Chapter 5 — Eligibility

Unlike other qualified plans, the eligibility requirements for tax-sheltered annuities are based primarily on employer type, not on minimum employee age and service. Only certain nonprofit and public employers are granted the privilege of establishing a TSA plan. To establish a TSA, an employer must qualify as one of the following:

• a public educational institution,
• a tax-exempt §501(c)(3) organization, or
• a church organization.

To qualify as a public educational institution, the employer must be a state, a political subdivision of a state, or an agency or instrumentality of one. This encompasses virtually the entire public educational system operated by or through a state government, including:

• elementary and secondary schools (K–12),
• colleges and universities, and
• professional schools such as medical and law schools.

Trade schools, adult training institutions, and other educational entities may also qualify if they are run by the state (or a state agency), have organized facilities, and operate under a defined curriculum.

Employees eligible to participate must perform services directly or indirectly for the public educational institution. Eligible employee categories include:

• teachers and other members of the faculty,
• administrators, managers, supervisors, principals, and other administrative staff,
• counselors,
• clerical staff and maintenance workers, and
• individuals such as nurses and doctors who perform services for the institution.

Section 501(c)(3) of the Internal Revenue Code lists the types of tax-exempt organizations whose employees are eligible to participate in TSA plans. Eligible §501(c)(3) employers include:

• private colleges and universities,
• trade and correspondence schools,
• parochial schools,
• hospitals and medical schools,
• museums and zoos,
• adult education schools,
• humane societies,
• religious organizations,
• public forums and united funds,
• public interest law firms,
• literary groups,
• research and scientific foundations,
• charitable institutions, and
• welfare agencies.

However, merely being tax-exempt is not sufficient. Many tax-exempt organizations are classified under other subsections of §501(c) and are not eligible to establish TSA plans. To be eligible, the employer must have applied for and received an IRS determination letter recognizing its status as a §501(c)(3) organization.

A religious organization, for TSA purposes, means an employer that is:

• a religious body such as a church, synagogue, mosque, or similar house of worship,
• a convention or association of churches, or
• an elementary or secondary school controlled and operated by a religious body.

An individual is considered an employee of a religious organization if employed as a duly ordained, commissioned, or licensed minister of a church, or as a missionary. Clerical and administrative staff of religious organizations are also eligible to participate in TSA plans.

Only a common-law employee of a qualified employer is eligible to participate in a TSA. Self-employed individuals are not eligible, even if they perform services for an eligible employer.

The IRS applies a behavioral and financial control test to determine employee status — the common-law employee test. Key questions include:

• Does the employer have the right to control and direct the individual in the services performed?
• Does the employer have the right to discharge the individual?
• Does the employer control or direct the method for accomplishing the final result?

As a general rule: if the employer controls both what the individual does and how it is done, the individual is a common-law employee. If the individual offers services to the general public and controls how the work is accomplished, the individual is an independent contractor — and not eligible for a TSA.

A practical rule of thumb: if the employer is paying FICA (Social Security and Medicare) taxes on behalf of the individual, that individual is generally considered an employee for TSA purposes.

Unlike other qualified plans, part-time employees are not excluded from TSA coverage when the plan is funded by employee elective deferrals. Both full-time and part-time workers are eligible to participate in an elective deferral TSA plan. The hours-of-service minimum that applies to employer-contribution plans does not apply to deferral-based TSA plans.

As a general rule, a TSA plan must be established with a written plan document. TSA plans are considered “employee pension benefit plans” under ERISA and must be in writing. However, there are exceptions:

• When retirement savings are invested in annuity contracts, a plan established by a public educational institution does not require a written plan document.
• All plans established by a §501(c)(3) organization require a written plan document.
• When savings are invested in mutual funds, a written custodial agreement is required regardless of employer type.

Only the employer may deposit contributions into the TSA. Employees may not contribute directly — however, the money used for contributions may originate from employee salary deferrals, which the employer then deposits on the employee’s behalf.

When TSA contributions are used to purchase annuity contracts from an insurance company, the employer signs the insurance application as the “purchaser.” However, the employee’s rights under the contract are nonforfeitable — the employee is 100% vested immediately and those rights cannot be taken away. The savings cannot revert to the employer. Additionally, the tax code requires these annuity contracts to be nontransferable: the employee cannot assign or pledge the annuity contract as collateral for a loan.

When TSA savings are invested in mutual funds, a custodial agreement is established between the employer and a custodian (typically a bank). Employee savings may be temporarily held in a bank savings account but must ultimately be invested in mutual fund shares issued by a regulated investment company.

The vast majority of TSA plans are funded through employee elective deferrals — amounts employees choose to have deferred into the plan rather than received as current wages. Employers favor this approach because it requires no cash outlay on their part, minimal administrative support, and simple payroll procedures. Employees favor it because deferred amounts are excluded from current taxable income.

Every eligible employee must be given the opportunity to make elective deferrals, as long as those deferrals would amount to at least $200 per year. An employer may not selectively offer or deny the opportunity to defer based on individual employee characteristics.

The employee and employer enter into a formal salary reduction agreement in which the employee agrees to accept a reduction in salary (or forego a pay raise). The employer deposits the equivalent amount as a premium for an annuity contract or into a custodial account.

Key requirements for salary reduction agreements:

• The agreement must be in writing — informal arrangements are not accepted by the IRS.
• All deferrals must come from compensation earned after the date of the agreement — retroactive deferrals are not permitted.
• Employees cannot enter into a salary reduction agreement and then make additional contributions from personal funds.
• The agreement is typically part of the employment agreement or an amendment to it.

Prior to 1996, only one salary reduction agreement was permitted during an employee’s tax year. If cancelled, it could not be reinstated until the following year. Since 1996, employees may stop, change, and restart salary reduction agreements mid-year.

When a salary reduction agreement calls for a fixed dollar amount, that amount remains constant regardless of compensation changes — a raise or pay cut does not alter the deferral. When the agreement specifies a percentage of compensation, the dollar amount of the deferral fluctuates with pay, but the percentage remains fixed until a new agreement is executed.

The employer does not have to transmit employee deferrals immediately to the insurance company or custodian. The employer may hold the funds until the end of the month, the end of the pay period, the end of the school year, or the end of the salary reduction period. However, to avoid lost earnings on the deferred amounts, it is generally better practice to transmit funds as promptly as possible.

When the employer makes contributions to a TSA plan (as opposed to purely employee-funded deferrals), the plan must comply with the standard qualified plan minimum participation standards and nondiscrimination requirements.

A TSA with employer contributions must generally cover each employee who has:

• completed one year of service, and
• reached age 21.

Exception for educational institution plans: A TSA maintained for employees of educational institutions may impose a minimum age requirement of 26, provided that any employee who meets the age-26 threshold is immediately 100% vested upon reaching that age and completing one year of service.

As with all qualified plans, employers may make participation requirements less stringent — for example, allowing participation from day one — but may not be more restrictive than these minimums.

For TSA plans with employer contributions, the following employees may be excluded from coverage:

• employees under age 21 (or under 26 for educational institution plans with immediate vesting),
• employees who work fewer than 1,000 hours per year,
• employees who have worked for less than one year,
• union employees whose retirement benefits were collectively bargained, and
• nonresident aliens with no U.S. source income.

In addition, the law permits two further exclusions unique to TSA plans:

• employees already participating in a 401(k) plan, and
• employees already participating in a §457 deferred compensation plan.

A TSA plan with employer contributions must satisfy at least one of the following coverage tests (discussed in detail in Chapter 1):

• the ratio test (percentage of non-highly compensated employees covered vs. highly compensated), or
• the average benefits test.

Even after satisfying one of these coverage tests, the plan must also pass the 50/40 test — requiring that at least 50 employees (or 40% of all employees, whichever is less) benefit under the plan.