Employer Sponsored Retirement Accounts – A Mishmash of Rules

Take-Away: The Tax Code is a bewildering set of contribution rules and limits that pertain to employer sponsored 401(k), 403(b) and 457(b) retirement plans. The danger exists when assuming that the ‘rules’ that apply to one type of retirement plan apply to the other retirement plans.

Background: We are all familiar with an employee’s contribution to a 401(k) plan. We are sorta familiar with 403(b) contributory plans sponsored by non-profits, e.g. public schools and public charities. We are not very familiar with 457(b) plans sponsed by municipal and governmental units. Each type of retirement plan accepts a tax deductible contribution by an employee. Some rules are the same for each type of contributory plan. Sadly, some rules associated with each plan are often very different, thus making assumptions about which rules apply, and which don’t, a dangerous practice.

1. Eligibility to Participate:  The rules that pertain to an employee’s eligibility to participate in an employer’s sponsored retirement plan are not always the same.

401(k): Some 401(k) plans permit employees to participate as soon as they are hired. However, these plans can be more restrictive, e.g. they can require a new employee to first complete a year of service with 1,000 hours of service and attain age 21. Part-time employees can become eligible to participate in the 401(k) plan by working at least 500 hours for 3 consecutive years.

403(b): A 403(b) plan can only exclude employees who work fewer than 20 hours per week. These plans  generally permit a new employee to immediately make salary deferrals.

457(b): A municipal or governmental plan is not required to be offered to all employees and the plan can in limited situations exclude specific classes of employees. A ‘first day of the month’ rule applies only to 457(b) plans,  which requires employees who wish to begin making elective deferrals for a particular month to make an election prior to the beginning of that month.

2022 Compensation Limits: The Tax Code imposes a dollar limit on the amount of compensation that can be considered for an employer’s contributions: $305,000 for 2022. This limit has no practical effect though on an employee’s contributions. However, employee contributions may be limited due to non-discrimination testing requirements. In order to pass these tests, plans often restrict employee contributions for highly compensated participants, or they require the return ‘excess’ contributions to the highly compensated employee if the tests are failed. Note, too, that some plans will not permit any after-tax contributions because of the ACP test (identified below.) . The Tax Code also provides a safe harbor for employer contributions.  The safe harbor contributions that are used to avoid non-discrimination testing must be 100%, immediately, vested and owned by the participant.

401(k): A 401(k) plan is subject to both the actual deferral percentage (ADP) test and also the actual contribution percentage (ACP) test. The safe harbor option is available, as noted above.

403(b): A 403(b) plan is subject only to the ACP test. The safe harbor option is available, as noted above.

457(b): A 457(b) plan is not subject to either the ADP or the ACP non-discrimination tests.

1. Contributions: All 401(k), 403(b) and 457(b) plans allow for pre-tax deferrals. Plans with other kinds of contributions must hold pre-tax deferred contributions and their earnings in a separate account. Roth contributions are permitted (but not required) in 401(k), 403(b) and 457(b) plans, however, the Roth contributions and earnings must be held separately.

401(k): After-tax contributions are allowed but the contributions and earnings are normally held in a separate account by the plan sponsor. The earnings on after-tax contributions will still be taxable when distributed. A distribution from a partially taxable account to the participant will be based on the pro rata rule that we have previously covered, i.e. the cream-in-the-coffee rule.

403(b): After-tax contributions are allowed and taxed comparable to after-tax contributions to a 401(k) account.

457(b): No after-tax contributions are permitted to be made to a 457(b) account.

Example: Kristen, age 35, has a job with Ajax which sponsor’s a 401(k) plan. Kristen also operates as a sole proprietor a ‘solo’ 401(k) plan as a creative marketing consultant, B-Aware. Kristen has already made $20,500 of Roth contributions to the Ajax plan in 2022. Even though Ajax and B-Aware are not related entities, Kirsten cannot make any pre-tax or Roth contributions to her solo 401(k) plan because she has ready reached the 2022 deferral limit. However, Kristen can still receive employer contributions made to both the Ajax 401(k) and the B-Aware 401(k) plans, and she can potentially make after-tax contributions to both plans. Kristen can slo make a traditional or Roth IRA contribution of us pt $6,000.

1. Employer Match and Profit Sharing Contributions: Employer matching or profit sharing contributions are common for 401(k) plans, less common with 403(b) plans, and very rare with regard to 457(b) municipal and governmental plans. An employer matching contribution can even be made on Roth contributions, however, those employer matching contributions are still allocated to the pre-tax employer contribution account.

401(k): A 401(k) plan can impose service requirements before the employee is fully vested in the employer’s contributions made on his/her behalf.

403(b): Like the 401(k) plan, a 403(b) plan can impose service requirements before the employee is fully vested in the employer’s contributions made on his/her behalf.

457(b): As noted, there are very few plans that have employer matching contributions.

1. Contribution Deferral Limit: Retirement saving plans are subject to two different contribution limits: (i) the elective deferral limit; and (ii) the annual additions, or the so-called ‘section 415 limit.’

Effective Deferral Limit: This limits a participant’s total pre-tax and Roth plan contributions in any calendar year.

401(k):  For 2022, the limit is $20,500 with a ‘catch-up’ contribution limit of another $6,500 for participants who are age 50+, i.e. a total of $27,000 for those age 50+. This limit applies to all plans an individual may participate in during the year,  even when the plan sponsors are totally unrelated.

Exception: If an individual participates in both a 457(b) and either a 401(k) or a 403(b) plan, he/she can defer up to the maximum amount to both the 457(b) plan and either the 401(k) plan,  or the 403(b) plan.

After-Tax Contributions: After-tax, but non-Roth, contributions, if allowed by a retirement plan do not ‘count’ towards the $20,500/$27,000 annual deferral limit.

403(b): A participant in a 403(b) plan with at least 15 years of service with the same employer can qualify for up to $3,000 of extra deferrals each year. If the participant is age 50+ with over 15 years of service with their employer can use both ‘catch-up’ contributions ($3,000 + $6,500 = $9,500.).

457(b): A participant in a 457(b) plan, in each of the last three (3) years before retirement age, is eligible for a special ‘catch-up’ contribution up to the deferral limit for that year, e.g. $20,500 in 2022. Thus, this special ‘catch-up’ contribution opportunity enables the 457(b) participant to effectively double their annual deferral limit contribution, i.e. $41,000; however, this ‘double’ contribution opportunity cannot be used in conjunction with the over-age 50 catch-up deferral of $6,500.

Overall Limit: This separate overall limit regulates the total contributions that can be made in a single plan year. The overall limit includes: pre-tax employee deferrals; employee Roth contributions; employee after-tax contributions; employer matching contributions; and employer profit sharing contributions. For 2022 this limit is $61,000, or for employees age 50+ with catch-up deferrals $67,500.

Combined Deferrals- Sometimes: These contributions are combined for all plans sponsored by the employer and also combined for companies that are considered related under the Tax Code are also combined. However, if the employee participates in two plans sponsored by unrelated employers, he/she can receive the benefit of a separate overall limit for each retirement plan that is sponsored.

Example: Dan, age 40,  is employed by Ajax as its controller. Dan also provides tax preparation services ‘on the ‘side’ to friends as a sole proprietor using an LLC. Thus, Ajax and the LLC are unrelated businesses. Ajax sponsors a 401(k) plan. Dan’s LLC has also adopted a 401(k) plan. As such, there are separate overall limits for each of Ajax and the LLC’s 401(k) plans. Dan receives a $2,500 matching contribution from the Ajax plan. Thus, Dan could make up to $38,000 ($61,000 – $20,500 – $2,500) of after-tax contributions to the Ajax 401(k) plan in 2022, if the plan formally adopted that after-tax contribution option. Dan also has a separate $61,000 overall limit to his LLC’s 401(k) plan. Although Dan cannot make any more pre-tax or Roth contributions to that plan (because of the deferral limit) Dan could theoretically make after-tax contributions (if offered by the plan) and/or employer contributions (depending upon Dan’s pay) to his LLC’s solo 401(k) up to $61,000.

Solo 401(k) Plan: Note that for business owners with a ‘solo’ 401(k) plan, such as Dan in the prior example, the employer contributions are limited to 25% of the employee’s W-2 reported earnings or 20% of the net earnings, less the tax deduction for self-employee taxes.

Conclusion: The annual contribution limits to these employer sponsored plans are much higher than the annual IRA contribution limit, which is why qualified plan accounts play an important role in an individual’s retirement planning. Unfortunately, however, plan eligibility, contribution, and contribution limit rules are not standard for all of these retirement plans, thus making it difficult to fully understand all options and limitations on retirement planning. It would be nice if Congress spent less time scabbing over face masks and our ‘woke’ culture and more time bringing some common sense to the rules with regard to saving for retirement.