403(b) Plan Terminations: FAQs
Note: We have revised the FAQs regarding 403(b) plan termination to reflect recent conversations with a representative of the IRS National Office. The IRS clarified that in some circumstances the investment product may not provide the employer with sufficient legal control to effect a plan termination. Prior to the issuance of the final 403(b) regulations, Code §403(b) did not provide for plan termination as a distributable event. An employer which wanted to terminate its 403(b) plan could not distribute a participant’s account balance until the participant incurred a distributable event. For plans subject to ERISA, it forced the employer to continue complying with the reporting and disclosure requirements until all participants incurred a distributable event (e.g., termination of employment). One of the more significant changes in the new 403(b) regulations was the inclusion of a provision which treats plan termination as a distributable event. The following questions and answers address several of the more important issues regarding 403(b) plan termination.
Q: May an employer sponsoring a 403(b) plan freeze (i.e., cease future contributions) the plan?
A: Yes. An employer may amend the plan to eliminate future contributions for existing participants. Since the frozen plan would continue to be subject to the written plan requirement, the employer would need to update the plan for any required changes. Furthermore, if the plan were subject to Title I of ERISA, the plan would need to continue to comply with the reporting (e.g., 5500) and disclosure requirements (e.g., summary plan description).
Q: May an employer sponsoring a 403(b) plan terminate the plan?
A: Yes. For taxable years commencing after December 31, 2008, an employer may terminate a 403(b) plan. In order for the employer to effect a plan termination, the plan would need to contain provisions permitting termination. Note: The fact that a plan contains language permitting termination does not supersede the annuity contract or custodial account. In other words, if the annuity contract does not provide language which accommodates distribution upon plan termination, the plan will not be able to terminate. Furthermore, the regulatory language permitting plan termination does not confer upon the employer the authority to force a participant with an individual annuity contract or custodial agreement to receive a complete distribution.
Q: Is plan termination a distributable event?
A: Yes. A plan termination is a distributable event for 403(b) plans. Generally, a plan termination distribution would qualify as an eligible rollover distribution and the participant could roll over the distribution to an eligible retirement plan (e.g., IRA). However, there are limitations as described below.
Q: May a 403(b) plan sponsor treat plan termination as a distributable event before the effective date of the final regulations (January 1, 2009)?
A: Yes. However, if a plan sponsor wants to distribute pursuant to plan termination before January 1, 2009 (and after July 26, 2007), all contracts (and custodial accounts) must be in operational compliance with all of the new regulatory requirements other than the written plan requirement. However, an insurance company may object to making an annuity contract distribution on plan termination because the contract does not provide for the distribution, regardless of the fact that the regulations permit the distribution.
Q: In order for an employer to terminate a 403(b) plan, what steps do the regulations require the employer to complete?
A: The steps are:
1. The plan must contain plan termination provisions (after 2008).
2. The employer (including related employers) cannot make contributions to any other 403(b) plan for the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan. However, if, for the period 12 months before plan termination and ending 12 months after distribution of all plan assets from the terminated plan, fewer than 2% of the employees who were eligible under the terminated plan were eligible under an alternative 403(b) plan, the employer may disregard the alternative plan.
3. The employer may not treat contributions which were not vested (considered as part of a 403(c) contract) at plan termination as contributions to a 403(b) plan. However, the employer may choose to vest the contributions prior to termination.
4. The plan must distribute all accumulated benefits under the plan to all participants and beneficiaries as soon as administratively practicable after plan termination.
Regarding requirement 2, note that a 401(k) plan is not an alternative 403(b) plan. This means an employer can terminate a 403(b) plan, establish a 401(k) plan, and allow participants to roll balances into the 401(k) plan. Notice that a rollover (following a distributable event) is the only way to move money between a qualified plan and a 403(b) plan; the employer cannot simply transfer the funds or otherwise merge the plans.
Note: The employer should note that ERISA and state law may impose other requirements, such as: (1) filing a final Form 5500, and (2) adopting some form of a corporate resolution.
Q: Do the regulations provide any alternative methods to comply with the distribution requirement?
A: Yes. The regulations will treat a plan’s distribution of a fully paid individual insurance annuity contract as a distribution.
Note: Generally, when the regulations refer to a contract the reference also includes custodial account. However, in this provision, the reference is limited to an annuity contract.
Note: A fully paid individual insurance annuity contract is an annuity contract where the employer has ceased contributions and the insurance company has assumed certain plan distribution responsibilities (e.g., distribution notices, consent requirements, joint and survivor annuity requirements). Generally, the insurance company issues a different certificate. In conversations with the IRS, they have indicated that this provision in the regulations is simply recognizing that a 403(b) can take advantage of a procedure available to terminating pension plans (e.g., distributing a paid up annuity contract where the participant and spouse will not consent to a lump sum distribution).
Q: If a 403(b) plan includes individual custodial accounts, may the employer satisfy the distribution requirement by informing the participant and vendor that it is treating the custodial account as “distributed”?
A: No. Unlike individual annuity contracts, a participant would have to liquidate the account to effect a distribution.
Note: Many practitioners interpreted the provision in the regulations as recognizing the difficulty a 403(b) plan would have in satisfying the distribution requirement where the plan has individual contracts. Practitioners assumed the plan would be able to effect plan termination by treating an individual contract as distributed. However, the IRS has indicated that if a plan contains individual annuity contracts (or custodial agreements), the participant (and insurance company or mutual fund company) would need to agree to a liquidation, conversion to an IRA annuity or a distribution of a paid up annuity contract to terminate the plan. Since the employer lacks sufficient legal control to force any action upon the participant, the ability to terminate a 403(b) plan is illusory in the absence of vendor cooperation.
Example. An employer maintains a 403(b) plan with a group annuity contract covering 99 participants. The plan also has a participant with an individual annuity contract. The participant has possession of that contract. The employer adopts a resolution to terminate the plan. The employer directs the insurance company to make lump sum cash distributions or distribute paid up individual contracts to each participant in the group contract. However, since the employer lacks any legal control over the one individual contract, the employer cannot terminate the plan unless the participant with the individual contract will agree to a liquidation of the contract, conversion to an IRA, or distribution of a fully paid up annuity contract.
Example. Assume the same facts as in the previous example, except the individual contract is an individual custodial account. The employer could not terminate the plan and make distributions from the group contract unless the participant with the individual custodial agreement liquidated his/her account and received a cash distribution from such account.
Q: Do the principles of Rev. Rul. 89-87 apply to a 403(b) plan termination?
A: Apparently yes. The IRS has indicated that the principles of Rev. Rul. 89-87 apply to a 403(b) plan. Therefore, if a plan generally completes distribution from a 403(b) plan within 12 months of the termination date, the IR will. Example: If an employer terminates a 403(b) plan on December 1, 2008 and distributes all of the assets of the plan by November 30, 2009, the IRS will consider December 1, 2008 as the distribution date. Accordingly, the employer will not need to comply with the written plan requirement. Of course, if the plan does not complete distributions within the 12-month period, the plan would violate the regulations unless the document is in compliance with the regulations. Therefore, an employer that is terminating a plan should adopt an updated document unless it is certain it will complete distributions during the 12-month period.
Q: If the employer terminates the plan in 2009, must the employer adopt a written 403(b) plan?
A: Yes. Notice 2009-3, which extended the deadline to adopt a 403(b) plan to December 31, 2009, did not excuse plans terminated after December 31, 2008 from the written plan requirement. Only plans terminated prior to January 1, 2009 (and fully distributed within the 12-month period) can avoid the requirement to adopt a written plan.
For more information about 403(b) Plans consider:
403(b) Prototype Plan. SunGard offers a 403(b) prototype-formatted document to assist employers in complying with the new written plan requirement. The 403(b) Prototype includes a basic plan document and two alternative adoption agreements: deferral only and employer contributions and deferrals. For additional information about this plan, call 800-326-7235, Ext. 1100.
To comply with the final regulations, you will need to become educated on the topic, acquire a written plan document, determine how to administer the plan, and process the correct government forms.