Carol V. Calhoun

Are we talking about a governmental 403(B), a church 403(B), or a 403(B) of a private tax-exempt employer?

Yes, the contract can lose 403(B) status. You might consider one of the IRS correction programs if this has been going on long enough so that there is potential back tax liability.

It's not the "eligible" part that's the hang-up, it's the "distributions." Until you have the right to receive a distribution from the plan, the eligible rollover distribution rules don't apply, so you're stuck with the transfer rules, which are much more restrictive.

Here is the Department of Labor regulation on the subject: This is the typical basis on which mandatory retirement is imposed on public safety personnel. However, even to the extent it applies, it permits only mandatory retirement. It would not permit the employer to restrict contributions by an employee who was still employed after age 70.

The answer in English is no. A transfer while you are still working and are not entitled to take a distribution from a 403(B) can occur only (a) in the form of a Rev. Rul. 90-24 transfer to another 403(B), or (B) to a qualified (401(a)) governmental defined benefit plan to purchase service credit.

llaplount, check the instructions to the 2002 Form 1099-R and 5498. (The document you will go to if you click on the link is a pdf document, so it requires the Adobe Acrobat reader, a free download, to read or print.) This was an EGTRRA change.

IRC 401 I think you and I are actually agreeing here. All I said was that if the arrangement was properly structured (e.g., fixed price, option price not less than 20% of the FMV of the stock on the date of the grant of the option, etc.), I think it works. I would agree with you that many of the current variants of the mutual fund option plan are much more aggressive than that, and thus would not be considered "properly structured" within the meaning of my first comment.

The issue of deeply discounted options is one of the reasons I added the weasel words, "if properly structured," to my original post. To the extent that the option exercise price is too low, I would agree that what you have is not really an option. At the time we looked at the issue, it appeared that 20% of value was a minimum. At the same time, an option has a value under Black-Scholes even if the exercise price at issue is exactly the same as the value at issue. This is because there is some calculable value to being able to wait x period of time (with no possibility of the losses you might experience if you actually owned the stock) and buy it only if the exercise price on the date the stock is purchased is less than the value on that date. Thus, it is at least in theory possible to structure an option plan in which the options are not discounted at all, have a value under Black-Scholes, but are treated as having no ascertainable value under the regulations. Such a plan would appear to work under the current regulations. Of course, as IRC 401 points out, the regulations predate Black-Scholes, and may well be modified in the near future.

Federal tax law used to limit people to no more than one salary reduction agreement per year, but that law has long since been repealed. Thus, the only reason that open enrollment would be limited to once a year would be if the plan's terms, or applicable state or local law, imposed such a limitation.

To the extent that they are treating the situation as a spin-off of a portion of the plan, followed by a termination of the plan covering the transferred employees, pre-ERISA section 401(a)(7), applicable to governmental plans under Code section section 411(e)(2), requires full vesting of all funded benefits upon plan termination.

The argument that the vendors are making is that these options do not have a "readily ascertainable fair market value" so long as they cannot be traded on an established market. There is language in the regulations which supports this view, which is why we think they work under existing regulations. But, as you say, that regulatory language may well be modified.

I've moved this to the Governmental Plans board, because it appears that it deals with a governmental plan that is not a 457 plan. Whether the situation represents a partial termination (or complete discontinuance of contributions, which would also require full vesting) depends on whether the employees can continue to receive contributions and accrue vesting credit with the new employer. One way of dealing with the situation is merely to provide that all account balances will be transferred to the new employer's plan (assuming that both the old and new plans are 401(a) plans), and that the new employer will credit service in determining vesting with respect to both the money transferred over and the new money. This avoids either (a) a situation in which the old employer has to figure out what service the employees have with the new employer, when the old employer may not have access to the new employer's payroll records, or (B) a partial termination, requiring full vesting. Alternatively, you could treat the switch to the new employer as having terminated the employees' service with the old employer. That would require full vesting of account balances. You could also provide that employees could receive a distribution of their account balances at that time. In that instance, they would be able to roll over the money to the new employer's plan (if it permitted such rollovers) or to an IRA. Again, you would need to consult state law to determine whether it mandated and/or permitted either of these options.

We looked at this a few years ago, and it appeared that from a strict reading of the existing applicable statute and regulations, this probably worked for nongovernmental tax-exempt organizations if properly structured. However, the IRS obviously has concerns about such arrangement, so I would not be surprised to see changes or interpretations that would disallow them, at least for the future. The question then becomes how economically feasible it is to adopt an arrangement now that the organization may not be able to continue for very long in the future.

You'd have to check the legislation to see if it affects the decision. However, state law permitting, your best option would seem to be a direct transfer (not a rollover, since that cannot occur without a distributable event) of all account balances from the old plan to the new one. The events should not (barring contrary state law) require full vesting. Even for a 401(a) plan, that is required only on a termination of a plan (i.e., when the employees lose the right to have future vesting service applied), not just when contributions to the plan cease. On the other hand, if this is a 457(B) plan, it would be unusual to have anything less than full vesting in any event. Are there some employees who are only partially vested? How did this arise?

That would be prohibited.

Yes. The only caveat is that with limited exceptions, a state or local governmental employer may not maintain a SIMPLE plan in the form of a 401(k) plan.

In theory, you should have been taxed when you separated from service, if you did not make an election at that time and if you had the right to take the money out at that time. On the other hand, after 5 years the IRS may not be inclined to pursue this one. In general, the statute of limitations on innocent errors on your tax return is 3 years from the date of filing or the deadline, whichever comes last. Although there may be a longer statute of limitations on "substantial understatement of income," as a practical matter the IRS is unlikely to come after you after 5 years if they haven't done so already. So it's probably in the interest of the IRS just to let you pay the tax when the money is distributed.

There would be, in theory, two ways of complying with the equal protection clause of the VT constitution. The first would be to give early distribution rights to both married couples and parties to civil unions. The second would be to deny such rights to both. It is the Internal Revenue Code's qualification rules, combined with the Defense of Marriage Act, that make the first alternative risky, and therefore in effect mandate that a plan required to comply with the VT constitution must choose the second option if it is to avoid that risk. True. Given the current state of the law, that is the only risk-free option. But it means that a governmental plan in VT is in effect prohibited from allowing an early distribution option to married couples that other governmental and private plans are permitted to allow. Not only does it not require a state that permits civil unions to treat members of such unions to the same rights as married couples, it actually puts barriers (as described above) in the way of any state that on its own wants to treat members of such unions as having the same rights as married couples. Hmm, I thought I was arguing that equal protection should go both ways. I believe that the pensions of both husbands and wives should be divisible upon a divorce. I also believe that the pensions of parties to a civil union should be divisible upon a termination of the civil union. In what respect are my "comments about the impact of the Act to married couples ... similar to the outrage I heard from divorced women after REA was enacted because their ex husbands would be entitled to their pension benefits"?

Yes, the employee would be taxed on the income, unless the other party to the civil union was a dependent within the meaning of section 152. However, this at least is an issue that can often be worked out between the parties (e.g., by giving the alternate payee less in recognition of the fact that the employee will have to pay the tax). The question is whether you can ever get to that point, i.e., will plans be so concerned about potentially jeopardizing their own qualification that they simply will not allow a distribution to an alternate payee who is a party to a civil union until the employee has a distributable event? And in Vermont, which prohibits treating parties to civil unions differently than spouses, does this mean early distribution rights must be taken away from opposite-sex spouses because they cannot be given to parties to civil unions? (And does anyone but me find it ironic that a statute called the "Defense of Marriage Act" may have the effect of taking rights away from opposite-sex married couples?)

mbozek, You are correct that the Defense of Marriage Act permits Georgia, for example, to refuse to treat a Vermont civil union (or even a Dutch same-sex marriage) as not being a marriage, thereby precluding a Georgia court from even issuing a dro with respect to such relationship. However, the issue becomes what happens in, for example, a Vermont court, where state law prohibits treatment of parties to a civil union differently than spouses and thus a court could issue a dro in favor of a party to a same-sex union. Would compliance with such an order not only create unfavorable tax consequences to the employee and/or alternate payee, but risk disqualification of the plan? As you say, the IRS may have political reasons for not aggressively disqualifying state or local plans that comply with dros in favor of parties to a civil union. However, the politics goes both ways. State and local governments often do not want to get their names in the newspapers for doing something which, even in theory, could disqualify the plan. It is my understanding, for example, that the Vermont law establishing the statewide retirement system currently prohibits distributions pursuant to a dro earlier than when the participant has a distributable event, regardless of whether the alternate payee is an opposite-sex spouse or a party to a civil union. The reasoning was that treating a party to a civil union differently than an opposite-sex spouse would violate Vermont law, while allowing an early distribution to a party to a civil union could disqualify the plan. The solution was not to allow early distributions to anyone.

If the wages of an employee of a state or local government are exempt from the Social Security portion of OASDI, 414(h)(2) contributions will indeed be exempt from Social Security, also (although, as you correctly note, they will be subject to Medicare taxes). However, there are two major limitations on the application of the exemption in section 3121(B)(7): [*]Section 3121(B)(7)(E) excludes from that exemption Most states (although not Pennsylvania) have entered into such agreements with respect to all of their employees. For a list of those which have not, see Section 1014 of the Social Security Handbook. Even those states may have entered into Section 128 agreements with respect to some of their political subdivisions.[*]Section 3121(B)(7)(F) further excludes from that exemption Treas. Reg. § 31.3121(B)(7)-2 interprets this rule to impose a requirement that employees must be covered by a retirement system that meets various minimum requirements before they can be exempt from Social Security coverage.[/list=1]Thus, the only employees of state and local government to whom section 3121(B)(7) applies are those (a) whose employment is not covered by a Section 218 agreement, and (B) who are personally covered by a retirement system meeting minimum requirements. If the employee is either (a) subject to a Section 218 agreement, or (B) covered by a retirement plan that requires section 414(h)(2) contributions, but does not meet minimum requirements under the regulation, the 414(h)(2) contributions are subject to Social Security taxes to the extent they reduce the employee's salary.For more information on OASDI coverage of state and local government employees, see http://www.ssa.gov/slge/overview.htm.

It depends. If the 414(h)(2) contributions are taken out of the employee's salary, OASDI withholding (and payment of employer taxes) is required under section 3121(v). Otherwise, it is not. Of course, this is in large part a matter of semantics. In practical terms, there is really little difference between stating the employee's salary as $100x, but then having a "salary reduction" of $5x and a corresponding employer contribution of $5x, and stating the employee's salary as $95 with a non-salary-reduction contribution of $5x. Nevertheless, the semantics have a purpose. At least in social security states, the basis for the tax is the same as the basis for the ultimate social security benefits. The idea is to make sure that if the employer is reporting only $95x as social security wages at the time OASDI taxes are due, the employee should not later, when s/he claims benefits, be able to claim that the wages were $100x.

Out of curiousity, why is the union plan considered "private" if your governmental employer contributes to it? Does it cover workers in the private sector as well as public employees? If not, union involvement should not by itself make the plan "private."

My understanding from informal conversations with the relevant IRS people is that the reason they have not set a deadline for amending 403(B) plans is that 403(B), unlike 401(a), does not require a written plan document. Thus, they do not believe that they have the authority to require an amendment to a plan document by any particular time, but can only require that the plan be operated in accordance with 403(B). In the case of a 403(B) plan subject to ERISA, the Department of Labor requires a written plan document. However, this has traditionally been interpreted in a fairly loose manner--i.e., that no amendments are required until the summary plan description is due.

kkost and mbozek, Will I spoil the fun here if I agree with both of you? It is true that a state or local retirement system has no ERISA preemption, and therefore must comply with a valid domestic relations order. On the other hand, there may be a question is whether a valid domestic relations order can be issued. In the first place, state spendthrift trust law is as much a part of state law as state domestic relations law, so it is necessary to determine whether state spendthrift trust law may preclude a state domestic relations order from being issued with respect to the plan. In the second place, many state plans are embodied in state statutes, and many local plans are adopted pursuant to state enabling legislation. If such a statute provides that the plan is not required to comply with domestic relations orders, again it is necessary to try to reconcile the laws to determine whether a valid domestic relations order can even be issued. mbozek, I agree that "The fact that the state pension benefits are included as marital assets does not automatically mean that the spouse can receive a payout of the interest upon divorce. " All I was saying is that a state pension plan can provide for a payout to a spouse upon divorce, whereas it in many instances cannot provide for a payout to a participant at that time unless the participant has had some distributable event. Thus, although many would assume that protecting pension assets from a divorcing spouse is always in the interest of the participant, in fact there are many circumstances in which attempts to "protect" pension benefits creates inflexibility for the participant as well as the spouse.