The Internal Revenue Service (the “IRS”) has issued final regulations under Section 403(b) of the Internal Revenue Code (the “Code”). Section 403(b) governs retirement plans for employees of certain taxexempt organizations and public educational organizations that are funded either by annuity contracts issued by insurance companies or by custodial accounts invested in mutual funds. Section 403(b) also governs retirement income accounts established by churches and church-affiliated organizations.
The IRS first published regulations under Section 403(b) in 1964. The IRS subsequently added additional regulations to reflect rules relating to eligible rollover distributions and minimum required distributions. In addition, Congress has made numerous legislative changes to Section 403(b). The IRS issued proposed regulations on November 16, 2004, which reflected these legislative and regulatory changes. The proposed regulations represented the first comprehensive guidance under Section 403(b) in over 40 years. On July 23, 2007, the IRS issued final regulations under Section 403(b). The final regulations generally take effect in 2009, although certain plans are subject to delayed effective dates and transition rules contained in the final regulations.
An article in our January 2005 issue examined many important aspects of the proposed regulations. The final regulations are identical to the proposed regulations in many respects. This article highlights the key differences between the proposed regulations and the final regulations. In the coming months, we will release a more comprehensive article examining the final regulations, related guidance recently issued by the Department of Labor and the steps that sponsors of Section 403(b) plans should take before the final regulations take effect in 2009.
It will be particularly important for tax-exempt Section 501(c)(3) organizations whose employees are covered by non-ERISA Section 403(b) plans to formulate a strategy for bringing these plans into compliance with the final regulations. The final regulations provide increased opportunity for employer involvement in Section 403(b) plans, which may make it difficult for employers to stay within the Department of Labor’s safe-harbor limits on employer involvement in non-ERISA plans.
The following changes and clarifications were adopted in the final regulations:
Written Plan Requirement
The final regulations, like the proposed regulations, require that Section 403(b) arrangements be pursuant to a written plan which, both in form and operation, satisfies the requirements of Section 403(b) and the regulations. The final regulations clarify that the plan may allocate to the employer or another person (such as the issuer of an annuity contract) the responsibility for administering the plan. The final regulations also clarify that the plan may satisfy the written plan requirement by incorporating other documents by reference (such as an annuity contract). In the preamble to the final regulations, the IRS recognizes that the written plan requirement will impose additional costs on employers that do not have existing plan documents. The IRS also states in the preamble that it expects to publish model plan provisions for Section 403(b) plans sponsored by public schools.
Section 403(b) plans may permit participants to exchange one annuity contract for another if the successor contract has certain distribution restrictions, regardless of whether the successor contract is offered by the plan. These tax-free contract exchanges had previously been authorized by Revenue Ruling 90–24. The proposed regulations restricted such tax-free exchanges of annuity contracts to situations in which the new contract is provided under the plan. The final regulations lack this restriction, permitting contract exchanges in any case where the distribution restrictions under the successor contract are at least as restrictive as those under the original contract, and the employer and issuer agree to periodically provide each other with information necessary to maintain the plan’s taxdeferred status (such as whether a participant has taken a hardship withdrawal or a plan loan). Under a transition rule, a contract exchange that occurs on or before September 24, 2007 is not subject to the new rules imposed by the final regulations if the exchange would have been permitted under prior law (i.e., Rev. Rul. 90–24).
Universal Availability Rule
Section 403(b) provides that if an employer allows any employee to make elective deferrals to a Section 403(b) plan, it must allow all employees to do so except for the following employees:
- nonresident aliens;
- employees eligible to participate in Code section 457(b) plans;
- students; and
- employees who normally work less than 20 hours per week.
The final regulations clarify that the right to make elective deferrals includes the right to designate them as Roth 403(b) contributions (if the plan contains a Roth feature).
In addition, Notice 89–23 permitted Section 403(b) plans to exclude:
- collectively bargained employees;
- employees who elect to participate in a governmental plan instead of the Section 403(b) plan;
- certain visiting professors; and
- employees of a religious order who have taken a vow of poverty.
The final regulations clarify that the four categories of employees added by Notice 89–23 may no longer be excluded from a Section 403(b) plan.
The final regulations retain the distribution restrictions of the proposed regulations, including the rule that a “stated event” must occur before distributions commence, and make the following changes and clarifications related to distributions:
- The rule requiring a stated event to occur before distributions may commence does not apply to annuity contracts issued prior to 2009.
- After-tax employee contributions are not subject to in-service distribution restrictions.
- Insurance contracts that provide for a continuation of contributions after a participant becomes disabled are subject to the incidental benefit rules.
- Section 403(b) must comply with the automatic rollover rules if the plan provides for mandatory distributions.
The proposed regulations would have allowed plan-to-plan transfers only if the participant was an employee of the employer maintaining the receiving plan. The final regulations allow these transfers if the participant is either an employee or former employee of the employer maintaining the receiving plan.
Special Catch-up Contributions
Employees who have at least 15 years of service with a “qualified organization” may make a special catch-up contribution of up to $3,000 (in addition to the catch-up contribution available to participants who are age 50 and over). The proposed regulations defined a “qualified organization” as a school, hospital, health and welfare service agency, or a churchrelated organization. The proposed regulations further define a health and welfare service agency as an organization whose primary activity is to provide certain types of medical care (such as a hospice), to provide personal services to the needy, or to prevent cruelty to animals. The final regulations expand the definition of “qualified organization” to include adoption agencies and agencies that provide home health services or assistance to disabled persons and those with substance abuse problems.
Effect of Failure to Satisfy Section 403(b) Requirements
Section 403(b) treats all contracts purchased for an employee as a single contract. Accordingly, if any single contract fails to meet the requirements of Section 403(b), all contracts issued to that employee would lose their tax-deferred status. The final regulations clarify that failure to satisfy the written plan requirement or nondiscrimination rules will cause all contracts under the plan to lose their tax-deferred status. However, an operational failure (such as deferrals in excess of the Section 402(g) limit) involving one employee’s contract will not adversely affect the contracts issued to other employees.
As provided in the proposed regulations, the final regulations do not permit an endowment contract, or a life, health, accident, property, casualty or liability insurance contract to constitute an annuity contract for purposes of Section 403(b). However, the final regulations provide that this rule does not apply to contracts issued before September 24, 2007.
Please contact us with your questions regarding the application of the final regulations to your Section 403(b) plan.