“Can the plan add the in-service distribution provisions going forward under the annuity contract? It is my understanding that once funds are subject to the withdrawal restrictions imposed on the 403(b)(7) plan accounts, they remain subject to these restrictions after transfer to the annuity contract. (Treas. Reg. §1.403(b)-10(b)(2)(i)(C)) Therefore, following the transfer to the 403(b)(1), the plan can impose more stringent in-service rules, but not more liberal.”
Michael A. Webb,Vice President, Retirement Plan Services, Cammack LaRhette Consulting answers:
You hit the nail on the head as to the fact that the withdrawal differences between 403(b)(7) custodial accounts, more commonly known as mutual funds, and 403(b)(1) fixed/variable annuities can be quite confusing at times. By way of background, there are THREE different sets of regulations that apply to 403(b) distributions, depending on the type of contribution and contract involved:
1) EMPLOYER contributions to a 403(b)(1) fixed/variable annuity account may be withdrawn upon the earlier of severance from employment OR the attainment of a stated age, the completion of a fixed number years in the plan, or disability. The plan can stipulate the age (such as 59 1/2) or number of years completed (such as five years).
2) EMPLOYER contributions to a 403(b)(7) custodial account may be distributed only in the event of severance from employment, attainment of age 59 1/2, death, or disability.
3) ELECTIVE deferrals to ALL 403(b) account types, whether to a 403(b)(1) fixed/variable annuity or a 403(b)(7) custodial account, may not be withdrawn except in the event of severance from employment, hardship, attainment of age 59 1/2, death, or disability (note that there is an exception for 12/31/89 account balances in a 403(b)(1) account, where funds may be distributed for any reason).
The plan may choose to be MORE restrictive than these contract provisions (e.g. the plan may choose not to permit ANY in-service restrictions, as it appears that the plan sponsor did with the existing 403(b)(7) plan in your example). In addition, as you imply in your question, employer contributions that are EVER invested in a 403(b)(7) custodial account retain the 403(b)(7) restrictions even if subsequently transferred to a 403(b)(1) annuity account.
In your situation, you wish to permit age-59 1/2 distributions from all accounts, and hardship distributions from all elective deferrals. Since both of these provisions are consistent with current regulations as described above, you would have no issues at the plan level with permitting age 59 1/2 withdrawals from all accounts and hardship distributions of elective deferrals, provided that your plan language is drafted to permit such transactions.Where you may have an issue, however, is on the contract level. You state in your question that the existing plan did not permit hardship distributions of elective deferrals, nor did it permit in-service distributions at age 59 1/2. If the reason that the plan did not permit such distributions is that the custodial agreement did not permitsuch distributions, you have an issue. To the extent that funds will remain in the 403(b)(7) custodial account (it was unclear in your questions as to whether all funds were being transferred to the 403(b)(1)), the custodial agreement would need to be amended to permit the distributions the plan sponsor desires. If it is not possible to amend the custodial agreement, you will be dealing with two different sets of distribution restrictions, which will be an administrative challenge.
Note that §1.403(b)-10(b)(2)(i)(C) is a CONTRACT level, as opposed to plan level, restriction. Thus, if the actual 403(b)(7) CONTRACT (custodial agreement) permits in-service distributions at age 59 1/2 and hardship distributions of elective deferral (regardless of the fact that the PLAN did not permit such distributions), that would be the determining factor in administering the “not less stringent” distribution rule of the regulation. Thus, even though the PLAN was not permitting such distributions at the time, I believe that the plan could be amended to permit such distributions, and that 403(b)(7) contracts in the plan could be exchanged for 403(b)(1) contracts without worrying about whether historic plan restrictions would then limit permissible age 59 1/2 hardship distributions for funds transferred to the new 403(b)(1) contract.
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.