Parts of the guidance are consistent with prior informal remarks made by IRS representatives, and some of the interpretations may raise questions.
The Four Scenarios Described in the Ruling
Revenue Ruling 2011-7 essentially describes how 403(b) plans can be terminated in four specific factual situations. In each of the four situations, a termination is found to be validly effected.
Situations 1 and 2 in the ruling involve non-ERISA, governmental plans. Each plan holds non-elective and elective pre-tax contributions (i.e., no Roth or after-tax contributions) but in situation 1, they are held in “fully paid” individual contracts, and in situation 2, they are held in a group annuity contract. In both situations, before January 1, 2012, the employer takes action to terminate the plan, including adopting a binding resolution to cease future purchases and to terminate the plan effective January 1, 2012. All benefits became fully vested on the termination date, January 1, 2012. All plan participants are notified of the termination, and, as soon as administratively practical after the termination date of January 1, 2012, distributions are effected.
In situation 1, these distributions are effected by “distribution of fully paid individual insurance annuities” to all participants, beneficiaries and alternate payees.
In situation 2, distribution of amounts from the group annuity contract is “effectuated by issuing individual certificates” to each participant, beneficiary or alternate payee.
Situation 3 is similar to situation 2 (and the plan non-ERISA), but the plan also includes custodial accounts under 403(b)(7). In this case, the distribution of amounts under the custodial accounts upon plan termination is made by a distribution in cash or in kind (i.e., mutual funds) of an amount equal to the participants’ account balance either directly to the participant or beneficiary or to an IRA or other eligible retirement plan under an eligible rollover distribution.
Situation 4 is similar to situation 3, except that in this case the plan is a money purchase pension plan subject to ERISA. Thus, distributions on termination have to be made in accordance with the QJSA and QPSA requirements section 205 of ERISA. Any amount held in custodial accounts that is to be paid in the form of an annuity under section 205 of ERISA is made “by purchase and distribution of a fully paid individual insurance annuity.” For the year that includes the final distribution, a final Form 5500 was filed.Key Points of the IRS Analysis
The analysis makes a number of points concerning the situations:
- The "nonforfeitability" requirement of 403(b) and the regulations is only met if all participants are vested upon plan termination.
- The distribution requirement on plan terminations is satisfied by the delivery of fully paid individual insurance contracts, or certificates in a group annuity contract. Interestingly, the ruling does not seem to recognize that, often, participants in 403(b) plans already hold their individual contracts and certificates prior to plan termination. It is not clear whether this is a significant distinction.
- However, no amount is included in gross income on account of the distribution of such contracts until amounts are paid out of the policy, provided that the contract continues to adhere to the requirements of 403(b) as in effect at the time of the delivery of the contract.
- Despite requests from some in the plan sponsor and vendor community for a different result, the IRS holdings in situations 3 and 4 indicate that a different rule for distributions on plan termination applies to 403(b)(7) custodial accounts. They cannot be distributed like annuity contracts or certificates. Instead, they must be distributed in cash or in kind (mutual fund shares), as soon as administratively practicable after the termination date. A distribution may be rolled over into an IRA at that time (or another eligible retirement plan, if the distributee is a participant in another eligible plan that will accept it), but the participant cannot keep the assets in his or her 403(b)(7) custodial account. Presumably, if a custodial account does not provide for cash-out distributions on plan termination, that could be an issue in terminating a plan.
Some Questions Remaining
The ruling also raises some interesting questions:
- What are the ERISA consequences of the distributions? Only situation 4 involves an ERISA plan. The ruling seems to indicate that the distribution of an annuity contract will be considered a distribution from the plan (for example, where a QJSA distribution must be made). Is that distribution also a distribution of a fully allocated annuity and no longer a plan asset under ERISA? The ruling, issued only by the IRS, does not address that.
- Why are custodial accounts treated differently than annuity contracts for purposes of plan distributions? Code section 403(b)(7)(A) states that contributions to a 403(b)(7) custodial account "shall be treated as amounts contributed by [the employer] to an annuity contract." The ruling does not discuss why that annuity treatment does not apply in the case of a plan termination.
- When is a 403(b) plan a money purchase plan? Prior to this ruling, there has been some question of whether the concepts of money purchase and profit sharing had any application to 403(b) plans, since the definitions of those terms is found in a Treasury regulation for 401(a) qualified plans.
-David Powell, Groom Law Group, Chartered