(b)lines Ask the Experts – Consequence of Offering Non-Eligible Investments

“What is the consequence of a plan that, though written to permit only 403(b) eligible investments (403(b)(1) fixed/variable annuities and /or 403(b)(7) custodial accounts (mutual funds)), actually offers investments that do not qualify as 403(b) investments in  plan operation? Is this a defect that can be self-corrected?”

Stacey Bradford, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, vice president, Retirement Plan Services, Cammack Retirement Group, answer: 

First of all, the Experts assume that you are not referring to a 403(b)(9) retirement income account of a church plan here, as investments outside what would normally be permitted in a 403(b) plan are permitted in such accounts, and thus an operational failure would not exist for the fact pattern you provide.

For all other plans/accounts, a failure does indeed exist. And the consequences of such a failure, though it is an operational error and not a defect as to form in the plan document, can be substantial. The reason for this is that such defects are identified in the IRS Employee Plans Examination Guidelines for 403(b) Plans (specifically Section as causing the plan to fail to be a 403(b) plan. Two specific examples are provided, as follows:

  • Example 8: ABC Foundation, an Internal Revenue Code (IRC) 501(c)(3) organization maintains an annuity plan intended to be an IRC 403(b) plan. Foundation makes both elective deferrals and employer contributions that are not elective deferrals to individual investment accounts (not mutual funds) for each of its employees. Foundation purchases annuity contracts for employees at their retirement. The arrangement is not an IRC 403(b) plan.
  • Example 9: Employer A is a public education organization maintaining a plan intended to be an IRC 403(b) plan. All contributions under the plan are invested in life insurance policies for its employees. Because life insurance must be incidental to the primary purpose of providing retirement benefits, the plan is not an IRC 403(b) plan.

A plan level failure, which causes a plan to fail to be a 403(b) plan, is the most severe type of plan failure. In theory, the Internal Revenue Service (IRS) could disqualify the entire 403(b) plan upon audit, which would result in immediate taxation of all account balances in the plan to all participants as well as other taxation and withholding consequences. Obviously, this is not a desirable outcome, and, in practice, such disqualification is not a common occurrence. But it does underscore the significance of this type of plan defect.

As for possible correction, the IRS Employee Plans Compliance Resolution System (EPCRS), which provides the corrective procedures for retirement plans (including 403(b) plans), is silent as to the correction of this specific defect. Given the severity of the failure, it would be prudent for the plan sponsor to contact counsel with specific expertise in such matters for guidance as to how to approach the IRS on this issue.


NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.    

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