“Internal Revenue Code Section1.403(b)-10(b)(2)(i)(C) lists an exchange requirement that ‘the other contract is subject to distribution restrictions with respect to the participant that are not less stringent than those imposed on the contract being exchanged….’ I understand the restrictions would apply to current monies exchanged from the 403(b)(7), but would the restrictions also apply to new contributions made under the 403(b)(1) contract?”
David Levine and David Powell, with Groom Law Group, and Michael A. Webb, vice president, Retirement Plan Services, Cammack Retirement Group, answer:
This is an excellent question, which highlights some of the difficulties of administering 403(b) distribution provisions when both 403(b)(7) custodial accounts and 403(b)(1) annuities exist in a single 403(b) plan. As you no doubt are aware since you posed the question, contributions held in 403(b)(7) custodial accounts (mutual funds) are more restricted than 403(b)(1) fixed/variable annuity contracts with regard to distributions. The explanation of provisions section of the final 403(b) regulations provides details as follows:
“In addition, amounts held in a custodial account attributable to employer contributions (that are not section 403(b) elective deferrals) may not be paid to a participant before the participant has a severance from employment, becomes disabled (within the meaning of section 72(m)(7)), or attains age 591/2.”
Thus, the current 403(b)(7) plan with which you work could not permit employer contributions (and earnings related to such contributions) to be distributed for reasons of financial hardship. However that plan COULD permit such distributions at age 59 ½, but it appears that your plan sponsor has elected not to do so.
But what happens when plan assets are transferred to a 403(b)(1) annuity contract as you describe? Again, the explanation of provisions in the final regulations provides some guidance:
“This rule (the rule quoted above) also applies to amounts transferred out of a custodial account to an annuity contract or retirement income account, including earnings thereon.”
So, as you stated, the employer contributions (and related earnings) that are transferred from the old 403(b) custodial account to the new 403(b)(1) contract retain the old 403(b) account restrictions, and these restrictions cannot be unwound. Thus, such contributions cannot be withdrawn for financial hardship, and no action on the part of the plan sponsor can change that outcome.
However, since the age 59 ½ restriction was a PLAN restriction and NOT a requirement of the regulations, if you wanted to permit age 59 ½ distributions on the transferred funds, you could amend the plan to allow distributions at age 59 ½.
As stated in the above excerpt from the final regulations, elective deferrals (and related earnings) under the 403(b)(7) account are subject to the general distribution rules for elective deferrals under the 403(b) final regulations, and NOT the more restrictive custodial account rules. Thus, again the plan sponsor’s restriction here with respect to not permitting age 59 ½ or hardship distributions was an elective provision not required under the regulations. Thus, again, the plan sponsor could simply amend the plan to permit the distribution of elective deferrals at age 59 ½ and for reasons of financial hardship, in order to permit distribution of the funds transferred from the 403(b)(7) custodial account to the 403(b)(1) annuity for such reasons.
As for future contributions, as long as they are exclusively invested in 403(b)(1) fixed and variable annuity contracts, and never transferred or otherwise held in a 403(b)(7) custodial account, the custodial account distribution restrictions would not apply. Thus, not only could the plan could permit future elective deferrals to such contracts to be distributed for reasons of financial hardship, as you indicate is the intent of the plan sponsor in this scenario, but the plan sponsor could also permit distribution of EMPLOYER contributions for financial hardship or any of the other permissible reasons to withdraw such funds under the final regulations (e.g. attainment of fixed number of years of service or a stated age).
And finally, for all of this to work as the plan sponsor intends, of course the recordkeepers involved would need to separately track and account for the different money sources.
Thank you for your question!
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