On July 26, 2007, the IRS published the much-anticipated final regulations governing the administration, monitoring and documentation of 403(b) annuity plans ("403(b) plans"). The final regulations are the first comprehensive regulations addressing 403(b) plans since 1964 and reflect 43 years of legislative and regulatory developments. Internal Revenue Code Section 403(b) excludes from gross income contributions made by public schools, 501(c)(3) tax-exempt organizations and certain ministers to annuity contracts, custodial accounts and retirement income accounts.
The final regulations require employers to make significant changes in the administration and documentation of 403(b) plans. Many of these changes will make 403(b) plans look more like 401(k) plans, which require employers and plan sponsors to exercise significant administrative responsibility over the plans. Although the new regulations generally take effect on January 1, 2009, some action may be required by September 24, 2007.
Following are highlights of the final regulations.
A Written Plan Document is Required by January 1, 2009
Under the final regulations, 403(b) plans must have a written plan which satisfies the requirements of 403(b) and the regulations. The plan must contain the material terms and conditions for eligibility, benefits, applicable limitations, the contracts available under the plan, and the time and form under which benefit distributions will be made. If the plan contains optional features – such as hardship withdrawal distributions, loans, plan-to-plan or contract-to-contract transfers, and acceptance of rollovers to the plan – the optional provisions must satisfy the requirements of 403(b) and the regulations.
The plan may allocate responsibility for performing administrative functions, including compliance with 403(b), but responsibility generally may not be allocated to plan participants. Additionally, certain responsibilities cannot be allocated to annuity contract issuers. For instance, the employer must set forth the eligibility criteria for employees and provide employment-based information that is essential for compliance with 403(b), such as the limitations on elective deferrals, hardship distributions, and distributions permitted as a result of severance from employment.
The plan document may incorporate by reference other related documents, such as salary reduction agreements, custodial accounts, or insurance policies. If there is a discrepancy between the plan and another document, the plan must govern.
A 403(b) plan of a government employer is generally not subject to ERISA. A 403(b) plan for a non-government employer may be subject to ERISA. The Department of Labor concurrently released Field Assistance Bulletin 2007-02 addressing the 403(b) plan documentation requirement and a safe-harbor exemption from ERISA.
New Requirements for Exchanges and Transfers to Other 403(b) Annuities or Custodial Accounts
IRS Revenue Ruling 90-24 allows exchanges of annuity contracts in a 403(b) plan. Revenue Ruling 90-24 is formally superseded by the final regulations, but exchanges remain possible. Specifically, annuity contracts may be exchanged under the same 403(b) plan on a tax-free basis if (i) the plan provides for the exchange; (ii) the participant’s accumulated benefit does not decrease; (iii) the new contract is subject to distribution restrictions at least as stringent as those under the old contract; and (iv) the plan sponsor and contract issuer must agree to provide each other with certain information relating to 403(b) compliance such as eligibility, loans and hardship distributions.
A plan-to-plan transfer is permitted on a tax-free basis if (i) the participant is a current or former employee under the new plan; (ii) the old plan provides for transfers; (iii) the new plan provides for the receipt of transfers; (iv) the participant’s post-transfer accumulated benefit does not decrease; (v) the new plan imposes distribution restrictions at least as stringent as those under the old plan; and (vi) if the transfer is not a complete transfer of the participant’s interest in the plan, the new plan treats the amount transferred as a continuation of a pro rata portion of the participant’s interest in the plan.
A 403(b) plan may provide for the transfer of assets to a qualified defined benefit governmental plan if the transfer is for the purchase of permissive service credits or to make a repayment to a defined benefit governmental plan.
Grandfathered Revenue Ruling 90-24 Exchanges
Revenue Ruling 90-24 allowed participants to exchange their 403(b) contracts without income inclusion, even if the vendor or carrier receiving the exchanged contracts had no connection to the plan or employer. As discussed above, the final regulations supersede Revenue Ruling 90-24, and require not only that an employer is involved in any annuity contract exchange (through information sharing), but also that all 403(b) contracts be maintained pursuant to a plan. Until September 24, 2007, however, a participant can still make a Revenue Ruling 90-24 exchange to a vendor or carrier with no connection to the employer, and such an exchange will be grandfathered from the requirement that a 403(b) contract be maintained pursuant to an employer plan (assuming the exchange meets all other applicable requirements).
Effective September 25, 2007, a participant may not want to make an exchange related to an orphan contract (contracts unattached to any employer plan). Instead, it may be better to roll over such amounts to an IRA (if possible). This is because such an orphan product will be subject to the rule that it be "maintained pursuant to a plan" – but, the plan document will likely not include the orphan product. A plan sponsor may want to communicate this issue to plan participants prior to September 24, 2007.
It appears that non-grandfathered orphan contracts will fail to qualify as Section 403(b) contracts if not attached to an employer plan by January 1, 2009. Similarly, a grandfathered orphan contract that is exchanged after September 24, 2007, will lose its grandfathered status, and will fail to qualify under Section 403(b) if not attached to an employer plan.
A 403(b) plan may provide for a catch-up contribution for a participant who is age 50 or older (up to $5,000 in 2007) and a special catch-up contribution for a participant with at least 15 years of service. If a participant qualifies for both catch-up contributions, the contribution should first be treated as a special catch-up contribution, then as an age 50 catch-up contribution.
The final regulations repeal the nondiscrimination provisions of IRS Notice 89-23, which provided a good faith reasonable standard for meeting nondiscrimination requirements. Non-elective employer contributions to 403(b) plans must satisfy the nondiscrimination requirements applicable to qualified plans under 401(a). These requirements include rules relating to nondiscrimination in contributions, benefits, and coverage, a limitation on the amount of compensation that can be taken into account, and certain average contribution percentage rules. Churches and governmental plans are usually exempt from these requirements.
The Universal Availability Rule Applies to More Classes of Employees
The universal availability rule requires that if an employer permits any employee to make elective deferrals under a 403(b) plan, it must permit all employees to make elective deferrals.
Under the final regulations, the following groups of employees can no longer be excluded from making elective deferrals: employees covered by a collective bargaining agreement; employees who make a one-time election to participate in a governmental plan described in Code Section 414(d); certain visiting professors; and employees in a religious order who have taken a vow of poverty. Other final regulations may provide relief to employers who employ visiting professors or individuals under a vow of poverty.
However, the following groups of employees can be excluded from making elective deferrals: employees eligible to participate under another of the employer’s 403(b), 457(b) or 401(k) plans; non-resident aliens; students; and employees who work fewer than 20 hours per week. An employer must meet both parts of a two-part test to determine that an employee works fewer than 20 hours per week: first, the employer must reasonably expect the employee to work fewer than 1,000 hours during their first year of employment and second, the employee must actually work fewer than 1,000 hours each year after his or her initial year.
403(b) Plan May Be Terminated
Under the final regulations an employer may amend its 403(b) plan to permit termination and to distribute all accumulated benefits, so long as the employer (and its controlled group) does not make contributions to any alternative 403(b) plan during the twelve months following plan termination. This is very helpful, because under current guidance it was difficult, if not impossible, to terminate a 403(b) plan.
Failure to Satisfy 403(b)
If an employer offering a 403(b) plan fails to have a written plan document, is not an eligible employer, and/or fails to satisfy the nondiscrimination rules, none of the contracts issued under the plan will be 403(b) contracts. This means all the contributions and earnings would be taxable. However, an operational failure that is within a specific contract generally will not adversely affect contracts issued to other employees.
Under the final regulations, if two or more employers are linked by 80% or greater common control, they are treated as a single employer for 403(b) purposes. For tax-exempt entities, the 80% test focuses on board membership. Also, two or more exempt organizations may elect to treat themselves as being under common control for the purposes of Code Section 414(c) if they maintain a single plan covering one or more employees from each organization and if the organizations regularly coordinate their day-to-day exempt activities.
These rules are not limited to section 403(b) plans, but apply more broadly for the purposes of determining when tax-exempt entities are treated as a single employer. These rules do not apply to state, local or federal government entities or to certain church entities.
Severance From Employment Is Defined
Severance from employment that permits a distribution of elective contributions occurs when an employee ceases to be employed by an eligible employer, even though the employee may continue to be employed by an entity that is part of the same controlled group but that is not an eligible employer. Examples of severance from employment include: an employee transferring from a 501(c)(3) organization to a for-profit subsidiary and an employee ceasing to work for a public school, but continuing to be employed by the same state.
Separate Accounting May Be Required
Employers must maintain separate accounts in the following three circumstances: 1) where contributions under a contract are subject to different vesting schedules; 2) the employer makes contributions in excess of the section 415(c) limitation; and 3) elective deferrals are designated as Roth contributions to 403(b) plans.
Under the final regulations, Roth contributions can be made to a 403(b) program if certain requirements are met.
Action Items for Employees
First, an employer should determine what, if anything, to communicate to plan participants about the expiration of Revenue Ruling 90-24 on September 24, 2007. Second, to ensure compliance with the January 1, 2009 documentation deadline, employers should identify those plans, contracts and other arrangements subject to Section 403(b), and establish a schedule to ensure review and timely adoption of any required amendments. Finally, because 403(b) plans will be treated much like 401(k) plans, employers will need to exercise greater oversight over their 403(b) plans. This will likely require an employer to establish new policies and procedures to ensure compliance with the rules.
Michael Best will host a Webinar on this topic on Wednesday, September 5, 2007, at 9:00 a.m. Central Time. The cost is $100.00 per site. If you are interested in registering for this program, please contact Colleen Scruggs at 414.223.2505, or email@example.com. A separate invitation containing additional details of this Webinar will then be emailed to those interested.
For more information, contact your Michael Best attorney or one of the following attorneys: John L. Barlament at 414.225.2793, or JLBarlament@michaelbest.com; Charles P. Stevens at 414.225.8268, or CPStevens@michaelbest.com; or John C. Lapinski at 414.225.4941, or JCLapinski@michaelbest.com.