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(From the September 10, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Updated 403(b) Regulations -- an In-Depth Review

The August 20, 2007 Washington Bulletin contained the first installment of two articles presenting a comprehensive discussion of the new final 403(b) regulations. It discussed the types of contributions that may be made to a 403(b) plan, and analyzed the regulation's provisions on contribution limitations and nondiscrimination rules. It also discussed a companion regulation, providing guidance for determining whether tax-exempt organizations form a controlled group. This article discusses the remaining provisions.

I -- Plan Document Requirement

The final IRC 403(b) regulations impose a new requirement that a 403(b) plan be embodied in a written plan document as a condition for favorable tax treatment under IRC 403(b). This requirement was one of the most controversial provisions from the proposed regulations, and its inclusion in the final regulations will have a significant impact on sponsors of 403(b) arrangements.

Historically, many employers had limited involvement in the 403(b) arrangements they sponsored. Although employers might facilitate transactions between their employees and providers of annuities, custodial accounts, and retirement income accounts, the primary relationship was between the employee and the providers of the annuities, custodial accounts, and retirement income contracts. That is, of course, a far smaller role than it would play in a qualified retirement plan such as a 401(k) plan. Such an environment was possible due to the lack of a formal plan document requirement, and aside from the annuity contracts or custodial agreements themselves, plan documentation received scant attention.

The final IRC 403(b) regulations require that a 403(b) plan be maintained pursuant to a written plan document. The regulations further require that the plan document's provisions comply with the requirements of IRC 403(b) in both form and operation and that the document contain all the material terms and conditions for benefits under the plan.

In response to comments expressing concern about the burdens imposed by these additional formalities, the final regulations clarify and relax them in a few respects. First, the document may allocate the responsibility for performing administrative or compliance functions, including, for example, ensuring that contributions don't exceed the various limitations, to another party, such as one or more of the various annuity providers or custodians. The plan may not, however, impose on individual participants the duty to avoid excess contributions, premature distributions or other violations of legal requirements. Second, the plan may incorporate other documents by reference. It does not need to be a single, completely integrated document, as is typical for qualified plans. The master plan document must, however, control if there is any conflict between its terms and the documents incorporated by reference. In addition, "it is expected" that plans funded through multiple providers will have a single plan document rather than a separate document for each provider.

The preamble to the final regulations states that the IRS intends to publish a model plan document, primarily designed for public schools, which were perceived as least able to comply readily with the documentation requirement. However, IRS officials have informally indicated that the model document may be used as a model for other employers to create their own documents.

II -- ERISA Issues

Under longstanding Department of Labor regulations, 403(b) plans are exempt from ERISA if they are funded solely by elective deferrals and have only limited employer involvement. 29 CFR 2510.3-2(f). Comments on the proposed 403(b) regulations expressed concerns that, by preparing plan documents and taking on the greater administrative and compliance roles envisioned by the regulations, employers would subject their plans to ERISA coverage. To address this worry, the DOL published Field Assistance Bulletin 2007-2 at the same time as the final regulations. While ERISA coverage is inherently a facts and circumstances issue, the bulletin does provide useful guidelines:

Activities consistent with the safe harbor

  • Conducting administrative reviews of the program structure and operation for tax compliance defects, including nondiscrimination testing and compliance with maximum contribution limits
  • Fashioning and proposing corrections of plan operational or document failures
  • Developing improvements to the plan's administrative processes that will obviate the recurrence of tax defects
  • Obtaining the cooperation of independent entities involved in the program needed to correct tax defects
  • Certifying to an annuity provider facts within the employer's knowledge, such as employee addresses, attendance records, or compensation levels
  • Transmitting to the annuity provider another party's certification as to other facts, such as a doctor's certification of the employee's physical condition
  • Compiling the benefit terms of the contracts and the responsibilities of the employer, annuity providers, and participants
  • Adopting a written plan that consists largely of the separate contracts and related documents supplied by the annuity providers and account trustees or custodians
  • Developing and adopting a single document to coordinate administration among different issuers and to address tax matters that apply, such as the universal availability requirement in IRC 403(b)(12)(A)(ii), without reference to a particular contract or account
  • Identifying in the plan documents the parties that are responsible for administrative functions, including those related to tax compliance
  • Periodically reviewing the plan documents for conflicting provisions and for compliance with the Code and Treasury regulations
  • Adopting a written plan that limits exchanges of contract funds to the extent necessary to comply with the IRC 403(b) regulations
  • Limiting investment providers to a number designed to afford employees a reasonable choice in light of all relevant circumstances
  • Terminating a 403(b) plan in compliance with the IRC 403(b) regulations

Activities inconsistent with the safe harbor

  • Authorizing plan-to-plan transfers
  • Processing distributions
  • Making determinations regarding hardship distributions, qualified domestic relations orders, and eligibility for or enforcement of loans
  • Negotiating with annuity providers or account custodians to change the terms of their products

Note: Certain employers, such as governmental entities and church organizations are exempt from ERISA in any event, and the field assistance bulletin will have no impact on their arrangements.

III -- Timing of Distributions

The regulations include a number of rules addressing when a 403(b) plan may make distributions to participants, largely reflecting the applicable statutory requirements. The earliest permissible distribution date depends on both the type of contribution (elective or nonelective) and the investment vehicle (annuity contract or custodial account). Minimum distribution requirements after age 70 are discussed in a later section of this report.

Amounts attributable to employee elective deferrals

A 403(b) plan may distribute elective deferrals (including catch-up deferrals), Roth deferrals and earnings thereon only upon a participant's attainment of age 59, death, disability, severance from employment or hardship, or upon plan termination. A distribution prior to any of those events is prohibited. The distribution restrictions are identical for elective deferrals held in annuity contracts and custodial accounts, with one exception: Deferrals (but not related income) contributed to annuity contracts (but not custodial accounts) prior to 1989 are not subject to these restrictions and may be distributed under the rules applicable to employer nonelective contributions.

The restriction on in-service distributions does not apply to deferrals in excess of the annual maximum, which may be distributed by the following April 15th in order to correct the section 402(g) violation, or to contributions in excess of the section 415 limitation, which may be disgorged if they have been accounted for separately from other contributions.

The distribution rules include the following additional requirements:

  • The definition of disability is the same as that used for 401(k) plans: "inability to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or be of long-continued and indefinite duration." IRC 72(m)(7).
  • Severance from employment generally means cessation of employment with any member of the controlled group. Severance from employment also includes cessation of employment with an organization that is eligible to sponsor a 403(b) plan, as when a participant transfers from a 501(c)(3) organization to a for-profit subsidiary (even within the same controlled group) or ceases to perform services for a public school but continues to work for the same state government.
  • "Hardship" is defined by reference to the hardship criteria for 401(k) Plans. The amount available for hardship distributions is limited to the total of the participant's elective deferrals, without taking income into account.

Nonelective employer contributions to an annuity contract

Nonelective employer contributions to an annuity contract, earnings thereon and pre-1989 elective deferrals (not including earnings), are subject to the same distribution restrictions as employer contributions to a qualified profit sharing plan. Those rules are fairly lenient. Distributions may be made following attainment of a stated age, completion of a specified period of service, hardship (applying whatever standards the plan sets forth) or even the passage of more than a year from the date of contribution.

Nonelective employer contributions to a custodial account

Nonelective employer contributions to a custodial account and earnings thereon are not distributable until severance from employment, death, disability or attainment of age 59. Hardship or other in-service distributions are not permitted. Amounts transferred from a custodial account to an annuity contract must remain subject to these restrictions. The distribution rules for elective deferrals held in custodial accounts are the same as for annuity contracts.

After-tax and rollover contributions

There are no restrictions on the distribution of after-tax contributions, rollovers or earnings thereon, whether they are held under an annuity contract or a custodial account.

IV -- Participant Loans

The final regulations permit 403(b) plans to make loans to participants if the plan document so provides. The loan must be bona fide, not a disguised distribution. Its status depends on the facts and circumstances, such as whether it has a fixed repayment schedule, bears a reasonable rate of interest, and contains the types of repayment safeguards that one would expect a prudent lender to require. Loans made in compliance with these rules are not considered distributions for purposes of the restrictions on distributions.

Participant loans from a 403(b) plan are also subject to the rules of IRC 72(p), in the same manner as loans from qualified plans. Thus, a loan will be taxed as a deemed distribution if its amount or term exceeds the limitations of IRC 72(p), or if the participant fails to make repayments as scheduled. If a participant has contracts with multiple providers under the same plan, the plan document must include procedures to ensure that loans from different contracts do not in combination exceed the maximum amount that can be borrowed without violating section 72(p).

V -- Taxability of Distributions; Rollovers

In general, the full amount distributed from a 403(b) plan is taxable at the time distributed, except to the extent that it is rolled over. Distributions that include after-tax contributions are taxed under the rules of section 72, which allow the contributions (but not related earnings) to be recovered tax-free. Distributions from Roth contribution accounts are completely excluded from gross income if they meet the conditions for "qualified distributions" (made at least five years after the participant's first Roth contribution and either after age 59 or on account of death or disability). Nonqualified Roth distributions are treated as distributions of after-tax contributions.

The rollover rules for 403(b) plans are the same as for qualified plans. A 403(b) plan must provide a direct rollover option in accordance with IRC 401(a)(31) and give participants the written tax explanation required by IRC 402(f). A rollover is not included in the gross income of the distributee.

Alternatively, a participant may effect a rollover by taking a distribution from the 403(b) plan and rolling it to an eligible retirement plan within 60 days. The drawback to an indirect rollover is that distributions that are not rolled over directly are subject to 20 percent income tax withholding.

A distribution from a 403(b) plan (other than a distribution from a Roth account) may be rolled over to a traditional IRA, a qualified plan, another 403(b) plan or a section 457(b) eligible deferred compensation plan sponsored by a governmental employer. Beginning in 2008, distributions may also be included in taxable income and rolled over to a Roth IRA. Rollovers of distributions from Roth accounts are limited to Roth IRAs, or other qualified retirement plans or 403(b) arrangements that provide for Roth contributions and agree to accept the rollover. Rollovers of distributions from Roth accounts to accounts other than Roth IRA's of amounts that would not otherwise be included in gross income (i.e., the return of basis for a nonqualified distribution, or any qualified distribution) must be by direct rollover. During 2008 and 2009, distributions may be rolled to Roth IRAs only if the participant's adjusted gross income (not counting the distribution) is $100,000 or less. (The AGI condition will cease to apply in 2010).

Beneficiaries may roll over distributions that they receive on a participant's death. For surviving spouses, rollovers are governed by essentially the same rules as rollovers by participants. Nonspouse beneficiaries are limited to direct rollovers to IRAs.

VI -- Required Minimum Distributions

Like qualified plans, 403(b) plans are subject to the IRC 401(a)(9) required minimum distribution rules. Thus, distributions generally must begin by April 1 of the calendar year following the later of the calendar year in which the participant retires or turns 70. The minimum distribution requirements do not apply, however, to contributions made to 403(b) plans prior to January 1, 1987.

The final regulations state that for purposes of the minimum distribution rules, the IRA minimum distribution rules apply to 403(b) contracts. As with IRAs, and unlike qualified plans, an individual with a number of 403(b) contracts adds up the minimum required distributions and may then take that amount from any of the contracts in his discretion. He may not satisfy IRA minimum distribution requirements with 403(b) distributions, or vice versa. In addition, distributions from qualified plans may not be used to satisfy the 403(b) minimum distribution requirements. Finally, contracts held as a beneficiary must be kept separate from those held as a participant, and contracts held as a beneficiary of one individual must be kept separate from contracts held as a beneficiary of another individual.

In other respects, there are several differences between the 403(b) and IRA minimum distribution rules. First, the required beginning date for a 403(b) contract is the April 1 following the later of the year the individual reaches age 70 or retires from the employer maintaining the plan. Despite the rule that allows contracts issued to an individual as an employee to be aggregated, it is not clear whether someone who is past age 70 may satisfy the minimum distribution requirement for a contract acquired under the plan of a former employer by taking distributions from a contract under the plan of an employer for whom he is still working. Second, 403(b) contracts distributed to a surviving spouse may not be treated as if the spouse were the original owner. A surviving spouse who is the beneficiary of an IRA has the right to assume ownership and thus avoid required distributions until her own required beginning date. Third, Roth Accounts are subject to the minimum distribution requirements during the individual's lifetime, while Roth IRAs are exempt until the account owner dies.

VII -- Exchanges and Transfers

The final IRC 403(b) regulations relaxed some of the proposed regulations' requirements for contract exchanges and plan-to-plan transfers.

Contract Exchanges

A contract exchange in a 403(b) plan is similar to an investment change in a 401(k) plan: they are both tax free changes in the assets the participant holds in the plan. However, whereas a participant in a 401(k) plan selects investments from among those the plan sponsor has chosen to make available under the plan, a 403(b) plan participant usually contracts directly with the contract provider. Although the employer is typically the channel though which the contract provider contacts the employees and may in some cases limit contract providers, a 403(b) plan participant might nonetheless transfer assets to a provider that has no subsequent contact with their employer.

Revenue Ruling 90-24 held that a 403(b) plan participant could exchange one contract for another without income tax consequences so long as the successor contract included distribution restrictions that were at least as stringent as the original contract's. There was no requirement that the contract received in exchange be from any particular provider, or that the provider deal with the employer in any way. The potential lack of contact between the new provider and the employer raised questions about how to police tax requirements that apply on an aggregated basis, such the hardship withdrawal and participant loan rules.

To address those concerns, the final regulations allow tax-free contract exchanges only if the new contract is provided under the plan and includes distribution requirements that are at least as stringent as the old contract. In addition, the employer and the new provider must agree in writing to provide each other with certain information, such as employment status and notification of hardship withdrawals and plan loans, to the extent necessary to ensure compliance with all pertinent requirements. (Exchanges that occur on or before September 24, 2007, are grandfathered and do not have to meet this requirement.) The final regulations state that the Service may issue guidance of general applicability allowing exchanges in the absence of such an agreement if the new contract has procedures that are reasonably designed to achieve the same result. The preamble, however, specifically notes that procedures that rely on employee certifications generally will not be adequate.

Plan-to-Plan Transfers

There are two ways that a 403(b) plan participant can transfer his funds to a different plan. One is by way of a direct or indirect rollover. A rollover is a form of distribution and, therefore, is possible only if the participant has become eligible to receive a distribution. The alternative to a rollover is a plan-to-plan transfer. Unlike a rollover, a plan-to-plan transfer does not require a distribution event to have previously occurred. For example, different public universities in the same state might maintain separate 403(b) plans, and a faculty member who moved from one school to another might wish to consolidate all of his contracts under both plans under a single plan. If he is not yet eligible for a distribution from his former employer's plan, he may be able to accomplish his objective via a plan-to-plan transfer.

If plan-to-plan transfers were allowed as freely as rollovers, they could be used to circumvent some of the 403(b) requirements by making strategic transfers to qualified or section 457(b) plans. Dealing with that problem would necessitate fairly complicated sets of restrictions, so the regulations adopt the simple solution of allowing transfers from a 403(b) plan only to another 403(b). In addition, transfers must satisfy several other requirements: both plan documents must allow the transfer; the participant must be an employee or former employee of the receiving plan's sponsor; and the distribution restrictions must be at least as stringent in the new plan as in the old. If only part of the participant's interest is transferred, the old plan must treat the amount transferred as a continuation of a pro rata portion of the participant's interest in the old plan. For instance, if the participant made after-tax contributions, a proportionate share would be transferred to the new plan.

VIII -- Plan Terminations

Under prior guidance, there was no concept of plan termination for 403(b) plans comparable to that for qualified plans. An employer might decide that it no longer wanted to make contributions (or facilitate elective deferrals), but that event had no legal significance. In particular, distributions could not be made simply on account of plan termination in the absence of any other distribution event.

The final regulations define what the termination of a 403(b) plan is, along with its consequences. So far as form is concerned, a plan may be terminated by the employer's unilateral action. Following termination, all accumulated benefits must be distributed to participants as soon as administratively feasible; otherwise the plan is not considered "terminated." This requirement is comparable to the requirements imposed by Rev. Rul. 89-87 on qualified plan terminations. In the case of benefits held in an annuity contract, the accumulated benefit under the contract may be distributed, or the contract itself may be distributed in kind, after which prior restrictions on distributions from the contract cease to apply. This relaxation of the distribution rules is available for elective deferrals and custodial accounts, however, only if the employer and all members of its controlled group make no contributions to any 403(b) plan for the benefit of participants in the terminated plan for at least one year after the plan's assets are distributed. (There is a little leeway. As in the parallel rule for 401(k) plan terminations, contributions for a de minimis number of former plan participants (no more than two percent of the total) are ignored.)

The termination rules include a minor trap for plans with vesting schedules. A contract does not fall technically within the scope of section 403(b) until the participant's rights vest. Until then, its tax consequences are governed by section 83. That fact ordinarily makes no difference. Prior to vesting, the contract is not taxable under section 83, because it is subject to a substantial risk of forfeiture. Upon vesting, the participant is protected from immediate taxation by section 403(b). The regulations state, though, that section 403(b) never comes into play for contracts that are not vested at the time of plan termination. As a result, nonvested participants will recognize income immediately upon post-plan termination vesting. The way to avoid that result is to vest all participants fully upon termination, as would be mandatory in a qualified plan.

IX -- Disqualification Rules

The regulations provide detailed rules on the consequences of failing to satisfy the requirements of IRC 403(b). As in many other areas, the regulations narrow the distinction between qualified plans and 403(b) plans, though important differences remain.

The most important difference between a qualified plan and a 403(b) plan is the extent to which defects in the plan affect the plan as a whole. A qualified plan cannot be partially disqualified; any violation has adverse consequences for all participants. By contrast, certain defects in a 403(b) plan affect the entire plan (and all participants in the plan), while others affect only the contracts of particular participants.

Under the final regulations, the entire plan fails to satisfy section 403(b) if --

  • It does not have a written plan document that satisfies the requirements of section 403(b);
  • It is discriminatory in its coverage or benefits; or
  • The employer is not eligible to maintain a 403(b) plan.

In other cases, e.g., where contributions for a participant exceed the elective deferral or section 415 limitations, or where he receives an improper distribution, that participant's contracts lose their section 403(b) status, but other participants are unaffected. All of a participant's contracts under plans of the same employer are aggregated for this purpose, so that a violation in one contract disqualifies all of them.

The regulations include corrective mechanisms for excess contributions, similar to those available for qualified plans. Elective deferrals in excess of the IRC 402(g) limits may be distributed by the following April 15th; if that is done, there is no violation of IRC 402(g). Contributions in excess of the IRC 415 limits may be accounted for as a separate, non-403(b) contract, in which case the participant's other contracts will retain their 403(b) status. Unfortunately, the regulations do not make clear what steps must be taken to satisfy the separate accounting requirement. Prior to the final regulations, contributions in excess of the 415 limit did not result in disqualification of the entire contract, regardless of how the excess was handled; only the amount in excess of the 415 limit was considered outside the scope of Section 403(b).

Disqualification for failure to have a written plan document is a new concept that did not exist prior to the final regulations. Although a qualified plan is subject to the same requirements and faces the same consequences for defects in its document, the risk of disqualification is mitigated by the existence of a remedial amendment period, during which a plan sponsor may adopt retroactive amendments to cure defects, and by the IRS determination letter program. Neither is included in the new section 403(b) regulations. Hence, plan documentation may suddenly be a bigger issue for 403(b) than for qualified plans, reversing the historical position.

The final regulations also discuss the terms of the plan and the need to operate in accordance with the terms of the plan. The final regulations state that the plan must satisfy Section 403(b) both in form and in operation, and the plan document must contain all material terms and conditions for eligibility, benefits, limitations, the contracts under the plan, and the form and timing of distributions. Following the position taken by the IRS with respect to qualified plans, the final regulations further indicate that the failure to follow the terms of the plan will have adverse consequences. For this purpose, if the terms of the plan are not followed, the adverse consequences are limited to the contracts affected and do not affect the plan as a whole.

Section 403(b) plans are eligible to correct failures under the IRS Employee Plans Compliance Resolution System (EPCRS), set forth in Rev. Proc. 2006-27. The preamble to the final regulations notes that changes to EPCRS will be necessary to accommodate the concept of a "plan document failure" for 403(b) plans that will result from the imposition of a written plan document requirement.

The consequences of losing section 403(b) treatment differ between annuity contracts and custodial accounts. For an annuity contract, the only practical consequence is that contributions are includible in taxable income as soon as they are not subject to a substantial risk of forfeiture. Earnings credited under the contract are not taxed until distribution.

A custodial account that ceases to satisfy section 403(b) loses its tax-exempt status. Although the regulations do not spell out the effects, it appears that it would thereafter be treated as a grantor trust, with all income taxable to the participant. It is not clear when pre-disqualification contributions and earnings would become taxable. Immediate taxation upon disqualification is a definite possibility.

X -- Effective Dates

The final regulations are generally effective the first taxable year beginning after December 31, 2008, with these modifications:

  • The final regulations are not effective with respect to plans maintained pursuant to collective bargaining agreements until the earlier of the expiration of the bargaining agreement (determined without extensions) that was in place on July 26, 2007, or July 26, 2010.
  • Church plans are not subject to the final regulations until the first taxable year beginning after December 31, 2009.
  • Prior guidance included several exceptions to the Universal Availability Requirement for elective deferrals (for employees who made a one time irrevocable election to participate in the governmental qualified plan, visiting professors, and employees working under a vow of poverty) that were not carried over in the final regulations. The prior guidance may be followed until the first taxable year beginning after December 31, 2009. There is also an extended effective date, based on the date of expiration of the current collective bargaining agreement, for unionized employees who have previously been excluded.
  • For governmental plans that can only be amended by legislation, the regulations do not apply until the earlier of the close of the legislative session beginning on or after January 1, 2009, or January 1, 2011.
  • Annuity contracts (not custodial accounts) are not subject to the restrictions on in-service distributions until January 1, 2009.
  • Contract exchanges may be made under Rev. Rul. 90-24 until September 24, 2007. Contracts exchanged after that date will be required to comply with the final regulations.
  • The special rules for designated Roth contributions apply for taxable years beginning on or after January 1, 2007.

There is no delayed effective date for the written plan document requirement. Plan documents will need to be in place on January 1, 2009.

Deloitte logoThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2007, Deloitte.

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