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Distributions from individual annuity contracts after 403(b) termination


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Any thoughts on whether individual annuity contracts distributed when a 403(b) plan terminates must limit distributions to one of the events that would permit a distribution from a 403(b) plan (e.g., termination of employment)?

On the one hand, Rev. Rul. 2020-23 indicates that "The distributed ICA is maintained by the custodian as a § 403(b)(7) custodial account that adheres to the requirements of § 403(b) in effect at the time of the distribution of the ICA until amounts are actually paid to the participant or beneficiary."  (While this ruling relates only to a plan funded with custodial accounts, not one funded exclusively by annuities, presumably similar rules would apply under Rev. Rul. 2011-7 relating to plans funded by annuities.) This might be interpreted to suggest that the individual contract must adhere to the distribution requirements of a 403(b) plan, e.g., distributions are available only upon certain events including termination of employment.

However, I see two arguments against this interpretation.  First, the participant is entitled to take a cash distribution upon termination of a 403(b) plan.  Thus, allowing a participant to take a cash distribution from the annuity contract after termination of the plan would appear to adhere to the requirements of § 403(b).

Second, the revenue ruling provides that "the employer has no material retained rights under the distributed ICA after it has been distributed."  If the participant's right to a distribution is contingent on the employer certifying that the participant has terminated employment, that would seem to be a material retained right.

We are currently dealing with an annuity provider that claims the employer must continue to provide it with notices of when employees terminate employment, and that distributions will not be made under the individual annuity contracts until termination of employment occurs unless there is another basis (e.g., age) for allowing a distribution.  Are other providers taking this position?  And has anyone ever encountered the IRS taking this position?

 

 

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I read the tax law the way you do. A rule to interpret § 403(b) includes:

A section 403(b) plan is permitted to contain provisions that provide for plan termination and that allow accumulated benefits to be distributed on termination. However, in the case of a section 403(b) contract that is subject to the distribution restrictions in § 1.403(b)-6(c) or (d) (relating to custodial accounts and section 403(b) elective deferrals), termination of the plan and the distribution of accumulated benefits is permitted only if the employer (taking into account all entities that are treated as the same employer under section 414(b), (c), (m), or (o) on the date of the termination) does not make contributions to any section 403(b) contract that is not part of the plan during the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan.

26 C.F.R. § 1.403(b)=10(a)(1) https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/section-1.403(b)-10#p-1.403(b)-10(a)(1).

Why would the rule specify a restraint against after-termination § 403(b) contributions unless observing that restraint is an exception from § 403(b)(7)’s or § 403(b)(11)’s condition for restricting a distribution until age 59½ or severance-from-employment?

Further, the same rulemaking includes:

Except as provided in paragraph (c) of this section relating to distributions from custodial accounts, paragraph (d) of this section relating to distributions attributable to section 403(b) elective deferrals, § 1.403(b)-4(f) (relating to correction of excess deferrals), or § 1.403(b)-10(a) (relating to plan termination), a section 403(b) contract is permitted to distribute retirement benefits to the participant no earlier than upon the earlier of the participant's severance from employment or upon the prior occurrence of some event, such as after a fixed number of years, the attainment of a stated age, or disability.  . . . .

26 C.F.R. § 1.403(b)-6(b) https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/section-1.403(b)-6#p-1.403(b)-6(b).

Except as provided in . . . or § 1.403(b)-10(a) (relating to plan termination), distributions from a custodial account . . . may not be paid to a participant before the participant has a severance from employment, dies, becomes disabled . . . , or attains age 59½.  . . . .

26 C.F.R. § 1.403(b)-6(c) https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/section-1.403(b)-6#p-1.403(b)-6(c).

Except as provided in . . . or § 1.403(b)-10(a) (relating to plan termination), distributions of amounts attributable to section 403(b) elective deferrals may not be paid to a participant earlier than the earliest of the date on which the participant has a severance from employment, dies, has a hardship, becomes disabled . . . , or attains age 59½.

26 C.F.R. § 1.403(b)-6(d)(1)(i) https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/section-1.403(b)-6#p-1.403(b)-6(d)(1)(i).

Why would § 1.403(b)-6 so methodically specify two exceptions (corrective distribution and plan-termination distribution) from a condition against a too-early distribution unless they are exceptions?

(Even if we’re right about what an annuity contract may permit without losing § 403(b) income tax treatment, an annuity contract might state provisions more restrictive than those needed to tax-qualify as a § 403(b) contract.)

Consider that it might be unnecessary for the employer to resolve whether the insurer is right or wrong about the meaning of its contract.

If an annuity contract is an individual contract and the employer is not a party under the contract, what gives the insurer a right to demand that the employer furnish an instruction or information?

Imagine an annuitant claims a payout and the insurer denies the claim because it finds the contract does not provide a distribution until age 59½ or severance-from-employment. A frustrated claimant may ask a court to decide who is right about what the contract provides. More immediately and practically, one might ask an insurance regulator to investigate whether the insurer’s claims handling observes fair practices. And even if it is harsh to expect an annuitant to fight her insurer, an annuitant might be no worse off than had the employer not terminated the plan.

Call me if you’d like a conversation more candid than fits this website.

Peter Gulia PC

Fiduciary Guidance Counsel

Philadelphia, Pennsylvania

215-732-1552

Peter@FiduciaryGuidanceCounsel.com

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I have always found the guidance on 403(b) plan terminations confusing, even after the Secure Act. It seems to me that the following statements excerpted from page 5 of Rev. Rul. 2011-7 may explain the insurer's position:

"Since the employer took action to fully vest any participants with respect to amounts not otherwise fully vested at the date of plan termination, all contracts under the plan will be § 403(b) contracts upon plan termination. See §§ 1.403(b)-3(d)(2) and 1.403(b)-10(a)(1). Such contracts may permit benefits to begin immediately upon plan termination, or may permit the participant to begin benefits at a later date to the extent provided in the plan document and the termination resolution, subject to applicable Code (and ERISA rules where applicable.)....

"Following termination of the plan, participants and beneficiaries who hold fully paid insurance annuity contracts are entitled to payments in accordance with the terms of the contracts (which may permit single-sum payments in connection with plan termination)."

Rev. Rul. 2020-23 has similar language for individual custodial contracts. In either case, the gist seems to be that while 403(b) plans can permit participants to elect lump sum distributions upon plan termination, which are eligible rollover distributions, if the plan did not provide for lump sums at termination, or if it does but the participant does not choose to take a lump sum, if offered, then post-termination you are stuck with the terms of the annuity contract regarding distributable events.

I think an employer's explicit or implicit obligation to inform the issuing insurance company regarding the date of the contractor's termination of employment would be an obligation, not a right.

I agree that this does not make sense, given, again, that the participant could have taken a lump sum and rolled it over to an IRA.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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I agree with the above.    Once distributed, the annuity contract prevails.  The annuity contract would not have been distributed without a distribution event (plan termination).  The annuity contract issuer now wants information or proof of another distribution event??  A letter to the insurance commissioner of the relevant state with a copy to the President of the insurance company should fix this.

Patricia Neal Jensen, JD

Vice President and Nonprofit Practice Leader

|Future Plan, an Ascensus Company

21031 Ventura Blvd., 12th Floor

Woodland Hills, CA 91364

E patricia.jensen@futureplan.com

P 949-325-6727

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Purely playing Devil's Advocate here, because I have no idea. Is it possible that particularly on some of the older annuity contracts that were used to fund these 403(b)'s, that the specific contract language contains such a requirement? There's a lot of wackiness in the 403(b) world.

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Carol Calhoun’s originating post asks about individual annuity contracts.

Under a typical individual annuity contract, even when used as a § 403(b) contract, the owner’s or annuitant’s employer (or former employer) is not a party to the contract and has neither rights nor obligations under the individual’s contract.

Even if an insurer administering its contract might properly request evidence of an annuitant’s severance from employment beyond the annuitant’s claim or further statement, it’s unlikely that a typical individual annuity contract obligates an employer to furnish that information.

As I mentioned above, it is possible an annuity contract states provisions more restrictive than those needed to tax-qualify as a § 403(b) contract. But such a fact alone might not obligate an employer.

Peter Gulia PC

Fiduciary Guidance Counsel

Philadelphia, Pennsylvania

215-732-1552

Peter@FiduciaryGuidanceCounsel.com

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1 hour ago, Patricia Neal Jensen said:

I agree with the above.    Once distributed, the annuity contract prevails.  The annuity contract would not have been distributed without a distribution event (plan termination).  The annuity contract issuer now wants information or proof of another distribution event??  A letter to the insurance commissioner of the relevant state with a copy to the President of the insurance company should fix this.

Has anyone seen a 403(b) contract or annuity that is designed as a post-termination annuity or account, and says that if the contributions to the account are attributable to a terminated plan then the owner can ask for distributions whenever he or she wants at any age? In any event, if the contracts that were the subject of the OP do not contain such a provision, I don't see how you can get the insurer to base distributions on legal reasoning and not the terms of the contract.

I suppose if the annuity contract has less specific language in it saying that distribution can be made in a lump sum upon plan termination, maybe you could convince the insurer that this meant any time after the plan termination had occurred, indefinitely. One would need to study the contract language. Could depend on whether it says "at the time of termination" (bad), "in connection with the termination" (arguable), or "after termination" (good). But I do think the insurer or custodial account vendor will want to stay within the language of its contract.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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