This article is intended to familiarize tax-exempt organiza-tions and their advisors with the retirement plans availablefor employees. These include: tax-qualified retirement plans,tax-deferred annuities, simplified employee pensions, and

nonqualified retirement plans.In all cases, where annual dollar limitations are described

below (which are typically cost-of-living-based and may changefrom year to year), the amount in effect for 2009 is indicated.

Tax-Qualified Retirement PlansThe hallmark of a tax-qualified retirement plan is that it provides

the contributing entity with an immediate tax deduction.Obviously, this primary benefit is inapplicable to a tax-exempt orga-nization. Perhaps the other most notable aspect of tax-qualified retire-ment plans is that the contribution is required to be made current-ly, even though the retirement benefit itself may not be payable formany years or decades. (Contrast this to agreeing to pay a non-

Retirement Plans for Employees of Tax-Exempt Organizations

M A N A G E M E N T

e m p l o y e e b e n e f i t p l a n s

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By Dana Scott Fried

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qualified pension in the future of, for exam-ple, $3,500 per month. In such a case, theemployer would only need to come upwith the monthly pension amount, and per-haps not until well into the future). Thus, atax-exempt organization appears to get a rawdeal—it is required to make current contri-butions without the attendant benefit enjoyedby for-profit employers, namely the taxdeductions that decrease the cost to theemployer of maintaining the plan.

Then why would a tax-exempt organi-zation sponsor a tax-qualified retirementplan? The answer is simple—employeeswant them and the great majority of for-profit employers, with which tax-exemptorganizations must compete for staff, pro-vide them. Why do employees want them?The following tax-qualified retirement planfeatures are appealing to employees andprospective employees:■ No income taxes are due until thebenefits are paid.■ The plan’s assets are held in trust andare not subject to the claims of the employ-er’s creditors.■ Employees in defined contributionplans may be able to direct the investmentsof their plan accounts.■ Employee eligibility and benefits maynot discriminate in favor of highly com-pensated employees.■ The maximum vesting period is threeyears (if all-or-nothing “cliff” vesting is uti-lized) or six years (if graded vesting isutilized).■ Plan loans may be available.■ Hardship withdrawals may be available.■ For certain defined contribution plans,other pre-termination withdrawals (e.g., age59 �� ) may be available.■ A variety of distribution options maybe available, from which the employee canselect after termination.■ Benefits can be rolled over to an IRAor another employer’s tax-qualified retire-ment plan without the imposition ofincome tax.

The protection of assets from an employ-er’s creditors is especially noteworthy, espe-cially for companies and organizations expe-riencing or anticipating financial distress.Tax-qualified retirement plans are uniquein that employees are not currently taxableon their benefits, even though the plan isfunded, yet the plan’s assets are not subjectto claims of the employer’s creditors.

Another key aspect of tax-qualified retire-ment plans is that they may not provide ben-efits that discriminate in favor of highly com-pensated employees (HCE) or provide fordiscriminatory eligibility requirements thatfavor HCEs. (An HCE is defined as anemployee with compensation in excess of$110,000.) Therefore, a tax-qualified retire-ment plan cannot be used to provide bene-fits solely for an employer’s executives;where this outcome is desired, a nonquali-fied plan will be required. For example, itwould be discriminatory (and thereforeimpermissible) for a plan to provide a 20%of base salary employer contribution forHCEs but only 10% for non-HCEs.Conversely, a plan could provide a $15,000employer contribution for an HCE with a$150,000 base salary and only a $5,000employer contribution for a non-HCE witha $50,000 base salary, because the contri-bution formula is the same for all employ-ees—10% of base salary.

Tax-qualified retirement plans (whichmust have a trustee) are subject to specialrequired minimum distribution rules as wellas nondiscrimination requirements withregard to the following:■ Eligibility for plan participation.■ Contributions and benefits.■ Compensation eligible under the plan’sformula (amount and type—no more than$245,000 of an employee’s compensationmay be considered).■ Amounts contributed to 401(k) plansby employees (via salary reduction) or byemployers.■ For any year that the plan is “top-heavy,” special minimum employer contribution and vesting requirements.(Top-heavy means that the accountsunder a defined contribution plan or thebenefits under a defined benefit plan of“key employees”—officers with compen-sation in excess of $160,000—exceed 60%of those for all employees.) ■ Availability of plan benefits, rights, andfeatures (e.g., hardship withdrawals, loans,or certain payments options) to all partic-ipants, not just HCEs.

The nondiscrimination requirements areimposed on a controlled-group basis—allmembers of a controlled group are deemedto be a single employer, to prevent anemployer from moving all of its non-HCEsto a subsidiary with an inferior plan. For for-profit enterprises, the controlled group test is

based on 80% ownership (e.g., stock for acorporation, profits, or capital interest for apartnership). For tax-exempt organizations,the test is based on commonality (80% test)of board members (or control over the rightto select 80% of board members).

Contributions to a tax-qualified retire-ment plan may be made by the employer,the employee (typically via salary reduc-tion), or a combination of both.

The tax-qualified retirement plan rulesplace limits on 1) the benefits that may beaccrued under a tax-qualified defined ben-efit plan (i.e., where the employer bearsthe investment risk and may be required tocontribute additional amounts to fund the defined benefit), and 2) the annual contributions that may be allocated to anemployee’s individual account under a tax-qualified defined contribution plan (i.e., aplan where the employee bears the invest-ment risk and the employee’s account bal-ance is the employee’s benefit). The definedbenefit plan limit is the lesser of $195,000or 100% of the employee’s compensationfor her three highest-earning years. Thedefined contribution plan limit is $49,000per year per employee. On account ofthese limitations, far greater retirement ben-efits can be provided under a defined ben-efit rather than a defined contribution plan.

With a tax-qualified defined contribution401(k) plan, the maximum annual employ-ee elective deferral amount is limited to$16,500 ($22,000 for employees who reachage 50 by the end of the year). This limitapplies in the aggregate to tax-qualified401(k) plans, tax-deferred annuities, andSavings Incentive Match Plan for Employees(SIMPLE) plans under IRC section 408(p).

Tax-qualified retirement plans are sub-ject to myriad distribution, operational, andreporting and disclosure requirements, typ-ically necessitating the services of a third-party administrator and other experts toassist the employer sponsoring the plan. Inthe case of a defined benefit plan, a con-sulting actuary is needed to assist the plansponsor with the many applicable fundingrules, requirements, and calculations. Thesanctions for failing to comply with thetax-qualified retirement plan requirementscan be severe. Finally, the administrationand investment of tax-qualified retirementplans are subject to the fiduciary require-ments of the Employee Retirement IncomeSecurity Act (ERISA).

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Tax-Deferred AnnuitiesFunded typically through the use of

annuity contracts issued by insurance com-panies (custodial accounts of noninsurancecompanies such as banks, credit unions,and trust companies can also be utilized),tax-deferred annuities (TDA) are con-tracts to provide retirement benefits toemployees of public educational organi-zations, states, and organizations that aretax-exempt under IRC section 501(c)(3)(i.e., religious, charitable, scientific, edu-cational, and public-interest organizations).TDAs, like tax-qualified retirement plans,are subject to a host of technical rules andrequirements, including the following:■ The plan must be in writing. (Effectivefor 2009, this requirement applies to non-ERISA TDAs—formerly, only ERISATDAs were required to have a written plandocument.)■ Nondiscrimination requirements mustbe in place, including a “universal avail-ability” requirement (i.e., virtually allemployees must be permitted to makesalary reduction contributions if any arepermitted to do so).■ Distribution requirements must be inplace.■ All contributions must be immediatelyand fully vested.■ Rollovers must be permitted.■ Contributions may be made by theemployer, the employee (via salary reduc-tion) or a combination of both.

Why would a tax-exempt organizationopt to maintain a TDA rather than a tax-qualified retirement plan? One importantreason is that, depending on a number offactors, certain TDAs are not subject toERISA. (Not being subject to ERISAavoids numerous government and partici-pant reporting and disclosure requirementsas well as fiduciary requirements andobligations that are applicable to ERISATDAs.) TDAs of government and churchemployers are generally not subject toERISA. As to other tax-exempt organiza-tions, a TDA will not be subject to ERISAwhere the following conditions are met:■ Participation is completely voluntaryby employees.■ There are no employer contributions(employee contributions via payroll reduc-tion are permitted).■ All rights under the annuity contract (orcustodial account) are enforceable solely

by the employee, the employee’s benefi-ciary, or their authorized representatives. ■ Most critically, the sole involvement ofthe employer must be limited to—

■ permitting or facilitating annuitycontractors and service providers to meetwith and distribute marketing informa-tion to employees;■ summarizing or compiling informa-tion with respect to available productsand services;■ collecting employee contributions (viapayroll reduction) and remitting those con-tributions to the contractors and main-taining employee contribution records;■ holding one or more group annuitycontracts covering its employees in theemployer’s name; and■ limiting the funding media or prod-ucts available to employees, or the annu-ity contractors who may approachemployees, to a number and selectiondesigned to afford employees with a rea-sonable choice.In addition, the employer may receive

no compensation or other consideration inconnection with the TDA (other than rea-sonable amounts to cover expensesincurred in the performance of its dutiesunder a salary reduction agreement).

Perhaps the most popular tax-qualifiedretirement plans today, where all contri-butions are made by employees on a pre-tax basis via payroll reduction (i.e., salarydeferral), are the 401(k) plan, and, in theTDA arena, a salary-deferral TDA. Manyof the limitations and requirements appli-cable to these plans are the same (e.g., con-tribution limits). For example, the federalannual limitation on employee deferral con-tributions under both types of plans is$16,500 ($22,000 with the “catch-up” forthose who reach age 50 by the end of theyear). [The $16,500 amount is aggregatedwith tax-qualified 401(k) plan and SIMPLE Plans under IRC section 408(p).]

As mentioned above, a TDA can be oper-ated in a fashion so as not to be subject toERISA. Such is not the case, however, fora 401(k) plan, which must comply withERISA’s many fiduciary, disclosure, andreporting obligations. Furthermore, a401(k) plan is subject to the actual deferralpercentage test that limits the differencebetween contributions made by HCEs as agroup and those made by non-HCEs as agroup, often with the result that participants

who are HCEs must receive back theirexcess deferrals (i.e., the amount that doesnot satisfy the average deferral percentagetest requirements) on a fully taxable basisduring the first quarter of the following year.Salary deferral TDAs are not subject to theaverage deferral percentage test (or any sim-ilar test). Consequently, where salaryreduction employee contributions are intend-ed to be the sole source of contributions, asalary deferral TDA may be preferable to a401(k) plan. In addition, new for 2009, annu-al reports (in certain cases requiring auditedplan financial statements) will be requiredfor many TDAs subject to ERISA.

Simplified Employee Pension PlansA simplified employee pension (SEP) is

essentially a series of IRAs established byan employer for its employees to receiveemployer contributions. Under a SEP, anemployer can contribute far more each yearon behalf of its employees than each employ-ee would be able to contribute under a tra-ditional IRA. The maximum annual SEPcontribution is equal to the lesser of 25% ofthe employee’s compensation (for this pur-pose, only a specified portion of anemployee’s compensation may be consid-ered—$245,000), or $49,000. As is thecase under a tax-qualified retirement planor TDA, the employee is not taxed on theamounts of the employer’s contributionswhen they are made; taxation does notarise until receipt of the SEP benefits.

SEPs are simpler to establish andmaintain than tax-qualified retirement plansand TDAs. No trust or annuity contract isrequired. All contributions must be fullyvested, further minimizing the employer’sadministrative responsibilities—often agood choice for a smaller employer. Eachemployee selects his own investment, andSEPs are not subject to ERISA, therebyrelieving the employer from ERISA’s fidu-ciary obligations regarding investments. NoIRS annual report is required. IRA rolloversare permitted.

On the negative side, employee salaryreduction contributions are not permissible,loans cannot be provided, all contributionsmust be fully vested when made (i.e., noforfeitures by short-service employees upontheir termination of employment), andemployees must be entitled to withdrawthe employer contributions at any time. Inaddition, SEPs are subject to special required

SEPTEMBER 2009 / THE CPA JOURNAL 63

minimum distribution rules as well as thefollowing nondiscrimination requirements:■ All employees (including part-time andseasonal but possibly excluding those cov-ered by a collective bargaining agreement)age 21 or older and who have performedservices for the employer during at leastthree of the five immediately precedingyears must be covered.■ Contributions may not discriminate infavor of HCEs.■ Only the first $245,000 of an employ-ee’s compensation may be considered. ■ The top-heavy plan rules are applica-ble—if the plan is top-heavy under the def-inition as stated above in the tax-qualifiedretirement plans section, the employer is obli-gated to contribute for each non-key employ-ee the lesser of 3% of the employee’s com-pensation or the percentage allocated to theIRA of the best-treated key employee.

Smaller employers may consider thepositives and negatives of a SEP as prefer-able to establishing a tax-qualified retire-ment plan or TDA. Recall, however, thatemployee salary reduction contributions arenot permitted under a SEP. Consequently,an employer wishing to utilize a plan thatoffers solely salary reduction contributions,or a combination including such contribu-tions, will not be able to do so with a SEP.

Nonqualified Retirement PlansWhere discriminatory retirement benefits

(e.g., benefits only for particular executivesor senior management) are desired suchthat a tax-qualified retirement plan or TDAcannot be utilized—or where a tax-exemptorganization simply cannot or prefers not tofund the benefit in advance—IRC section457 will apply. Section 457 is applicable tononqualified deferred compensation plans ofgovernmental and nongovernmental tax-exempt employers. There are essentially twotypes of 457 plans: eligible deferred com-pensation plans that meet the requirementsof section 457(b), or ineligible deferred com-pensation plans under section 457(f), whichdo not satisfy the requirements under sec-tion 457(b). A 457(b) plan typically requiresa separate plan document whereas a 457(f)plan can be included within an employ-ment agreement.

An eligible deferred compensation planunder IRC section 457(b) is an unfundedplan that provides for annual deferrals lim-ited to the lesser of $16,500 (the additional

catch-up is available to employees of gov-ernmental employers but is not available toemployees of nongovernmental tax-exemptorganizations; there is also another catch-upopportunity for the last three years preced-ing the year in which the plan’s normalretirement age is reached, available to bothgovernmental and nongovernmental tax-exempt organizations) or 100% of theemployee’s compensation. [This limit isaggregated for all 457(b) plans.] For this pur-pose, “unfunded” means that all amountsunder the plan remain (until paid out) sole-ly the property of the employer and subjectto the claims of the employer’s creditors.IRC section 457(b) plans must also satisfyspecific distribution (including required min-imum distribution) requirements. Hardshipwithdrawals and rollovers to other 457(b)plans are permitted.

To the extent a deferred compensationarrangement or plan provides contributionsor benefit accruals that exceed the annual$16,500 limit under section 457(b), or lesslikely, where such an arrangement or plancannot satisfy some other requirement undersection 457(b), section 457(f) will apply.To satisfy the section 457(b) “unfunded”requirement, the plan must be exempt fromERISA’s funding requirement—namely, theplan must qualify as an excess benefit planor a “top-hat” plan. (An excess benefit plansolely provides benefits in excess of the lim-itations on annual contributions and bene-fits under tax-qualified retirement planspursuant to IRC section 415. A top-hatplan provides deferred compensation for a“select group of management or highly com-pensated employees.” Although there is nobright-line test for this requirement, less than20% or less than 10% are aggressive or con-servative positions on selectivity.) Assumingthat the plan qualifies as a top-hat plan, thekey remaining aspect of IRC section 457(f)relates to the timing of participant taxation.Essentially, section 457(f) provides that theemployee will be taxable upon becomingvested (rather than upon payment, whichcould lead to current taxation on an amountnot to be received for many years).Conversely, to the extent the benefit is sub-ject to a “substantial risk of forfeiture,” theemployee is not currently taxed. Upon elim-ination of the forfeiture risk, taxation isimmediate, regardless of the (later) contrac-tual time for payment.

Where an employee’s own compensa-

tion is voluntarily deferred, the vestingrequirement under IRC section 457(f)will generally be unacceptable; conse-quently, a voluntary deferral arrangementunder a nonqualified plan will need to bea 457(b) plan, and the annual deferralopportunity will be limited to $16,500 (pluscatch-up). Where no vesting requirementor typical vesting schedule is envisioned,a 457(b) plan should be used for the first$16,500 (plus catch-up). For amounts inexcess of the limitation, a 457(f) planwould be required.

Because full taxability occurs under a457(f) plan upon vesting, the plan may pro-vide for full payment upon vesting orpayment of the lesser amount necessaryto meet the tax liability generated by vest-ing. These approaches place additionalcash-flow pressures upon the employer andfail to provide employees with much of adeferral. Another alternative is simply tosubject the benefit to a substantial risk offorfeiture until a stated retirement age.Generally, the “substantial risk of forfei-ture” requirement is satisfied where anemployee forfeits her benefit upon resign-ing or being terminated for “cause” (notsufficient if forfeit solely upon a termina-tion for cause) prior to vesting.

Selecting the Right PlanTax-exempt organizations may have

only a few employees or hundreds ofemployees. Depending upon their size andfinancial condition (both current andfuture), certain organizations may be in aposition to offer greater employer contri-butions (matching or nonelective), whileothers will not be able to make anyemployer contributions but may wish topermit employees the opportunity to fundtheir own retirement benefits. Larger orga-nizations may have their own HR profes-sionals available to administer their plan,whereas smaller organizations may need toavoid additional administrative responsi-bilities to the extent possible. In this regard,the management of tax-exempt organiza-tions should obtain expert advice to selectthe most appropriate plan under the cir-cumstances. ❑

Dana Scott Fried, MBA, JD, LLM, is apartner at Loeb & Loeb, LLP, in NewYork, N.Y.