This is the second post in our 403(b) Crunch Time Series, the purpose of which is to help 403(b) plans get ready for the January 1, 2009 compliance deadline for the new Internal Revenue Service regulations. On Tuesday, Bob Toth , our guest blogger, wrote about Avoiding Problems with Custodial Accounts.

Now it’s my turn, and today’s post is about complying with the 403(b) contribution limits. So let’s start with some background. One of the concerns that the IRS had in their audits over the last several years was cases in which the contribution limits were exceeded and corrections not being done.

Those contribution limits are governed by Section 402(g) of the Internal Revenue Code and are adjusted annually. For 2009:

  • Elective deferrals are limited to the lesser of $16,500, or 100% of the participant’s includible compensation.
  • Designated Roth contributions count toward the $16,500 402(g) limit.
  • A catch-up contribution of $5,500 is available for participants age 50 and older.

In addition, there is a special life-time catch-up of $3,000 per year, not to exceed $15,000 for an employee of a qualified organization. If a plan participant is eligible for both types of catch-up contribution, then the special catch-up contribution limit is applied first to their accounts.

Sounds simple, doesn’t it, but it won’t be. The new regulations take the approach that the employer is generally responsible for compliance with the 402(g) limits and the correction of any excess that occur. This will be a big departure from the current 403(b) environment in which there is an individual relationship between the employee and the 403(b) investment provider.

Here’s two examples of potential problems for employers.

Monitoring Special Catch-Up Contributions. Pre-regulations, the employer could rely on the employee’s representations regarding his or her eligibility for and the amount of special catch-up contributions. It’s a complicated calculation based on the availability of extensive employee historical data. Many employers, I would think, would avoid this responsibility by not permitting the special catch-up.

Returning Excess Contributions. For those 403(b) plans in which there are individual contracts, the employer has no ability to direct the return of excess contributions. So what if the employee who must have contributions returns, simply doesn’t comply. That is, not notify the investment provider to return the excess funds. The answer, it would seem to me, would be for the employer to inform the provider who would then do the appropriate tax reporting to the IRS.

There are serious issues since the penalty for failure to comply with the contribution limits can be harsh – adverse tax consequences for both the employer and the employee.

The practical solution for those employers who decide not assume responsibility for this plan compliance is to do what 401(k) plan sponsors do – delegate the responsibility to a third party adviser or to the investment provider.

Coming Attractions: Bob will be back on Monday with with #3 in the 403(b) Crunch Time Series, Trouble in Terminating Tax Deferred Annuities.