Prior to the final 403(b) regulations, published in 2007 and generally effective in 2009, there was no IRS guidance regarding how, or even if, a 403(b) plan could be terminated. There were no exceptions to the withdrawal limitations of Code section 403(b)(11) and 403(b)(7), to permit a cash distribution if a plan sponsor wished to terminate the plan. And there was no published guidance confirming that a distribution of contracts or accounts could itself constitute a plan termination. The final 403(b) regulations addressed both of those gaps, creating a new distribution event – plan termination – and also provided that a distribution of a fully paid annuity contract could satisfy the distribution requirement for plan termination.
The regulations also recognized that a 403(b) plan could be frozen, following a cessation of contributions. These changes were made in the context of broader 403(b) regulations which for the first time expressly required the maintenance of, and compliance with, a written 403(b) plan.
In the absence of guidance prior to 2007, plan sponsors and their counsel had to reach their own conclusions, to determine whether – and if so, how – a 403(b) plan could be frozen or terminated. For many plan sponsors that were either governmental employers, church organizations, or sponsors of ERISA safe harbor 403(b) plans (consisting only of voluntary employee contributions, with limited employer involvement, and thus not treated as being maintained by the employer, for purposes of Title I of ERISA), there was a fairly limited universe of issues. For them, stopping their contributions seemed to satisfy their obligations under the Code: their primary concern, the excludability of contributions, became a non-issue upon cessation of contributions. If the plan imposed withdrawal restrictions in excess of those found in the Code, those excess restrictions could be eliminated, and the administrators of the contracts and accounts could remain responsible for enforcing the restrictions that remained.This was not sufficient, however, for plans subject to Title I of ERISA. Those plans would need to continue to comply with ERISA requirements until all of the assets were distributed out of the plan. However, there was no guidance as to what that meant for purposes of ERISA, and even those questions seemed to hinge on how the IRS itself might treat an attempted plan termination. Clearly a cash distribution of all of the assets of the plan, if permitted under the Code, would qualify. Beyond that, there were questions that plan sponsors and their counsel sought to answer.
Fast forward to today, and you see most if not all of the tax issues and questions addressed in the recent IRS guidance (see IRS Provides Guidance on 403(b) Plan Terminations), which methodically walks through a set of scenarios, adding a new wrinkle with each one, and in each scenario concluding that the actions were sufficient to satisfy the plan termination requirements of the Code and the regulations:
- In the first scenario, a non-ERISA plan is funded solely with fully paid individual annuity contracts. The ruling confirms that a plan termination could be accomplished by taking formal action to declare the contracts, which were already owned and held by the participants (and alternate payees and beneficiaries), to be distributed. Those distributed contracts would still be considered 403(b) contracts and would no longer be subject to Code withdrawal restrictions. The ruling also indicates that some of the contracts distribute cash in the plan termination, and for those contracts the appropriate rollover notices are provided.
- The second scenario involves the same facts as the first, and adds a group annuity contract to the mix alongside the individual contracts. It does not indicate whether the group annuity contract is allocated (i.e., provides for individual participant accounts described in a certificate issued to the participant) or unallocated. However, it makes clear that distribution of a certificate is necessary in order to accomplish the termination distribution. Certificates that were already held by participants (and alternate payees and beneficiaries) would be considered distributed in the same manner as with the existing individual contracts.
- Yet another new fact is added in the third scenario. The plan is funded with individual and group annuity contracts and with one or more 403(b)(7) group or individual custodial accounts. Distribution of the custodial accounts is limited to actual distributions from the account. Consistent with the terms of the regulations, the ruling does not contemplate a distribution of the custodial account itself, in the same way that it (and the regulations) recognizes a distribution of the annuity contract or certificate.
- The final scenario incorporates the details of the first three and adds one important fact: the plan is subject to Title I of ERISA. While the ruling does not – and could not – address what would be sufficient for purposes of ERISA, it does address the reverse question. Specifically, it notes that steps in the first three scenarios, when combined with steps necessary to satisfy specific ERISA requirements would be sufficient for purposes of the Code.
The totality of the examples highlights an important detail for any 403(b) plan termination: the termination can only be accomplished if the plan sponsor has the authority to direct the necessary distribution.
- In the case of an individual or group annuity contract, that may be a distribution of either the account value (cash) or the annuity contract or certificate. To the extent that the latter involves a declaration of the independence of the contract or certificate from the plan, the plan sponsor is likely to have such authority. Such authority may not exist, however, to require a cash distribution.
- For individual or group custodial accounts, accomplishing the plan termination requires more authority, to require the distribution out of the account.
To underscore the importance of this particular question, unless all contracts and accounts can be distributed in the proper form, the termination cannot be accomplished – there is no de minimus rule, as there is for post-termination contributions.
Richard Turner serves as Vice President and Deputy General Counsel at VALIC. He was recently appointed to the U.S. Department of Labor ERISA Advisory Council and is a contributing author of the “403(b) Answer Book.”