Tax-exempt organizations have unique needs and concerns. Like a taxable, for-profit business, though, a tax-exempt organization can derive significant benefits by implementing and maintaining an employer-sponsored retirement plan. While a tax-exempt organization cannot receive a tax deduction for employer contributions (since it pays no income tax), the employees of such an organization can reap tax benefits from a retirement plan. This means that tax-exempt organizations themselves will likely benefit indirectly by attracting and retaining quality employees.
While most of the employer-sponsored retirement plan options available to for-profit businesses are available to tax-exempt organizations as well, there are some significant regulatory differences. In addition, some options are available to tax-exempt organizations that are not available to for-profit businesses.
Qualified vs. Nonqualified Plans
Qualified retirement plans offer significant tax advantages to both employers and employees. Employers are generally permitted to deduct their contributions on their federal income tax returns (generally not a consideration in the case of a tax-exempt organization), while all participants can benefit from pretax or after-tax contributions and tax-deferred (and in some cases, tax-free) growth. In return for these tax benefits, a qualified plan must generally adhere to strict IRC (Internal Revenue Code) and ERISA (Employee Retirement Income Security Act) guidelines regarding participation in the plan, vesting, funding, nondiscrimination, disclosure, and fiduciary matters.
In contrast to qualified plans, nonqualified retirement plans are often not subject to the same set of ERISA and IRC guidelines. As you might expect, this freedom from extensive requirements often provides nonqualified plans with greater flexibility for both employers and employees. In addition, nonqualified plans are often less expensive to establish and maintain than qualified plans. Generally, the main disadvantages of nonqualified plans are (a) they are typically not as beneficial from a tax standpoint, (b) they are generally available only to a select group of employees, and (c) plan assets are not protected in the event of the employer’s bankruptcy.
Tip: Some retirement plans are technically nonqualified, but have tax advantages under the Internal Revenue Code that are very similar to those offered by qualified plans. Two such plans, the 403(b) plan and the 457(b) plan, are described below. State and local government and church plans are generally exempt from ERISA but are subject to IRC requirements.
Qualified Plans for Tax-Exempt Organizations
Tax-exempt organizations may establish a qualified retirement plan (e.g., profit-sharing plan, money purchase pension plan, defined benefit plan, cash balance plan). In the case of plans established by a state or local government or a church, however, special rules apply, including specific provisions regarding coverage, vesting, minimum funding, and benefits.
In addition, state and local governments may not establish a 401(k) plan. Tax-exempt organizations, however, have been allowed to establish 401(k) plans beginning with plan years after 1996.
403(b) Plans
A 403(b) plan is a special type of employer-sponsored retirement plan designed for certain religious, public educational, and other tax-exempt organizations. Typically, the employer either purchases annuity contracts for eligible employees, or establishes custodial accounts to be invested in mutual funds or other investments. In the case of annuity contracts, a 403(b) plan is sometimes referred to as a “tax-deferred annuity” or a “tax-sheltered annuity (TSA).” Depending on the specific type of 403(b) plan, plan contributions may be made by only the employee (either pre-tax or Roth after-tax), only the employer, or both employee and employer. As with a qualified plan, participating employees in a 403(b) plan are generally not taxed on their plan benefits (including both contributions and investment earnings) until they begin to receive distributions from the plan (qualified Roth distributions are tax-free).
457(b) Plans
A Section 457(b) plan is a special type of employer-sponsored retirement plan that certain governmental units, governmental agencies, and non-church-controlled tax-exempt organizations can establish for their employees. As with a qualified plan, participating employees in a 457(b) plan are generally not taxed on their plan benefits (including both contributions and investment earnings) until they begin to receive distributions from the plan. A 457(b) plan somewhat resembles a 401(k) plan. Employee contributions are made on a pre-tax basis. 457(b) plans can also allow employees to make after-tax Roth contributions. There’s no up-front tax benefit, but qualified distributions are totally free from federal income tax.
Unlike a 401(k) plan, a 457(b) plan for a tax-exempt organization is generally structured to include only a select group of employees (a “top-hat” group) so as to avoid the requirements of ERISA. (Governmental plans are exempt from ERISA, and therefore do not need to be limited to the top-hat group.)
Other Employer-Sponsored Retirement Plans
Payroll Deduction IRA Plan: A payroll deduction IRA plan is a type of arrangement that allows employees to make payroll deduction contributions to IRAs (traditional or Roth). It can be offered to employees instead of a more conventional retirement plan (such as a 401(k) plan), or to supplement such a plan. Each participating employee establishes and maintains a separate IRA, and elects to have a certain amount deducted from his or her pay on an after-tax basis. That amount is then invested in the participant’s designated IRA. Payroll deduction IRAs are generally subject to the same rules that normally apply to IRAs.
SEP Plan: A simplified employee pension (SEP) plan is a tax-deferred retirement savings plan that allows contributions to be made to special IRAs, called SEP-IRAs, according to a specific formula. Generally, any employer with one or more employees can establish a SEP plan. With this type of plan, you can make tax-deductible employer contributions to SEP-IRAs for yourself and your employees (if any). Except for the ability to accept SEP contributions from employers (allowing more money to be contributed) and certain related rules, SEP-IRAs are virtually identical to traditional IRAs.
SIMPLE IRA Plan: A SIMPLE IRA plan is a retirement plan for employers with 100 or fewer employees that is established in the form of employee-owned IRAs. The SIMPLE IRA plan is funded with voluntary employee contributions and mandatory employer contributions. The annual allowable contribution amount is significantly higher than the annual contribution limit for traditional and Roth IRAs.
SIMPLE 401(k) Plan: A SIMPLE 401(k) plan is another retirement plan for employers with 100 or fewer employees. Structured as a 401(k) cash or deferred arrangement, this plan was devised in an effort to offer self-employed persons and small businesses a tax-deferred retirement plan similar to the traditional 401(k), but with less complexity and expense. The SIMPLE 401(k) plan is funded with voluntary employee pre-tax contributions and mandatory employer contributions. The annual contribution limits are less than the limits applicable to regular 401(k) plans.
Caution: Like a regular 401(k) plan, a SIMPLE 401(k) plan generally cannot be established by a state or local government.
Tip: 403(b), 457(b), and qualified plans can allow employees to make their regular IRA contribution—traditional or Roth—to a special account set up under the retirement plan. These accounts, called “deemed IRAs,” function just like regular IRAs.
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