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When Timing Is Everything: Understanding Includible Compensation in Special Pay Plans

Linda Segal Blinn, J.D.

“Special pay” (also known as “accumulated leave”) features became popular among 403(b) plans after the Economic Growth and Tax Relief Reconciliation Act of 2001(EGTRRA) enabled 403(b) sponsors to make employer nonelective contributions to the 403(b) account of a former employee. As amended by EGTRRA, an employer could make contributions to the 403(b) account of a former employee for up to 5 years after the year that the individual terminated employment, subject to the Internal Revenue Code Section 415(c) annual additions limit. (The lesser of 100% of includible compensation capped at the 2016 dollar limit of $53,000).

As is often the case, the devil can be in the details. Paraphrasing from a Facebook status, it’s complicated — the definition of “includible compensation” is different for current and former employees. However, the IRS, through its 403(b) List of Required Modifications (LRMs) and its pre-approved 403(b) plan document program, is looking to establish order out of administrative chaos.

If a 403(b) participant is currently employed, that individual’s includible compensation for purposes of the Internal Revenue Code Section 415(c) annual additions limit is determined based on the most recent period of service. As defined in Section 2.2 of LRM 38 (Limitations on Annual Additions), “Includible Compensation” focuses upon “an Employee’s compensation received from the Employer that is includible in the Participant’s gross income for Federal income tax purposes (computed without regard to Section 911 of the Internal Revenue Code, relating to United States citizens or residents living abroad), including differential wage payments under Section 3401(h) of the Internal Revenue Code for the most recent period that is a Year of Service.”

However, there is an exception to this general rule — namely, when determining includible compensation for a former employee. In that case, the IRS takes the position that the former employee is considered to have includible compensation on a monthly, rather than annual, basis. So, for purposes of allocation of employer nonelective contributions to former employees, LRM 78 (Nonelective Contributions for Former Employees) — not LRM 38 — applies:

“For purposes of section ____ of the Plan, a Participant is deemed to have monthly Includible Compensation for the period through the end of the taxable year in which he or she ceases to be an Employee and through the end of the next 5 taxable years. Except as provided in section 1.403(b)-4(d) of the Treasury Regulations, the amount of the monthly Includible Compensation is equal to one-twelfth of the Participant’s Includible Compensation during his or her most recent year of service. No contribution shall be made after the end of the Participant’s fifth taxable year following the year in which the Participant terminated employment.”

The IRS has begun to provide comments to submitters seeking pre-approval of their 403(b) plan documents. If the 403(b) plan document submitted for pre-approval includes a special pay feature, expect that the IRS reviewer will be checking to see if such a 403(b) plan document uses the appropriate definition of “includible compensation” for former employees eligible to receive an allocation of special pay employer nonelective contributions.

This approach is consistent with the IRS’ 403(b) Examination Guidelines, which remind the IRS auditor in part to review the terms of the 403(b) plan document to ensure that “plan language properly limits contributions” to comply with 415(c) annual additions limit. As a reminder, an excess of the 415(c) annual additions limit under a 403(b) plan must be corrected by the end of the year in which the amount was contributed to the 403(b) plan in order to prevent such excesses from being considered nonqualified 403(c) amounts (if contributed to a 403(b) annuity contract) or 401(a) amounts (if contributed to a 403(b)(7) custodial account).

Of course, adopting a 403(b) plan document that reflects the Internal Revenue Code is only the first step. A 403(b) plan sponsor must also operate in accordance with the IRS rules and plan document provisions. An employer whose plan offers a special pay feature should establish and maintain internal controls to monitor post-termination employer nonelective contributions so that they do not exceed either special definition of “includible compensation” for former employees or the 415(c) annual additions limit. In fact, in its 403(b) Fix-It Guide, the IRS reminds 403(b) plan sponsors of the importance of knowing how these contributions work and keeping good records.

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.