participant who is a former employee dies during the first five calendar years following the date on which the participant ceases to be an employee, a contribution is made that is equal to the lesser of:

1. The excess of the individual’s includible compensation for that year over the contributions previously made for the individual for that year; or
2. The total contributions that would have been made on the individual’s behalf thereafter if he or she had survived to the end of the five year period.

Individual C’s annual includible compensation is $72,000 (so that C’s monthly includible compensation is $6,000). A $600 contribution is made for C for January of the first taxable year following retirement (10 percent of individual C’s monthly includible compensation of $6,000). Individual C dies during February of that year. Public University A makes a contribution for Individual C for February equal to $11,400 (Individual C’s monthly includible compensation for January and February, reduced by $600).

Note: The contribution does not exceed the amount of Individual C’s includible compensation for the taxable year for purposes of IRC 415(c), but any additional contributions would exceed Individual C’s includible compensation for purposes of IRC 415(c).

If an employer makes post-termination contributions to its 403(b) plan, the sponsor’s checklist should include controls to ensure that employer non-elective contributions allocated to former employees’ accounts under the 403(b) plan be consistent with the 415(c) annual additions limit.
 
Linda Segal Blinn, J.D.*, is vice president of Technical Services for Tax-Exempt Markets at Voya Financial. In this capacity, Blinn leverages over 25 years of experience administering and designing defined contribution plans to provide general legislative and regulatory information to assist public and non-profit employers in operating their retirement plans.
This material was created to provide accurate information on the subjects covered. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. These materials are not intended to be used to avoid tax penalties, and were prepared to support the promotion or marketing of the matters addressed in this document. The taxpayer should seek advice from an independent tax advisor.
* Linda is not a practicing attorney for Voya Financial.

Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA or its members.