Issues to Think About From the Proposed 403(b) Regulations
There are some major changes to 403(b) plan operation that 403(b) plan sponsors may wish to consider before they are incorporated into the final regulations, which are anticipated to become effective for 2006. These proposed changes include:

Effective date of the final regulations
As proposed, the final regulations will apply to 403(b) plans in plan years beginning after December 31, 2005. It is hoped that the IRS will consider the huge number of changes that are being implemented simultaneously and provide a remedial amendment period (RAP), as part of the final regulations. Qualified plans usually have a remedial amendment period of at least one year. Traditionally, the RAP has been extended at least for another year, and, may be extended again while plan sponsors struggle to complete the arduous restatement process. Considering that this is the first time a formal plan document will be required of a 403(b) plan, and the myriad changes occurring simultaneously; a RAP is critical if this is to be implemented efficiently.

The Written Plan Document
The proposed regulations call for a written plan document with many of the same requirements of a qualified plan built into the document (the IRS has made it clear that there will be no determination letter program for 403(b) plans at this time).

The major open issue is whether a 403(b) plan that was never before considered to be covered by Title I of ERISA would now become an ERISA-covered plan because of the existence of a plan document. If the answer is yes, such plans would have to comply with new disclosure and reporting requirements and other ERISA issues such as fiduciary requirements and Form 5500 filings. Further guidance is needed from both the IRS and the DOL to clarify this issue.

The proposed written plan requirement would bring a compliance need to satisfy the plan document requirements in form and operation. The document would also need to include all the rules for eligibility, benefits, limitations, time and form of distributions, and contracts available under the plan. Although a plan does not have to consist of a single plan document, further precise clarification of this concept is expected. However, it would appear that providing a supplemental document, which contains the plan provisions that are not included in an annuity contract, would be the way this concept will be applied.

Life Insurance
Simultaneously, the IRS used the proposed regulation to announce that life insurance or endowment contracts and accident, health, property, casualty and liability contracts may not be issued as a 403(b) annuity contract effective from February 14, 2005. Such insurance purchased before that date remains acceptable as part of the annuity contract. This is a major retroactive change that is effective before the regulations are finalized.

Required Minimum Distribution
The pre-1987 balance in a 403(b) plan has been grandfathered so that those amounts would not be subject to minimum distribution until the 403(b) individual attained age 75. The proposed regulations were silent as to whether this will still be permitted under the final regulations. Considering its effect on long-term plan participants, it is hoped that this will be clarified in the final regulation. Absent guidance, the grandfather will likely continue.

Distribution Restrictions on Annuity Contract Amounts Not Attributable to Elective Deferrals
The proposed regulations introduce a restriction on the distribution of annuity contract amounts, not attributable to elective deferrals, by requiring severance from employment or the completion of a period of service before an in-service distribution is permitted. This is an interesting issue for two reasons. First, Code Section 403(b) does not currently contain this restriction. Secondly, to introduce this change retroactively to funds that were contributed before this restriction would operationally be a cutback of a distribution option.

Universal Availability: Changes to Exceptions
The proposed rules override IRS Notice 89-23, which provided exceptions to the universal availability requirement. Thus, the proposed regulation will eliminate the following exceptions: visiting professors for up to one year under certain circumstances, employees affiliated with a religious order who have taken a vow of poverty, employees who make a one-time election to participate in a governmental plan instead of a 403(b) plan and employees covered under a collective-bargaining agreement. The ability to exclude collective bargaining employees on the basis of good faith negotiations is a statutory exclusion for qualified retirement plans, and it would again be inconsistent, if the final regulations for 403(b) plans do not parallel the qualified plan rules in this case. The same would be true for the elimination of the other traditional exclusions provided under Notice 89-23, which have proven to be of administrative value.

403(b), 403(c) and Vesting
The proposed regulations would subject non-vested amounts in a 403(b) plan to taxation under 403(c) and would treat such amounts as a separate account until they become fully vested. A better solution might be to treat nonvested amounts simply as non-vested amounts (as treated under the qualified plan rules). Whether this approach will be adopted remains to be seen.

Plan Termination
If finalized, for the first time employers would have the ability to terminate a 403(b) arrangement, distribute the plan assets and set up a 401(k) plan in its stead. However, how this will be applied to group annuity contract plans and whether termination distributions may remain in 403(b) contracts or must be rolled over, are some of the issues that need to be clarified in the final guidance.

A Year of Service Defined
A year of service definition was added to the proposed regulation in order to determine how to make contributions for former employees for the 5-year period after severance, as well as to determine a year of service that is counted towards the 15 years of service for eligibility for the special catch-up contributions. The participant’s compensation earned in the last year of service will be used for determining the 5-year post-employment contribution. The year of service definition is unique to 403(b) plans. (We will address this more in a future article.)

Ordering of catch-up contribution usage
An issue arises for an individual who is eligible for both the over age 50 catch up contribution and the 15 years of service catch up contribution. For such an individual, the 15 year catch-up is used first, and only if that amount (maximum $3,000) is fully used for the applicable year, is the over age 50 catch up available to be used. If the final regulations confirm this proposal, it will be critical to educate eligible individuals about how the two catch-up options interact, because the over age 50 catch-up is lost if the individual is unable to take advantage of both options. This ordering may cause some to be unable to use both catch-up amounts.

Excess annual additions
The proposed regulations state that excess annual additions should be treated as a taxable 403(c) contribution. It is hoped that the final regulations may provide additional ways to treat them as under qualified plans (such as return of the excess or placing it in a suspense account until next year).