2.3 Other DC Designs: ESOPs, SEPs, SIMPLE IRAs, SIMPLE 401(k)s, 403(b)s & 457(b)s

2.3 Other DC Designs: ESOPs, SEPs, SIMPLE IRAs, SIMPLE 401(k)s, 403(b)s & 457(b)s

[!IMPORTANT] Beyond Standard 401(k) Plans: The retirement landscape includes a broad array of statutory plan designs engineered for specialized business structures, institutional tax-exempt entities, and small employers seeking reduced administrative complexity. A Qualified 401(k) Administrator (QKA) must master the legal parameters, coverage boundaries, and unique distribution rules of ESOPs, SEPs, SIMPLE arrangements, 403(b) tax-sheltered annuities, and 457(b) deferred compensation plans.

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Employee Stock Ownership Plans (ESOPs)

An Employee Stock Ownership Plan (ESOP) is a qualified defined contribution plan defined under IRC §4975(e)(7) and ERISA §407(d)(6). It is structured as a qualified stock bonus plan (or a combination stock bonus and money purchase plan) that is designed to invest primarily in qualifying employer securities.

+─────────────────────────────────────────────────────────────────────────────────────────────────+
|                               LEVERAGED ESOP TRANSACTION CYCLE                                  |
+─────────────────────────────────────────────────────────────────────────────────────────────────+
|                                                                                                 |
|   1. External Bank / Lender ──── (Loan Proceeds) ─────────> ESOP Trust                          |
|                                                                  │                              |
|   2. ESOP Trust ──────────────── (Buys Stock) ────────────> Selling Shareholders                |
|                                                                  │ (Shares held in Suspense)    |
|   3. Employer Company ────────── (Tax-Deductible Contrib) ─> ESOP Trust                         |
|                                                                  │                              |
|   4. ESOP Trust ──────────────── (Debt Repayment) ────────> External Bank / Lender              |
|                                                                                                 |
|   5. As debt is amortized, shares are released from suspense & allocated to participant accs!   |
+─────────────────────────────────────────────────────────────────────────────────────────────────+

Leveraged vs. Non-Leveraged ESOPs

• Non-Leveraged ESOP: The employer simply contributes newly issued company stock, treasury stock, or cash (which the trust immediately uses to purchase company stock) directly to participant accounts.
• Leveraged ESOP: The ESOP trust borrows money (an "exempt loan" under IRC §4975(d)(3) guaranteed by the employer) from an external financial institution or the employer itself. The trust uses the loan proceeds to acquire a large block of employer stock from existing owners.
  • The acquired shares are placed into an unallocated suspense account.
  • The employer makes annual tax-deductible contributions to the ESOP, which the trust uses to pay principal and interest on the loan.
  • As debt is paid down, a proportionate number of shares are released from the suspense account and allocated to eligible participant accounts based on relative compensation.

Qualifying Employer Securities (IRC §409(l))

The ESOP must invest primarily in common stock issued by the employer (or a member of the same controlled group) that is readily tradable on an established securities exchange. If the stock is not publicly traded, it must be common stock possessing a combination of voting power and dividend rights equal to or greater than the highest classes of common stock issued by the employer.

Put Option Protection (IRC §409(h))

Because privately held stock has no public market, participants could face an illiquid distribution of non-tradable shares. To protect participants, IRC §409(h) mandates a put option:

• If employer securities are not readily tradable on an established market, the distributee has the legal right to require the employer to repurchase the shares at fair market value.
• Put Option Windows: The put option must be exercisable for at least 60 days following distribution. If not exercised, the employer must provide an additional 60-day window in the following plan year.
• Independent Appraisal (IRC §401(a)(28)(C)): All valuations of non-publicly traded employer securities must be performed by an independent, certified third-party appraiser.

Statutory Diversification Rights (IRC §401(a)(28))

To safeguard employees from over-concentrating their retirement wealth in company stock, IRC §401(a)(28) provides statutory diversification rights for qualified participants:

• Qualified Participant: An employee who has attained at least age 55 and completed at least 10 years of participation in the ESOP.
• 6-Year Election Period: Begins in the plan year following the year the participant becomes qualified.
  • Years 1 through 5: Participant may elect to diversify up to 25% of their total company stock account balance (less shares previously diversified).
  • Year 6 (Final Year): Participant may elect to diversify up to 50% of their total stock balance.
• Fulfillment: The plan must offer at least three distinct investment options within the plan, or distribute the diversifiable portion in cash to the participant.

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Simplified Employee Pensions (SEPs)

A Simplified Employee Pension (SEP) under IRC §408(k) is an employer-funded retirement arrangement where contributions are made directly into traditional Individual Retirement Accounts (SEP-IRAs) established for each eligible employee.

Statutory Eligibility Requirements (IRC §408(k)(2))

A SEP contains the most stringent coverage rules among defined contribution designs. An employer must make a contribution for every employee who satisfies all three statutory conditions:

1. Has attained age 21,
2. Has performed service for the employer in at least 3 of the immediately preceding 5 calendar years (any service, even one hour, constitutes a year of service!), and
3. Received at least $750 in compensation (for 2024 and 2025; adjusted for cost of living).

[!WARNING] The 3-of-5 Rule Trap: Unlike standard 401(k) plans where an employee must complete 1,000 hours of service in a 12-month computation period, a SEP measures service in calendar years regardless of hours worked! An employee who worked 20 hours per year in 2021, 2022, and 2023, earns $800 in 2024, and is age 21 must receive a full SEP contribution in 2024.

Vesting and Funding Characteristics

• 100% Immediate Vesting: All contributions made to a SEP-IRA are immediately, 100% non-forfeitable at all times. Vesting schedules are illegal.
• Employer-Only Contributions: SEPs are funded exclusively by employer contributions. (Salary Reduction SEPs / SARSEPs were grandfathered prior to January 1, 1997, though SECURE 2.0 now allows designated Roth contributions to SEPs).
• Contribution Limit: The employer may deduct up to 25% of eligible payroll under IRC §404(h). Individual allocations are capped at the lesser of 25% of compensation or the IRC §415(c) limit ($69,000 in 2024; $70,000 in 2025).
• Form 5305-SEP: Employers can adopt an IRS model SEP using Form 5305-SEP, eliminating document drafting costs and Form 5500 annual filings.

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SIMPLE Plans: SIMPLE IRA vs. SIMPLE 401(k)

The Savings Incentive Match Plan for Employees (SIMPLE) was created by Congress to offer small employers a turnkey, test-exempt retirement program under IRC §408(p) (SIMPLE IRA) and IRC §401(k)(11) (SIMPLE 401(k)).

Employer Sizing Limit (The 100-Employee Rule)

To sponsor a SIMPLE plan, the employer must have had 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. If an employer exceeds 100 employees, a 2-year grace period applies before the plan must be frozen or terminated.

The Exclusive Plan Requirement

Under IRC §408(p)(2)(D), an employer maintaining a SIMPLE plan cannot maintain any other active qualified retirement plan (such as a 401(a), 403(b), or SEP) covering employees eligible for the SIMPLE during that calendar year. (SECURE 2.0 §332 allows an exception permitting an employer to terminate a SIMPLE IRA mid-year if replaced by a safe harbor 401(k) plan).

Mandatory Employer Contributions (Choose One)

The employer must choose one of two mandatory contribution formulas each year and provide advance written notice to employees:

1. 3% Matching Contribution: The employer matches employee deferrals dollar-for-dollar up to 3% of compensation.
   • SIMPLE IRA Special Reduction: In a SIMPLE IRA, the employer may elect to reduce the matching contribution to no less than 1% of compensation in no more than 2 out of any 5 consecutive calendar years.
   • SIMPLE 401(k) Distinction: In a SIMPLE 401(k), the 3% match cannot be reduced!
2. 2% Nonelective Contribution: The employer contributes 2% of compensation for all eligible employees earning ≥ $5,000, regardless of whether the employee elects to defer.

Contribution Limits and SECURE 2.0 Enhancements

• Elective Deferral Limit: $16,000 in 2024; $16,500 in 2025; age 50+ catch-up is $3,500.
• SECURE 2.0 §117: Employers with 25 or fewer employees (and larger employers offering higher matching) may permit higher deferral limits (10% higher).
• SECURE 2.0 §601: Employees may elect to treat SIMPLE deferrals and employer contributions as Roth contributions.

The 2-Year / 25% Early Withdrawal Penalty (IRC §72(t)(6))

Under IRC §72(t)(6), if an employee takes a distribution from a SIMPLE IRA within the first 2 years of initial participation, the normal 10% early withdrawal tax is increased to 25%!

• Rollover Restriction: During this 2-year window, a SIMPLE IRA can only be rolled over to another SIMPLE IRA. Any rollover attempted to a traditional IRA or qualified plan within the first 2 years is treated as a taxable, non-qualifying distribution subject to the 25% excise penalty!

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403(b) Tax-Sheltered Annuities (TSAs)

An IRC §403(b) plan is a tax-advantaged retirement arrangement designed exclusively for two distinct categories of employers:

1. Public educational institutions (e.g., state colleges, universities, and public school districts organized under IRC §170(b)(1)(A)(ii)), and
2. Tax-exempt charitable organizations organized under IRC §501(c)(3).

Permissible Investment Vehicles

Under statutory law, 403(b) assets can only be held in:

• IRC §403(b)(1) Annuity Contracts: Purchased from licensed life insurance companies.
• IRC §403(b)(7) Custodial Accounts: Invested exclusively in regulated investment company shares (mutual funds).

The Universal Availability Requirement (IRC §403(b)(12)(A)(ii))

Unlike 401(k) plans which may exclude broad classes of employees (subject to §410(b) testing), 403(b) plans are governed by the Universal Availability Rule:

• If an employer permits any employee to make elective deferrals, the employer must permit ALL employees of the organization to make elective deferrals of at least $200.
• Narrow Permissible Exclusions: The employer may only exclude:
  1. Employees who normally work fewer than 20 hours per week (subject to SECURE 2.0 LTPT rules),
  2. Student employees enrolled and regularly attending classes at the institution,
  3. Nonresident aliens with no U.S. source income, and
  4. Employees who participate in another 401(k), 403(b), or 457(b) plan of the employer.

ERISA vs. Non-ERISA 403(b) Status

• Governmental & Public Schools: Completely exempt from Title I of ERISA.
• 501(c)(3) Non-Profit Plans: Subject to ERISA Title I (Form 5500, SPD, fiduciary rules) UNLESS they qualify for the DOL Safe Harbor (29 C.F.R. §2510.3-2(f)):
  • Participation is completely voluntary,
  • Zero employer contributions (employee elective deferrals only),
  • Employer involvement is strictly limited to ministerial payroll withholding and transmitting contributions to investment providers,
  • No employer discretionary control over investments or vendor selection.

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457(b) Eligible Deferred Compensation Plans

An IRC §457(b) plan is an eligible non-qualified deferred compensation plan established by:

1. State and local governmental entities (IRC §457(e)(1)(A)), or
2. Tax-exempt organizations under IRC §501(c) (IRC §457(e)(1)(B)).

Private, for-profit commercial businesses are strictly prohibited from sponsoring 457 plans.

+─────────────────────────────────────────────────────────────────────────────────────────────────+
|                  GOVERNMENTAL 457(b) vs. TAX-EXEMPT 457(b) ARCHITECTURE                         |
+─────────────────────────────────────────────────────────────────────────────────────────────────+
|                                                                                                 |
|  FEATURE                   GOVERNMENTAL 457(b)                 TAX-EXEMPT 457(b) (Non-Profit)   |
|  ─────────────────────────────────────────────────────────────────────────────────────────────  |
|  • Asset Protection        Mandatory Trust / Custodial         NO TRUST ALLOWED: Assets remain  |
|                            Account under IRC §457(g)           property of employer subject to  |
|                            (Protected from creditors)          unsecured general creditors!     |
|                                                                                                 |
|  • Employee Eligibility    May cover all common-law            Must be restricted to a select   |
|                            employees (Rank-and-file ok)        "Top-Hat" management group!      |
|                                                                                                 |
|  • Rollover Portability    Full portability: Can rollover to   NO ROLLOVERS to IRAs or 401(k)s; |
|                            IRAs, 401(k), 403(b), 457(b)        can only transfer to another     |
|                                                                tax-exempt 457(b) plan!          |
|                                                                                                 |
|  • §72(t) 10% Penalty      NO 10% penalty on severance         NO 10% penalty on severance      |
|                            at ANY age!                         (Unfunded deferred comp)         |
|                                                                                                 |
+─────────────────────────────────────────────────────────────────────────────────────────────────+

The Trust Requirement & Creditor Risk

• Governmental 457(b): Under IRC §457(g), all plan assets and income must be held in trust, custodial accounts, or annuity contracts for the exclusive benefit of participants and beneficiaries. Assets are shielded from the government entity's creditors.
• Tax-Exempt 457(b): Must remain unfunded! Plan assets cannot be placed in a protective trust. They remain solely the property of the employer, subject to the claims of the non-profit's general creditors in the event of insolvency or bankruptcy.

The "Top-Hat" Requirement for Tax-Exempt Sponsors

Because ERISA Title I requires retirement plans to fund benefits in trust and satisfy strict vesting schedules, a non-profit 457(b) plan can only avoid violating ERISA Title I by qualifying as a Top-Hat plan:

• Participation must be restricted strictly to a "select group of management or highly compensated employees".
• Sponsoring a tax-exempt 457(b) covering rank-and-file staff violates ERISA Title I, exposing the sponsor to catastrophic civil liability and plan disqualification.

Rollover Portability and the §72(t) Penalty Exemption

• Rollover Portability: Governmental 457(b) balances can be rolled over to traditional IRAs, 401(k)s, 403(b)s, or other governmental 457(b)s. Tax-exempt 457(b) balances cannot be rolled over into an IRA or qualified plan; they may only be transferred to another tax-exempt 457(b) plan.
• Exemption from IRC §72(t) 10% Penalty: Distributions from a 457(b) plan following severance from employment are exempt from the IRC §72(t) 10% early withdrawal tax, regardless of the employee's age! (Exception: amounts previously rolled into a governmental 457(b) from a qualified plan or IRA remain subject to the 10% penalty upon early withdrawal).