On July 26, 2007, the Internal Revenue Service (IRS) published final regulations applicable to tax-sheltered annuities (also known as 403(b) annuities or tax-deferred annuities) offered to employees of public educational institutions and Internal Revenue Code (the "Code") Section 501(c)(3) tax-exempt organizations. The regulations finalize long-awaited guidance regarding the rules applicable to 403(b) annuities, that was first published in the form of proposed regulations on November 16, 2004. See our description of the originally proposed regulations at http://www.mwe.com/info/news/ots1104b.htm. The final regulations largely adopt the provisions contained in the proposed regulations, with certain additions and clarifications.
The final regulations continue two themes contained in the proposed regulations, in that the final regulations consolidate IRS and Department of Labor guidance issued since the last 403(b) annuity regulations were published in December 1964, and clarify provisions uniquely applicable to 403(b) plans. The final regulations also advance the IRS’ stated goal of making 403(b) annuities more like 401(k) plans, while maintaining the former as a distinct method of providing deferral opportunities to employees. Overall, the final regulations provide sponsors of 403(b) annuities with increased ease of administration and planning opportunities. However, in certain cases immediate action is required. For example, life insurance contracts cannot be purchased under 403(b) arrangements after September 26, 2007, and certain transfers between and among investment options are limited after that date. Plan sponsors should review their plans to ensure compliance with these effective dates.
Given the changes incorporated in the final regulations, the IRS has allowed sponsors of 403(b) plans additional time to review and prepare for changes to their plans and programs. The final regulations are generally applicable to taxable years beginning after December 31, 2008 (one year later than previously indicated). However, taxpayers may rely in good faith on the final regulations prior to that date, provided that such reliance is on a consistent and reasonable basis. Later required effective dates may apply to certain church-sponsored plans, plans maintained pursuant to a collective bargaining agreement and governmental 403(b) plans. In some cases, provisions of the final regulations have an earlier effective date than the general 2009 date. Sponsors of 403(b) plans should review the status of their plan to ensure that their plan is operated in accordance with the new regulations no later than the applicable effective date.
Written Plan Document
The final regulations require that all 403(b) plans be maintained pursuant to a written plan document. The document must contain all material terms and conditions of the arrangement, and can incorporate other pertinent documents (e.g., annuity contracts) by reference. The plan document also can delegate certain elements of plan operation, including plan administration, to an entity other than the plan sponsor. The IRS indicates in the final regulations that it will provide guidance for public educational institutions on meeting the plan document requirements, which will include sample plan language.
For organizations providing non-Employee Retirement Income Security Act (ERISA) 403(b) plans, the plan document requirement contained in the proposed regulations had been a concern because it suggested that all plans, including those that historically have been exempt from ERISA because they were not "established and maintained" by the providing employer, would be subject to ERISA by virtue of the plan document requirement. However, in conjunction with the final IRS regulations, the Department of Labor published Field Assistance Bulletin 2007-2, which describes how an organization offering a non-ERISA 403(b) plan can continue to maintain that arrangement as a non-ERISA plan while meeting the written plan requirement of the final regulations. Generally, sponsors of non-ERISA plans must ensure that they continue to disassociate themselves from the operation of the plan, while ensuring that they establish a plan document that satisfies the requirements of the final regulations.
Transferring Assets Among and Between 403(b) Plans
The final regulations revise the rules for transferring assets among and between 403(b) arrangements as provided in the proposed regulations, effective as of September 24, 2007.
Exchanges of investment contracts offered under a plan currently are governed by Revenue Ruling 90-24 and typically are referred to as "90-24 transfers." The proposed regulations suggested that 90-24 transfers would be eliminated, and that the rules applicable to transfers of assets would be liberalized. The final regulations retain the intent of 90-24 transfers, but restrict such transfers after September 24, 2007.
The final regulations permit transfers in the following three scenarios: a change in contract (investments) within the same plan; a transfer of assets from one plan to the plan of another employer; and a repayment or purchase of permissive service credits in a governmental defined benefit plan. Transfers to investment providers within and outside of a particular vendor group are permitted, but only when the employer and the investment provider have a written agreement to share certain specific plan information. In addition, the plan must permit the transfer, the employee’s benefit cannot be reduced as a result of the transfer, and distribution restrictions must be preserved in the receiving arrangement.
Plan-to-plan transfers also are allowed, provided that both plans allow such transfer and that the individual requesting the transfer is an employee or former employee of the employer that sponsors the receiving plan. The plan receiving the transfer must preserve the employee’s benefits earned under the transferring plan as well as the distribution restrictions applicable under the transferring plan.
A transfer that fails to meet the requirements of the 403(b) regulations will be treated as a taxable distribution to the employee (if a distribution-triggering event such as termination of employment has not otherwise occurred). As a result, plan sponsors will have to ensure that their plans are operated in accordance with the plan transfer restrictions, effective as of September 27, 2007, when the current 90-24 transfer concept expires. Ensuring compliance may require a review of the plan’s current documentation as well as the plan’s operation. Plan sponsors may wish to ensure that changes in contract procedures consistent with the final regulations are established by vendors receiving transfers. Also, if a particular plan allows for a plan-to-plan transfer, the plan sponsor should ensure that its plan preserves the distribution restrictions contained in the transferring plan.
Terminating 403(b) Plans
The final regulations confirm that a plan sponsor may terminate its 403(b) plan. This is a departure from existing law, which severely restricted the ability of 403(b) plan sponsors to terminate such an arrangement. If the sponsor of a 403(b) plan wants to terminate the arrangement, it should ensure that its plan document allows for such a termination (which may not be the case currently). It also must ensure that it does not contribute to another 403(b) plan within 12 months before or 12 months following plan termination. Following termination, the plan sponsor must distribute all benefits to all participants and beneficiaries within a reasonable period. Sponsors of 403(b) plans should revisit their existing arrangements, including those that are "frozen" to new participants and new contributions, to determine whether changes to their existing arrangements are appropriate (e.g., adding a provision to the plan allowing for termination) and whether action that was historically prohibited is now desirable (e.g., now being able to terminate a frozen 403(b) plan).
Application of the Universal Availability Rule
The universal availability rule requires that, subject to certain exceptions, all employees of an employer that offers a 403(b) plan must be permitted to make salary deferral elections, if any employee of the employer is allowed to do so. The final regulations maintain the flexibility regarding the universal availability rule that was built into the proposed regulations, but also eliminate classes of employees who previously could be excluded from participation in the plan without violating the universal availability rule. The final regulations allow sponsors of 403(b) plans to apply the universal availability rule separately to each employer and geographically distinct and independent operating unit, and also to exclude employees who are eligible to make elective deferrals under a 401(k) plan.
The final regulations eliminate the ability to exclude the following previously excludable classes of individuals from participation in a 403(b) plan:
Employees covered by a collective bargaining agreement
Employees who elect to participate in a governmental plan described in Code Section 414(d) instead of in a 403(b) plan
Members of a religious order who have taken a vow of poverty
The elimination of these exclusions is phased in until final elimination in 2010. The final regulations also state that if a plan permits designated Roth contributions, this option, like the ability to elect deferrals, must be universally available to all employees who are not otherwise excepted from the universal availability rule. Sponsors of 403(b) plans should review their plans to ensure that they comply with these changes. Plan sponsors also should ensure that their plans are structured to accurately reflect the intended participation in a particular plan.
Controlled Group Rules and the "Board Control Test"
The final regulations verify that the "board control test" is final and that the test is applicable for all employee benefit purposes and not just the 403(b) rules. The board control test generally states that 80 percent or greater board control or board overlap causes two tax-exempt organizations to be related for employee benefit purposes—they are treated as a single employer for the purpose of applying nondiscrimination rules and certain limits to the benefit plans that are subject to those tests and limits. The final regulations also provide that a plan sponsor may permissively aggregate related organizations for purposes of employee benefits participation even though those organizations may not satisfy the board control test.
The impact of the board control test extends beyond 403(b) plan administration and operation to relationships between tax-exempt organizations. All exempt organizations should review these rules, whether or not they maintain a 403(b) plan, to determine the effect of the board control test on their operations and on their employee benefit plans and programs. Sponsors of 403(b) programs should pay particular attention to these rules and evaluate their relatedness to other organizations and the effect they could have on plan operation, including the universal availability rule (described above) and nondiscrimination testing of employer contributions.
The final regulations confirm that employer contributions to 403(b) plans are subject to all the nondiscrimination tests that apply to employer contributions made to tax-qualified retirement plans. This includes special nondiscrimination rules that apply to employer matching contributions (the so-called "average contribution percentage" test). The nondiscrimination requirements generally are applied on an aggregated basis, taking into account all plans of the employer and its related organizations.
The final regulations confirm that the catch-up rules contained in the proposed regulations are adopted and that the ordering rule (determining which catch-up rule applies first, when more than one catch-up rule could apply) contained in the proposed regulations is retained.
The final regulations confirm that a separation from service is a distribution event for 403(b) plans. This rule could affect sponsors of 403(b) plans who are members of a controlled group of corporations in which employees move between members of that controlled group. For example, if Hospital A maintains a 403(b) plan, and an employee of Hospital A moves to Hospital B, which is part of Hospital A’s controlled group, but which maintains its own 403(b) plan, the employee would be entitled to a distribution from Hospital A’s plan. This outcome is counter to that required under the current rules applicable to 403(b) plans. 403(b) plan sponsors that are members of a controlled group of corporations should review their plans and business model to determine the effect of this change on employees and whether the effect is desired. If not, such sponsors may consider revising their plans to address this concern.
Incidental Death Benefits are Prohibited
The final regulations prohibit the purchase of life insurance contracts through 403(b) plans, and only allow for incidental death benefits under 403(b) plans. The final regulations grandfather life insurance contracts issued before September 24, 2007. Plan sponsors should assure that no new life insurance contracts are added to existing 403(b) arrangements on or after September 24, 2007.
The final regulations will at last bring a measure of certainty to 403(b) arrangements, their sponsoring vendors and to the tax-exempt organizations that make the arrangements available. The final regulations usher in a new period of employer sponsorship and responsibility, which will cause many exempt organizations to consider again whether they want their principal deferral and retirement income plan to be a qualified 401(k) plan or a 403(b) tax-sheltered annuity plan. Employers have a short time to prepare for certain of the new rules (such as the new transfer rules), but have until 2009 to prepare for more significant changes (such as the preparation of a plan document and aggregation rules). Exempt employers should begin the evaluation and planning process to be fully prepared for the onset of this new regulatory regime.