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Retirement Planning > Retirement Investing > Annuity Investing

Annuities and Taxes, Pt. 4: 9 Requirements of Tax-Sheltered Annuity Contracts

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As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.

What nine requirements must tax sheltered annuity contracts (403(b) plans) meet?

Under final regulations, amounts contributed by an eligible employer for the purchase of an annuity contract for an employee are excluded from the gross income of the employee under IRC Section 403(b) only if each of the nine requirements below are satisfied. The final regulations require the 403(b) plan, in both form and operation, to satisfy the applicable requirements for exclusion.

(1) Purchase by Eligible Employer. A tax sheltered annuity contract must be purchased by an eligible employer. Final regulations provide that the annuity contract cannot be purchased under a qualified plan, or an eligible governmental plan.

Thus, an employer must agree to pay premiums. Although the employer must pay premiums, the premiums may be derived either directly from the employer as additional compensation to the employee or indirectly from the employee through a reduction in his or her salary. If premiums are to come from a reduction in the employee’s salary, the reduction must be made under a legally binding agreement between the employer and the employee, and the agreement must be irrevocable as to salary earned while the agreement is in effect.

An employee is permitted to enter into multiple salary reduction agreements with the same employer during any one taxable year of the employer. For purposes of IRC Section 403(b), the frequency that an employee is permitted to enter into a salary reduction agreement, the salary to which such an agreement may apply, and the ability to revoke such an agreement generally is determined under IRC Section 401(k).

All annuity contracts, including custodial accounts and retirement income accounts, purchased by an employer on behalf of an employee are treated as a single annuity contract for purposes of applying the requirements of IRC Section 403(b).

Tax deferment will be achieved only for premium payments attributable to amounts earned by an employee after the agreement becomes effective; premium payments attributable to salary earned prior to the effective date, or after termination of the agreement, are includable in the employee’s gross income. For this purpose, salary is considered earned when the services for which it is compensation are performed, even though payment is deferred and subject to a risk of forfeiture. After-tax contributions can be made by payroll deduction to a 403(b) plan, but will not be excludable.

The final regulations specify that contributions to a 403(b) plan must be transferred to the insurance company issuing the annuity contract or the entity holding assets of any custodial or retirement income account that is treated as an annuity contract within a period that is not longer than is reasonable for the proper administration of the plan. A plan may provide for elective deferrals for a participant under the plan to be transferred to the annuity contract within a specified period after the date the amounts would otherwise have been paid to the participant, although in no event may that ever be longer than as soon as reasonably possible.

If a tax sheltered annuity plan is subject to Title I of ERISA, the Department of Labor requires that amounts an employee pays to the employer or has withheld from his or her salary by the employer for contribution to a plan become plan assets as soon as these amounts reasonably can be segregated from the employer’s general assets, but in no event ever later than the fifteenth business day of the month following the month in which the contributions are received or withheld by the employer. A tax sheltered annuity plan also can qualify for the ERISA contribution safe harbor for small plans.

(2) Nonforfeitable Rights. An employee’s rights under a 403(b) contract must be nonforfeitable except for failure to pay future premiums. According to final regulations, an employee’s rights under a contract are not nonforfeitable unless the participant for whom the contract is purchased has at all times a fully vested and nonforfeitable right to all benefits provided under the contract.]The effect of this requirement is that salary reduction contributions to a tax sheltered annuity must be immediately vested. Actual employer contributions can be subjected to delayed vesting by treating such non-vested contributions as being subject to 403(c) instead of 403(b).

Tax sheltered annuity plans are not subject to the vesting rules under Section 411, but may be subject to ERISA’s vesting rules. PPA 2006 extended to employer non-elective contributions the faster vesting requirements that had applied to employer matching contributions since 2002. The vesting requirements are satisfied under either a three year cliff vesting schedule that reaches 100 percent after three years of service or a graduated vesting schedule, i.e., 20 percent after two years of service, 40 percent after three years, 60 percent after four years, 80 percent after five years, and 100 percent after six years. This change effectively makes all employer contributions in defined contribution plans subject to the faster vesting requirements.

There are vesting rules applicable to employer contributions in plan years beginning after December 31, 2001. With exceptions for governmental and certain church plans, tax sheltered annuity plans with actual employer contributions generally are subject to ERISA and must comply with ERISA’s minimum vesting schedules if they delay vesting.

(3) Participation and Coverage. Except for contracts purchased under plans by certain churches or certain governmental plans, tax sheltered annuity contracts generally must be provided under a plan that meets minimum participation, coverage and nondiscrimination requirements if employer contributions are made to those contracts.

(4) Limits on Elective Deferrals. Under final regulations, a contract must satisfy IRC Section 401(a)(30), relating to limits on elective deferrals. A contract does not satisfy this limit unless the contract requires all elective deferrals for an employee not to exceed the limits of IRC Section 402(g)(1), which include (1) elective deferrals for the employee under the contract, and (2) any other elective deferrals under the plan under which the contract is purchased and under all other plans, contracts, or arrangements of the employer.

(5) Nontransferable. A contract must be expressly nontransferable. An agreement between employer and employee that the employee will not transfer the contract is not sufficient. For this purpose, an employer is considered to have purchased a new contract when it pays the first premium on a previously issued contract. Although the contract must be nontransferable, the employee can surrender the contract to the insurer, borrow against the loan value, and exercise all other ownership rights.

(6) Minimum Required Distributions. Tax sheltered annuity contracts and custodial accounts must provide that distributions of at least a minimum amount must be made. These requirements may be incorporated in a plan by reference.

(7) Direct Rollover Option. A plan generally must provide that if a distributee of any eligible rollover distribution  elects to have the distribution paid directly to a traditional IRA, another tax sheltered annuity (if applicable), or an eligible retirement plan and specifies the plan to which the distribution is to be paid, then the distribution will be paid to that plan in a direct rollover.

Before PPA 2006, amounts held in an annuity contract or account described in IRC Section 403(b) could not be converted directly to a Roth IRA. Effective for distributions beginning after December 31, 2007, distributions from a 403(b) plan may be rolled over directly into a Roth IRA, subject to the rules that apply to rollovers from a traditional IRA into a Roth IRA. This eliminates the necessity for a conduit traditional IRA.

The payor of a 403(b) annuity contract or custodial account must withhold 20 percent from any eligible rollover distribution that the distributee does not elect to have paid in a direct rollover. A safe harbor explanation that a payor may give to recipients of eligible rollover distributions from tax sheltered annuities is provided in Notice 2002-3.

(8) Limitation on Incidental Benefits. The contract must satisfy the incidental benefit requirements of IRC Section 401(a).

(9) Maximum Annual Additions. The annual additions to the contract must not exceed the applicable limitations of IRC Section 415(c), treating contributions and other additions as annual additions.

Plan in Form and Operation 

According to final regulations, a contract does not satisfy the requirements for exclusion from gross income unless it is maintained pursuant to a plan. For this purpose, a plan is a written defined contribution plan that, in both form and operation, satisfies the requirements set forth in IRC Section 403(b) and Treasury regulations. Thus, a plan must contain all of the material terms and conditions for eligibility, benefits, applicable limitations, the contracts available under the plan, and the time and form under which benefit distributions would be made.

For more tax stories and Tax Facts Q&A’s, check out ThinkAdvisor’s 21 Days of Tax Planning Advice for 2014 Special Report.