The Treasury Department has released long-awaited guidance on the treatment of post-severance compensation for 403(b) plans (as well as for qualified retirement plans and 457 plans). Specifically, the regulations permit a limited amount of post-severance compensation to be included for the purpose of making elective deferrals and determining employer contributions. Plan sponsors may implement these regulations immediately (for 2005), and the interim guidance may be followed until final regulations are issued.

Compensation Limits
The IRS has expanded the definition of compensation under section 415(c)(3) to permit the inclusion of post-severance compensation if it’s paid within 2½ months of separation from service. However, such compensation is includible only to the extent that:

This limited amount of post-severance compensation may be used for participant elective deferrals and for employer profit sharing, matching contributions and safe harbor contributions. The following three examples describe how the new rules are applied:

Example 1
An employee terminates on June 10, 2005, and is entitled to three weeks of unused vacation time. He is paid for that unused vacation time within 2½ months after June 10, 2005. He may make elective deferrals on those dollars and is entitled to have that payment included in plan compensation for employer contribution purposes.

Had the company provided a 6-month severance package instead, the only pay that qualified as bona fide sick, vacation, or similar paid leave during the first 2½ months after separation may be used for qualified plan purposes. Payments made, regardless of the date, after that 2½-month period are ineligible. In addition, a lump-sum settlement in which an employee waives potential claims against the employer would also constitute ineligible compensation for 403(b) plan purposes.

Example 2
An employee terminates October 15, 2005, and is granted a lump-sum severance equal to 12 months of compensation. The employee’s four weeks of unused vacation time is included in the lump-sum payment. The plan is a safe harbor 401(k) plan with a guaranteed 3% nonelective contribution. In this example, only the four weeks of unused vacation compensation may be used for qualified plan purposes. The employer would have to make a nonelective contribution for this employee, but only using four weeks of compensation (through November 15, 2005).

Example 3
Over her 20-year career, an employee has accumulated four months of sick leave. She is entitled to be paid for the sick leave when she leaves her job on July 1, 2005. The retirement plan is a 401(k) plan that provides elective deferrals, matching and nonelective contributions. Only the first 2½ months of compensation for the employee’s accumulated sick leave (through September 15, 2005) is eligible compensation for elective deferrals, matching contributions, and the determination of the nonelective contribution.

We will be including the necessary post-severance compensation language in the 403(b) document in 2006.

Coordination with the EGTRRA Up-to-5 years of Post-Retirement Contributions Based on Includible Compensation From Last Year of Work Prior to Retirement.
EGTRRA Section 632(a)(2)(C) (and clarified by JCWAA 411(p)) allows for contributions to a 403(b) annuity to be made for an employee for up to five years after retirement based on includible compensation from the last year of service before retirement. Includible compensation for purposes of the 403(b) contribution is the amount of compensation received from the employer and includible in the employee’s gross income for the most recent period (ending not later than the close of the employee’s tax year) that can be counted as a full year of service. This compensation may not precede the taxable year by more than five years. Finally, includible compensation may not include any amount contributed by the employer to the employee’s 403(b) annuity. This significant change is a major advantage available to a 403(b) participant, because it can allow for an employee to arrange for the employer to contribute up to $205,000 (5 years x $41,000, as adjusted) to the plan after the employer terminates employment. For example, for school districts wishing to buy out the contract of an administrator, this provides added flexibility for both parties. The district gets to pay out amounts over time and the employee gets contributions to a tax favored arrangement.

JCWAA also clarified that 403(b) contributions are subject to 415 limits for the year in which the contributions are made - regardless of whether the contributions are vested or not at the time they are contributed.

The new 415 regulation permitting up to 2½-month of post-severance compensation for pay that would have been been received if employment had continued is absolute and is different than the post-severance 5-year rule which applies to employer contributions only.

Example 4
If a teacher retired June 23, 2005 and received 6 months of accumulated sick pay and was being awarded post-severance employer contributions for five years after June 23, 2005, the teacher could only make 403(b) deferrals for the first 2½-months after June 23, 2005. However, post-severance employer contributions based on the EGTRRA 5-years-of-post-severance employer contributions rule could be made by the employer for five years after June 23, 2005.

Note: There has been a clarification that the 401(a)(4) rules apply to the 5-year payment; such that there may be a discrimination issue if the only one benefiting is an HCE or if this plan provision favors HCEs, and 401(a)(4) cannot be passed.