FALL 2004 - WINTER 2005 EDITION

403(b) BECOME QUALIFIED PLANS - ALMOST
The proposed regulations released by Treasury on November 16, 2004 represent the first time since 1964 that the Internal Revenue Service (IRS) has issued updated comprehensive regulations for 403(b) arrangements. These regulations follow the trend of recent years to eliminate many, if not most, of the differences between 403(b) plans and 401(k) and 457(b) plans. When finalized, it is anticipated that these regulations will supersede the revenue rulings and notices (over 20 in all) issued on 403(b) plans over the past 40 years. The operational and administrative positions taken in most of the rulings and notices are expected to be retained.

However, there are some major changes included: imposing a formal written plan document on most 403(b) arrangements, adding plan termination as a distributable event (under certain circumstances), applying a number of the qualified plan nondiscrimination rules, and establishing a variation of the 414 controlled group rules based on control of governing boards that would apply to tax-exempt entities under 501(a). Highlights include the following:

PLAN DOCUMENT REQUIRED
In a major policy change, the proposed regulations require that the contract be maintained pursuant to a written plan document. The plan document would supersede any agreement between vendor and participant. The current agreements between the participant and the vendor will disappear. Most 403(b) arrangements are non-ERISA plans, many accompanied by a DB plan, this will bring them a major change.

The plan document must include all material provisions such as eligibility, benefits, applicable limitations, vesting, required minimum distributions, eligible rollover distribution rules, non-transferability rules, the contracts available under the plan, and time and form of benefit distributions.

The Summary Plan Description would also be needed. The Department of Labor (DOL) will have to rule on what causes a previously non-ERISA plan to be subject to ERISA. Non-ERISA plans have never had a requirement for a plan document and, yet now, the IRS states there must be a document and we do not know if that will subject the plans to ERISA. We are looking to the DOL to rule on whether the addition of a plan document will cause a plan to be deemed to be an ERISA plan. We have to wait and see what DOL says.

NOTE: The IRS has recently made clear that although there will be a written plan document requirement, there is no immediate plan to have 403(b) plans go through a determination letter program. The IRS is gearing up for The EGTRRA amendment process and does not have the resources at this time to consider bringing a 403(b) prototype determination or opinion letter program into being.

UNIVERSAL AVAILABILITY RULES
Universal availability is the right that a participant has to make elective deferrals. All employees must have the right to defer with some limited exceptions. All employees in the eligible category must be able to make elective deferrals. There may be no artificial limits to prevent a contribution of at least $200. There may be no age or service requirements allowed for elective deferrals though they may be used for eligibility for employer contributions, including matching.

Universal availability rules apply separately in the following cases:

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to each common-law entity in a control group, i.e. 501(c)(3) organization

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for a 403(b) that covers employees of more than one government entity, the rules apply separately to each entity that is not part of a common payroll

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employer’s, who have always treated different geographic units separately for employee benefit purposes, may continue to treat such unit(s) as a separate organization provided it is operated independently on a day-to-day basis

Statutory exceptions to universal availability —
The categories are:

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employees eligible to participate in a governmental 457(b) which permits elective deferrals

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employees eligible to participate in a plan of the employer offering qualified cash or deferred elections under 401(k)

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nonresident aliens with no US source income

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employees who regularly work less than 20 hours a week

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employees who are students performing services described in 3121(b)(10)

Categories that were permitted to be excluded under Notice 89-23, but which are proposed to no longer be excluded include:

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employees who make a one time election to participate in a governmental plan instead of a 403(b)

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employees covered by a collectively bargained agreement

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visiting professors for up to one year in certain circumstances

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employees who have religious affiliation and have taken a vow of poverty

NOTE: If any employee listed in an excludable group has the right to make elective deferrals, then no employee in that category may be excluded.

Excluded organizations:
Nondiscrimination and universal availability generally do not apply to a public school, hospital, nursing home or a church (as defined for this purpose).

SECTION 403(b) NONDISCRIMINATION RULES
Nondiscrimination requirements currently covered under IRS Notice 89-23 would be superceded by the proposed regulations once they become final.

Code Section 403(b)(12)(A)(i) requires non-governmental plans to test employer matching and nonelective contributions and employee after-tax contributions for compliance with the nondiscrimination requirements. Specifically, these plans must satisfy nondiscrimination requirements for: contributions, benefits and coverage. This requires ACP testing of matching and after-tax contributions, the application of the compensation cap under 401(a)(17), and testing the compensation definition for discrimination using the safe-harbor definition of compensation under 414(s). For purposes of testing, tax-exempt employers will be combined as a single employer if 80% or more of their boards of directors are either identical or one organization controls the selection of 80% or more of the other entity’s board.

NOTE: Elective deferrals remain exempt from the qualified plan nondiscrimination rules. (ADP Testing).

Unlike 403(b) plans of tax-exempt employers, the only nondiscrimination rule that applies to a governmental plan is the compensation cap under 401(a)(17).

Interaction with ERISA
Though the exclusions to universal availability and nondiscrimination may appear to apply, these exclusions do not override the ERISA requirements. Thus, even if an employee works less than 20 hours a week, the individual may have to be covered by the plan due to the ERISA limitations on plan exclusions, such as the 1,000-hour-of-service rule.

INCOME EXCLUSION FOR CONTRIBUTIONS TO SECTION 403(b) CONTRACTS
403(b) plans will continue to have only three funding arrangements that permit contributions to be excluded from gross income:

Annuity contracts issued by an insurance company (defined in 401(g)).

Custodial accounts invested solely in mutual funds.

Retirement income accounts (limited to church employees only).

To exclude contributions from income the following requirements must be met:

All 403(b) annuity contracts purchased by the employer for the employee are treated as the purchase of one contract.

The 402(g) annual limit on elective deferrals is aggregated, and it applies on both a plan and an individual basis.

The controlled group rules of 414 apply for purposes of defining the employer.

SECTION 403(b) REQUIREMENTS INCLUDE ANNUITY NONFORFEITABILITY
403(b)(1)(C) states that the employee’s rights under the 403(b) contract must be nonforfeitable, except for failure to pay future premiums.

INTERACTION BETWEEN ERISA TITLE I AND SECTION 403(b) OF THE CODE
Generally, neither a “governmental plan” as defined under 3(32) of ERISA nor a “church plan” as defined under 3(33) of ERISA is subject to ERISA.

DOL issued regulation 29CFR2510.3-2(f) to describe circumstances under which a 403(b) plan will not be considered an “employee pension benefit plan” under Title I of ERISA. Whether an employer has established a plan subject to Title I is determined on a facts-and-circumstances basis. The factors entering into this determination include the degree of the employer’s involvement in the day-to-day affairs of the plan, as contemplated by the plan document and in operation.

The IRS has asked for comments concerning the scope and application of the DOL regulation to 403(b) plans. Under the proposal, 403(b) plans subject to Title I would be required to satisfy ERISA’s tax and labor requirements for reporting and disclosure, eligibility, vesting, benefit accrual, advance notice of contribution reductions, qualified joint and survivor annuities, minimum funding, fiduciary standards, fidelity bonding and claims procedures.

NOTE: Authority to interpret requirements relating to eligibility, vesting, benefit accrual, minimum funding and qualified joint and survivor annuities has been transferred to the IRS.

COMPARISON WITH SECTION 401(k) ELECTIVE DEFERRALS

The proposed regulations would cause the rules governing salary reduction contributions to 403(b) to become very similar to the rules applicable to elective deferrals to 401(k) plans in the following areas:

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Under the terms of the plan document, permit more frequent making of changes and revocations of elective deferral elections.

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Authorize automatic enrollment (already available under Rev. Ruling 2000-35).

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Allow deferral elections percentages made in one year to be carried forward to future years until modified.

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Treat one-time irrevocable elections as not being elective deferrals.

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Require that employees have an annual effective opportunity to make, revoke, or modify a deferral election.

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Permit deferral elections to be made for compensation up to the day before the compensation becomes currently available, if administratively feasible.

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Apply the 401(k) regulations to define a cash or deferral election to a 403b plan.

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Benefits may not be conditioned on election to defer. The proposed regulations have a rule comparable to 401(k)(4) that prohibits conditioning receipt of benefits other than matching contributions upon the making of elective deferrals.

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Require the distribution of excess elective deferrals.

However, the following major differences between 403(b) elective deferrals and 401(k) elective deferrals remain:

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403(b) plan eligibility remains limited to specific employers and employees (i.e., public schools, employees of 501(c)(3) tax-exempt organizations and certain ministers of religion). Whereas a 401(k) is available to all employers, except State or local government or any political subdivision, agency or instrumentality thereof.

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403(b) contributions may only be made to limited funding arrangements: insurance company annuities or custodial accounts limited to mutual fund shares. Churches may invest in retirement income accounts that have investment options more similar to qualified plans.

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As noted above, 403(b)s are subject to the universal availability requirement (with some exceptions) that apply to elective deferrals in lieu of coverage and ADP testing requirements for 401(k) plans.

Failure to Satisfy Section 403(b)
If 403(b) requirements are not met for an employer contribution, then the contributions become taxable under either:

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IRC Section 403(c), if the contribution is to an annuity contract; or

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IRC Sections 61, 83 or 402(b), if the contribution is to a custodial account or retirement income account.

Application of section 403(b) to tax-exempt entities that have State or local government features.
401(k)(4)(B)(i) and (ii) indicate that an entity that is both a 501(c)(3) and an instrumentality of a State cannot have a 401(k) plan. However, such a “dual” entity may have an eligible 457(b) deferred compensation plan if that plan is funded. In addition, 403(b)(1)(A)(i)and(ii) indicates that an entity that is both a 501(c)(3) and an instrumentality of a State may cover any of its employees, regardless of whether they are performing services for a public school.

NOTE: Guidance has not been provided as to whether a tax-exempt charter school is, or is not, a government entity.

MAXIMUM CONTRIBUTION LIMITATIONS
Annual addition limits and overall limitations on elective deferrals that apply to qualified plans also apply to 403(b) plans. Thus:

All amounts contributed by the employer for the purchase of an annuity contract or a custodial account may not exceed the applicable 415 limitations; and

Section 402(g) limits the amount of elective deferrals that may be made in a single year on both a plan and individual basis.

CATCH-UP CONTRIBUTIONS

Two catch-up contribution provisions, which must be coordinated, are available to certain 403(b) plan participants.

Depending on plan design, the same age 50 section 414(v) catch-up option that is available to 401(k) participants may be extended to 403(b) participants.

Participants who work for certain institutions (see paragraph b below) also have the 15 years of service catch-up option. This option is applied as follows:

This special catch-up limit is the lesser of the following three amounts:

$3,000,

ii.

the excess of $15,000 over the total special section 403(b) catch-up elective deferrals made for the qualified employee by the qualifying organization for prior tax years, OR

iii.

the excess of (A) $5,000 multiplied by the numbers of years of service of the employee with the qualified organization, over (B) the total elective deferrals made for the qualified employee by the qualified organization for prior taxable years.

Qualified organization: an eligible employer that is a school, hospital, health and welfare service agency (including a home health service agency), or a church-related organization.

Church-related includes all entities that are in such a church-related organization and are treated as a single qualifying organization so that years of service and any section 403(b) catch-up elective deferrals previously made for a qualified employee for any such church are taken into account for purposes of determining the amount of section 403(b) catch-up deferrals to which an employee is entitled under any 403(b) plan maintained by another entity in the same church-related organization.

Health and welfare service agency is defined as either an organization whose primary activity is to provide medical care as defined in section 213(d)(1) (such as hospice), or a 501(c)(3) organization whose primary activity is the prevention of cruelty to individuals or animals, or which provides substantial personal services to the needy as part of its primary activity such as proving meals to the needy.

Coordination of the two catch-up types.

If an employee is eligible for both types of catch-up, the ordering rules require that the special 15-year-of-service catch-up must be applied first. This has the effect of accelerating the use of the $15,000 limit and potentially missing out on the benefit of a given year’s age 50+ catch-up.

If the full special catch up amount is contributed, then the age 50 catch up may also be made. (For example, in 2005, a $4,000 catch-up contribution would first be considered $3,000 of special catch-up and only $1,000 of the age 50 amount).

It is possible to use both provisions in the same year.

EXCESS DEFERRALS
Excess deferrals must be distributed by April 15th along with net income attributable to the excess deferrals and are to be included in income for the taxable year that they were to be deferred.

SPECIAL RULE FOR CONTRIBUTIONS TO FORMER EMPLOYEES
A 403(b) plan may provide the nonelective employer contribution for up to five years after an employee terminates employment. The amount to be provided may be the lesser of the 415 annual additions limitation amount, or the former employee’s includible compensation, based on his or her most recent year of service. If an employee terminates in mid-year, the time until the end of the year is added to the five years after employment that may be taken into consideration. Monthly includible compensation is defined as 1/12th of the includible compensation earned during the most recent year of service.

NOTE: The IRS intends to issue separate guidance on the ability to defer or receive matching contributions from severance pay for 403(b), 401(k) and 457(b) plans, and thus, did not address this issue in the 403(b) proposed regulations.

DISTRIBUTIONS
Timing of Distributions and Benefit
The proposed regulations reaffirm the following statutory rules depending upon the type of funding vehicle:

Custodial contract (employer contributions distributable events): severance from employment, disability as defined in section 72(m)(7), attainment of age 59½. This includes amounts transferred from the custodial account to annuity contract or retirement income accounts, which retain the custodial account characteristics.

List of distributable events for elective deferrals:

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Severance of employment,

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hardship as defined for 401(k) plans,

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disability as defined in section 72(m)(7),

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attainment of age 59½, or

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death.

These rules do not apply to elective deferrals made prior to 1989.

A 402(f) special tax notice is required as a precondition to distribution. In addition, the timing requirements for eligible rollover distributions that apply to qualified plans would also apply to 403(b)s.

If the distribution restrictions do not apply, a 403(b) annuity contract may distribute benefits upon occurrence of an event such as a fixed number of years, attainment of a stated age or disability.

Severance from Employment
Severance from employment will occur on the date which the employee ceases to be employed by an eligible employer that maintains a 403(b) plan. Under the proposal, severance from employment may also occur when an employee changes employment status. Examples of when this may occur include:

an employee switching from a 501(c)(3) to a for-profit subsidiary of the same entity;

an employee leaving a school but working for the same state; and

a minister ceasing to perform services as a minister, but continuing to work for the same church entity.

Required Minimum Distributions
The required minimum distribution rules applicable to qualified plans are generally followed with some minor changes such as the omission of the 5% owner requirements.

NOTE: The proposal is silent as to whether the RMD for contributions made before 1987 may continue to be delayed until age 75, and this will require a clarification.

Loans
Rules similar to the qualified plan rules are included reflecting the requirements that would be applied to plan loans, if made to 403(b) plan participants.

QDROs
The proposal clarifies that the QDRO rules of 414(p) also apply to 403(b) plans.

Taxation of Distributions and Benefits From a Section 403(b) Contract
Generally, only amounts actually distributed from a 403(b) contract are included in the recipient’s gross income for the year distributed. Amounts directly rolled over or transferred to another retirement plan or IRA are not taxable.

The mandatory 20% withholding requirement would apply to all eligible rollover distributions that are not the subject of a direct rollover. As with qualified plans, the 402(f) notice must be provided at the time distribution is requested.

FUNDING OF SECTION 403(B) ARRANGEMENTS

Contribution Deposit Deadline

A controversial provision would apply the DOL plan asset rules to 403(b) plans. Thus, employers would be required to segregate employee contributions from the general assets of the employer and deposit those contributions with the insurer or custodian as soon as administratively feasible but in no event by no later than 15 days following the month in which these amounts would otherwise have been payable to the participant. Prior to these regulations, there has been nothing as specific as the deposit rules for the 401(k) plans.

Annuity Contracts
Except where a custodial or retirement income account is treated as an annuity contract, an annuity is defined as a contract issued by an insurance company qualified to issue annuities in a State. This definition requires payments be made in the form of an annuity. The practical effect of this provision is to prohibit inclusion of life insurance contracts, endowment contracts, health or accident contracts, or property, casualty or liability contracts in a 403(b) arrangement.

NOTE: A transition rule is provided for life insurance issued before the effective date of the final regulations, though no new insurance may be purchased after that date. Arrangements established on or before May 17, 1982 may continue under the relief provided in section 7805(b).

Custodial Accounts
A custodial account is defined as a plan or a separate account under a plan in which a 403(b) contribution or rollover to a 403(b) is held by a bank or a person who qualifies as a custodian, if amounts are limited to being invested in stock of a regulated investment company (a mutual fund). The exclusive benefit rule applies and the account may not be structured as a retirement income account.

SPECIAL RULES FOR CHURCH PLANS

Retirement Income Accounts

Section 403(b)(9) states that a retirement income account (RIT) for employees of a church-related organization be treated as an annuity contract for 403(b) purposes. A RIT is defined as a defined contribution program established/maintained by a church-related organization under which:

separate accounting is maintained for RIT’s interest in underlying assets.

investment income is based on the RIT’s assets.

RIT assets are for the exclusive benefit of participants or beneficiary(s).

An employer may not borrow from the assets of an RIT, and the plan document must specifically state that it is intended to constitute a RIT.

The proposal states that any asset of a RIT that is owned or used by a participant is treated as a distribution.

A RIT treated as an annuity is not a custodial account even if it is invested in mutual funds.

A life annuity can be provided through the purchase of an annuity contract. The proposed rules permit a life annuity to be paid if certain conditions are met. The conditions are spelled-out in the regulations and include actuarial assumptions and the plan sponsor’s guarantee that a payment exceeding the participant’s or beneficiary’s accumulated benefit will be paid.

Commingling Assets
Custodial accounts and retirement income accounts are subject to an exclusive benefit rule.

When the regulations are finalized, to the extent permitted by the Commissioner, assets held under custodial account or RIT may be pooled with trust assets held under a qualified plan.

CONTROLLED GROUP RULES FOR TAX-EXEMPT ENTITIES
The controlled group rules will apply to section 501(a) tax-exempt organizations. The controlled group rules would be based on 80 percent of the directors or trustees being either representatives of, or directly or indirectly controlled by, an exempt organization. An anti-abuse rule would permit tax-exempts to choose to be aggregated if it maintains a single plan covering one or more employees from each organization, and the organizations regularly coordinate day-to-day exempt activities. These rules would be relevant for nondiscrimination requirements, 415 limitations, special 403(b) catch-up and 401(a)(9) rules.

The controlled group rules do not apply to church entities and also excludes public schools.

PLAN TERMINATION
Currently, plan termination is not an event permitting distribution for a 403(b) plan. The proposal breaks new ground, as distribution of accumulated benefits would be permitted upon the plan’s termination if certain rules are followed. Specifically, distribution is permitted only if the employer (including entities that are part of a controlled group on the termination date) does not make contributions to another 403(b) contract that is not part of the original plan during the 12 months before and after the date of the plan termination. All benefits must be distributed as soon as administratively feasible after the termination of the plan.

If an employer ceases to be an eligible employer for sponsoring a 403(b) arrangement, contributions must cease and the contract may be frozen or the plan may be terminated in accordance with the above rules.

EXCHANGES AND TRANSFERS
The proposal preserves some of the rights to make transfers pursuant to Rev. Rule 90-24, subject to restrictions.

A 403(b) contract may be exchanged for another if:

the plan provides for the exchange,

the benefit after the exchange is at least equal to the benefit immediately before the exchange, and

the contract received in the exchange is subject to the distribution restrictions as stringent as the contract being exchanged.

A 403(b) contract may be transferred to another 403(b) plan if:

the participant or beneficiary of the assets being transferred is an employee of the employer providing the receiving plan (this is a major new restriction that eliminates a participant's right to choose any vendor to hold his or her assets, which is currently the major use of these transfers) ,

the transferor plan permits transfers,

the receiving plan accepts transfers ,

the participant’s or beneficiary’s benefit immediately after the transfer is at least equal to the benefit immediately before the transfer, and

the distribution restrictions on the receiving plan are as stringent as the restrictions on the assets being transferred.

Additional transfer concepts:

A partial transfer must be a pro rata portion of the participant’s or beneficiary’s interest in any after-tax employee contributions.

A 403(b) plan may provide for a transfer to a 401(a) plan to purchase permissive service credits under a defined benefit governmental plan, or to make a repayment to a defined benefit governmental plan.

Transfers that are not permitted:

Transfers are not permitted from a qualified plan to a 403(b); nor from a 457(b) to a 403(b).

A 403(b) contract may not be exchanged for an annuity that is not a 403(b) contract.

Transfers and exchanges are not taxable events.
There may be additional transfer rules that apply in the event of a plan-to-plan transfer to, or from, a 403(b) subject to ERISA Title 1 (Section 208 of ERISA and 414(l) of the IRC.)

SECTION 3121(a)(5)(D)
Under temporary regulations that were issue simultaneously with the proposed rules, amounts governed by a salary reduction agreement (including one-time elections) have been defined as subject to the Federal Insurance Contributions Act (FICA).

PROPOSED EFFECTIVE DATE
Generally the effective date is proposed to be applicable to taxable years beginning after December 31, 2005. The proposed regulations may not be relied upon until adopted in final form.

Two transition issues

403(b) contracts subject to collective bargaining agreements, the final regulations would not apply until the collective bargaining agreement terminates.

A 403(b) contract maintained by a church-related organization needing a church convention’s authority to amend the contract would have the final regulations apply at the earlier of January 1, 2007 or 60 days after the first church convention after the publishing of the final regulations in the federal register.

Comments and Public Hearing

Consideration will be given to written comments or electronic comments which were received by February 14, 2005. A public hearing was held February 15, 2005.

The 403(b) Proposed Regulations

Bill Grossman, QPA

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INCOME EXCLUSION FOR CONTRIBUTIONS TO SECTION 403(b) CONTRACTS 403(b) plans will continue to have only three funding arrangements that permit contributions to be excluded from gross income:

SECTION 403(b) REQUIREMENTS INCLUDE ANNUITY NONFORFEITABILITY 403(b)(1)(C) states that the employee’s rights under the 403(b) contract must be nonforfeitable, except for failure to pay future premiums.

INTERACTION BETWEEN ERISA TITLE I AND SECTION 403(b) OF THE CODE Generally, neither a “governmental plan” as defined under 3(32) of ERISA nor a “church plan” as defined under 3(33) of ERISA is subject to ERISA.