The Treasury Department and the Internal Revenue Service (the “IRS”) issued final regulations under Section 403(b) of the Internal Revenue Code (the “final regulations”) on July 26, 2007. Section 403(b) of the Internal Revenue Code (the “Code”) governs retirement plans for employees of certain tax-exempt 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 final regulations generally take effect in 2009, although certain plans are subject to delayed effective dates and transition rules.
An article in our July 2007 issue highlighted the key differences between the proposed regulations issued in 2004 (the “proposed regulations”) and the final regulations. This article provides a more comprehensive explanation of how the final regulations will impact plans governed by 403(b) (“403(b) plans”) and what employers sponsoring a 403(b) plan should do before the final regulations take effect in 2009.
Written Plan Requirement
Under current law only 403(b) plans governed by the Employee Retirement Income Security Act (“ERISA”) must have a written plan document. Section 403(b) plans that are exempt from ERISA are not required to have a written plan document, although such plans typically have written annuity contracts and/or custodial account agreements, depending on the funding vehicles offered under the plans. These non-ERISA plans include plans sponsored by a governmental employer or a church, and plans that satisfy the Department of Labor’s (the “DOL”) ERISA exemption for plans with limited employer involvement.
The final regulations require all 403(b) plans, including non-ERISA plans, to be maintained pursuant to a written plan which, in both form and operation, satisfies the requirements of Section 403(b) and the final regulations. The written plan must contain the material terms and conditions regarding:
- applicable limitations (e.g., limits on contributions imposed by the Code)
- contracts are available under the plan;
- distributions (both timing and form); and
- optional features (such as allowing loans or hardship distributions).
The written plan is not required to include all of these provisions in a single document. Other documents may be incorporated by reference to satisfy the requirements of the final regulations. For example, a plan might include the provisions that apply universally (such as eligibility requirements, contribution limits and nondiscrimination provisions) in one document and incorporate by reference other documents that contain provisions that are not universally applicable (such as an annuity contract with distribution provisions unique to that contract). The written plan must allocate responsibilities for plan administration to the employer or another person (such as the issuer of an annuity contract). The final regulations clarify that these responsibilities cannot be allocated to employees.
The IRS is requiring a written plan document so that participants will have a single source for obtaining information about the terms of the plan. The IRS also hopes that requiring a written plan document will prevent inconsistency amongst the annuity contracts and custodial account agreements of plans with multiple vendors.
The DOL recently issued companion guidance to the final regulations concerning its exemption from ERISA for 403(b) plans with limited employer involvement. This guidance responds to comments on the proposed regulations made by employers concerned that the written plan document requirement would subject non-ERISA plans to the requirements of ERISA. The guidance addresses this concern by stating that adopting a written plan and periodically reviewing the plan for regulatory compliance will not necessarily subject a plan to ERISA. The DOL will determine whether a plan is an ERISA plan on a case-by-case basis. However, the guidance further provides that an employer may not have authority to make discretionary determinations in administering the plan without exceeding the limits of the exemption. The following examples of such discretionary determinations are provided: authorizing plan-to-plan transfers, processing distributions, satisfying applicable qualified joint and survivor requirements, and making determinations regarding hardship distributions, qualified domestic relations orders, and eligibility for or enforcement of plan loans. Accordingly, the written plan documents of non-ERISA plans maintained by tax-exempt Section 501(c)(3) organizations should describe the employer’s lack of authority to make discretionary determinations and the employer’s limited role with respect to plan administration in general, and should identify the parties responsible for these functions.
Coordination of Catch-up Contributions
A participant generally may defer up to $15,500 per year (the Code section 402(g) limit for 2007 and 2008) and, if age 50 or over, may defer up to an additional $5,000 per year (an “Age 50 Catch-up”) to a 403(b) plan. Participants with 15 years of service at a hospital, educational organization, church related organization, or a health and welfare service agency also may make an additional special catch-up contribution (a “Special Catch-up”). The maximum annual Special Catch-up is equal to the lesser of:
- $15,000, less Special Catch-up contributions made in prior years; or
- $5,000 multiplied by years of service, less total elective deferrals made in prior years.
This allows eligible participants to contribute an additional amount each year until he or she has deferred an average of $5,000 per year of service, subject to a lifetime cap of $15,000 on Special Catch-ups.
Under current law, it is unclear what portion of a catch-up contribution must be treated as a Special Catch-up when an employee is eligible to make both types of catch-up contributions. For example, a $6,000 catch-up contribution could be treated as an Age 50 Catch-up of $5,000, followed by a Special Catch-up of $1000, or vice versa. Classifying only $1,000 of the contribution as a Special Catch-up would preserve $14,000 of the employee’s $15,000 lifetime limit.
The final regulations implement an ordering rule, under which catch-up contributions are classified first as Special Catch-ups until the employee reaches the annual limit, and then as Age 50 Catchups. For example, a participant aged 50 with 15 years of service who has deferred a total of $60,000 in prior years may defer up to $23,500 this year ($15,500, plus $3,000 Special Catch-up, plus $5,000 Age 50 Catch-up). Suppose this participant defers only $20,000. The final regulations confirm that $3,000 of the $4,500 catch-up contribution must be treated as a Special Catch-up, and $1,500 must be treated as an Age 50 Catch-up.
The final regulations also provide that part-time employment or full-time employment for less than the entire work period (e.g., academic year for teachers) must be aggregated to determine years of service for eligibility to make Special Catch-ups. Also, the definition of “health and welfare service agency” used to determine eligibility for Special Catch-ups has been expanded to include adoption agencies and agencies that provide home health services, assistance to disabled persons, or assistance to those with substance abuse problems.
Timing of Contributions
Sponsors of ERISA plans must remit elective deferrals to the plan on the earliest date the deferrals reasonably can be segregated from the employer’s general assets. Sponsors of non-ERISA plans are not subject to this timing rule.
The final regulations require all employers sponsoring 403(b) plans to remit elective deferrals to the plan within a period that is not longer than is reasonable for proper administration of the plan. This new rule will not significantly affect ERISA plans, because their compliance with the more stringent ERISA timing rule also will meet the requirement of the final regulations. However, employers sponsoring non- ERISA plans should review their payroll practices to determine whether under the new rule they must remit deferrals to the plan more quickly than they have in the past.
Post-Severance Employer Contributions
Unlike qualified plans, employers may make nonelective employer contributions to 403(b) plans on behalf of former employees during the tax year of the employee’s severance and the following five tax years. The final regulations limit the amount of these contributions to the lesser of the Code section 415(c) limit ($45,000 for 2007) or 100% of the former employee’s compensation during his or her final year of service. Note that post-severance employer contributions are subject to the same nondiscrimination testing requirements as other employer contributions (i.e., 410(b) testing for eligibility and 401(a)(4) testing for contribution amount). The final regulations also clarify that any post-severance contribution under this rule cannot continue after the participant’s death.
As with 401(k) plans, former employees can electively defer compensation up to the later of 2½ months after severance from service or the end of the year in which they separate from service, but only to the extent that the compensation is either regular pay or accumulated unused sick or vacation pay. Salary deferrals cannot be made from severance pay received after separation from service.
Nondiscrimination and Universal Availability Requirements
Section 403(b) plans are subject to different nondiscrimination standards than qualified plans. With respect to employer non-elective and matching contributions and after-tax employee contributions, employers currently must only satisfy a good faith standard with respect to the nondiscrimination tests applicable to employer contributions and employee after-tax contributions . Under the final regulations, employers may no longer rely on good faith compliance, but must actually satisfy the traditional nondiscrimination tests (i.e., the 401(m) actual contribution percentage test for employer matching contributions and employee after-tax contributions and the 401(a)(4) nondiscrimination test for employer non-elective contributions).
Elective deferrals are subject to the “universal availability” rule, rather than the actual deferral percentage nondiscrimination test applicable to 401(k) plans. Under the universal availability rule, if an employer allows any employee to make elective deferrals to a 403(b) plan, it must allow all employees to do so (with limited exceptions described below).
Under the final regulations, an employee is not considered to have the right to make elective deferrals unless he or she is given the “effective opportunity” to do so. Employees have the effective opportunity to make elective deferrals if they have the right to start, stop or modify a deferral election at least once each plan year and are notified of this right. The right to make elective deferrals includes the right to designate them as Roth 403(b) contributions (if the plan contains a Roth feature).
The final regulations permit 403(b) plans to exclude the following classes of employees without violating the universal availability rule:
- Nonresident aliens
- Employees eligible to participate in 457(b) plans
- Students performing services for a school
- Employees who are expected to work less than 20 hours per week, and actually work less than 1000 hours during the year
Notice 89–23 currently also permits 403(b) plans to exclude collectively bargained employees, employees who previously elected to participate in a governmental plan instead of the 403(b) plan, certain visiting professors, and employees affiliated with a religious order who have taken a vow of poverty. The final regulations provide that effective January 1, 2010, these classes of employees may no longer be excluded from 403(b) plans. As a result, employers will need to offer these employees the opportunity to make elective deferrals to their plans unless they are otherwise excludable (e.g., they do not work 20 hours or more per week).
Note that governmental plans are subject to the universal availability rule, but are exempt from the traditional nondiscrimination rules and that church plans are exempt from all of these rules.
Under Revenue Ruling 90–24, 403(b) plans could allow participants to exchange one annuity contract for another if the successor contract had certain distribution restrictions, regardless of whether the successor contract was offered by the plan. Under the final regulations these “90–24” transfers are not permitted after September 24, 2007, but participants can continue to transfer their account or contract to another vendor (which the IRS refers to as “contract exchange”), as long as the following rules are satisfied:
- The plan permits the exchange
- The participant’s benefit is the same before and after the exchange
- The distribution restrictions under the successor contract are at least as restrictive as those under the original contract
- The employer and the issuer of the new contract agree to periodically provide each other with information necessary to maintain the plan’s taxdeferred status (such as whether a participant has terminated employment, or has taken a hardship withdrawal or a plan loan)
Since the old 90–24 transfer rules do not apply after September 24, 2007, and the new contract exchange rules are not effective until January 1, 2009, there is a question as to how to handle transfer requests during the interim period. We recommend that employers do not approve transfer requests until January 1, 2009 unless the transfers comply with the new contract exchange rules at the time the transfer is being made.
The final regulations also permit plan-to-plan transfers if the participant is either an employee or former employee of the employer maintaining the receiving plan. In addition, both plans must permit the transfer, the participant’s benefit after the transfer must be the same as it was before the transfer, and the distribution restrictions under the receiving plan must be at least as restrictive as those under the plan making the transfer. The final regulations confirm that plan-to-plan transfers can only be made to another 403(b) plan and not to a qualified retirement plan, with the exception that a transfer may be made to a governmental defined benefit plan for the purchase of permissive service credit, or to make a repayment to that plan.
Under current law, there are no distribution restrictions on employer contributions held in an annuity contract. However, employer contributions held in a custodial account and elective deferrals to both annuity contracts and custodial accounts may be distributed only upon:
- severance from employment;
- disability; or
- attainment of age 59½.
Elective deferrals (excluding earnings) may also be distributed upon financial hardship.
The final regulations did not change the distribution restrictions for employer contributions held in a custodial account or for elective deferrals. However, the final regulations provide that employer contributions held in an annuity contract may be distributed only upon severance from employment or the occurrence of a stated event, such as the attainment of a certain age, completion of a certain number of years of service, death or disability. This restriction applies to annuity contracts issued on or after January 1, 2009.
The final regulations also clarified that severance from employment occurs when an employee ceases to be an employee of an employer eligible to sponsor a 403(b) plan. A severance from employment may occur, for example, when an employee transfers from a tax-exempt employer to a for-profit employer, even if the employers may be part of the same controlled group. Accordingly, the definition of severance from employment is particularly important to controlled groups that consist of both tax exempt and non-tax-exempt entities.
As with qualified plans, rollover contributions and after-tax employee contributions may be distributed at any time. Mandatory distributions are subject to the automatic rollover rules of Code section 401(a)(31).
Section 403(b) plans may be amended to eliminate future contributions, but distributions of accumulated benefits may not be made until a distributable event occurs. Under current law, termination of a 403(b) plan is not considered a distributable event. This effectively precludes a 403(b) plan from being terminated, because an employee benefit plan is not considered terminated until all plan assets have been distributed.
The final regulations allow 403(b) plan sponsors to make distributions to participants upon plan termination. Participants must be 100% vested upon termination. However, similar to the successor plan rules applicable to 401(k) plans, distributions are not permitted if the plan sponsor contributes to another 403(b) plan within 12 months before or after the date of termination (unless less than 2% of the terminating plan’s participants are eligible to participate in the other 403(b) plan). These rules are effective January 1, 2009. However, a 403(b) plan may be terminated prior to January 1, 2009 if the plan satisfies the requirements of the final regulations on the date of termination (other than the written plan requirement). As a result, employers that froze their 403(b) plans and adopted 401(k) plans may now terminate their frozen 403(b) plans and make distribution to participants. The participants may elect lump sum distributions or roll over their balances to an eligible retirement plan, such as the existing 401(k) plan or an individual retirement account or annuity.
The final regulations clarify the rules for determining whether two or more tax-exempt entities are treated as part of the same controlled group and, as a result, are treated as a single employer. Common control exists between a tax-exempt organization and another organization if at least 80% of the directors or trustees of one organization are representatives of or controlled by another organization. A tax-exempt entity may be in the same controlled group as a non-tax-exempt entity. The controlled group rules not only affect employers sponsoring 403(b) plans, but all tax-exempt entities. For 403(b) plans, controlled group status is important because it affects the availability of Special Catch-ups and the application of the nondiscrimination requirements, Code section 415 contribution limits and Code section 401(a)(9) minimum distribution rules.
A tax-exempt organization may choose to be aggregated with another organization in its controlled group if a single plan covers employees of both organizations and their day-to-day tax-exempt activities are regularly coordinated. The use of permissive aggregation is subject to anti-abuse rules which limit the extent to which an organization’s structure may be used to avoid or evade any tax.
The controlled group rules generally do not apply to churches or governmental entities, which may continue to rely on the rules of Notice 89–23 for determining controlled group status.
If an employer fails to timely adopt a written plandocument or the universal availability rule is not satisfied, all contracts and accounts of all participants under the 403(b) plan become taxable. An operational failure that occurs within a participant’s account or contract will result in the disqualification of all contracts or accounts held under the 403(b) plan for that participant, but generally will not impact other participants. Note that many plan failures can be corrected under the IRS’ voluntary compliance program, which the IRS is updating to more comprehensively address corrections of 403(b) plan failures.
Other Important Provisions
The final regulations permit a 403(b) plan to provide for distributions to an alternate payee pursuant to a qualified domestic relations order. Such distributions may be made immediately upon a determination that the order is a qualified domestic relations order or may be delayed until the participant’s earliest retirement age.
The final regulations provide that an endowment contract or life, health, accident, property, casualty or liability insurance contract does not constitute an annuity contract for purposes of Section 403(b). Accordingly, such contracts may not be purchased in connection with a 403(b) plan. The new rules do not apply to contracts issued before September 24, 2007.
Now that the final regulations have been issued, employers can begin to take steps toward managing their 403(b) plans, achieving compliance, and reducing risk. With a general effective date of January 1, 2009, employers have time to review their plans for compliance and make any necessary changes in form and operation. Please contact us if you have any questions.