The IRS issued its long-awaited guidance on how a Section 403(b) plan may be terminated and whether distributions upon such plan termination are includable in the participant’s gross income. A Section 403(b) plan is a type of retirement plan offered to employees of tax-exempt organizations and public educational institutions and typically funded by annuity contracts and/or custodial accounts.
The 2007 final regulations governing Section 403(b) plans allowed such plans to contain provisions for plan termination and for the distribution of plan benefits upon plan termination, but did not provide any details on the termination process. Revenue Ruling 2011-7 provides helpful guidance, illustrating the steps required to terminate a Section 403(b) and clarifying that the delivery of a fully paid individual annuity contract or certificate with respect to a group annuity contract is treated as a distribution of plan assets.
Steps to Terminating a Section 403(b) Plan
According to the IRS guidance, a 403(b) plan may be terminated as follows:
- The plan must include a provision allowing the plan sponsor to terminate the plan, or be amended to so provide;
- The employer must adopt a binding resolution to cease future contributions and to terminate the plan as of a specified date;
- All contributions must fully vest upon the plan termination;
- All plan participants must be notified of the plan termination and provided with information on the tax consequences of distribution, including the availability to rollover any distributions if the plan document and investment vehicle allow.
- The employer cannot make contributions to any other 403(b) plan during the 12-month period following distribution of all assets from the terminated plan.
- All plan assets must be distributed as soon as administratively practicable following the date of termination. Distributions may be made in the form an individual annuity contract, by issuing a certificate evidencing the participant’s benefit under a group annuity contract or cash.
Tax Treatment of Distributions
The Revenue Ruling clarifies the tax treatment of distributions from a terminating 403(b) plan. Generally, a distribution from a terminating 403(b) plan will be included in the participant’s gross income at the time of the distribution, unless it is rolled over to another tax-qualified retirement plan, such as an IRA or another employer’s eligible retirement plan, within 60 days following the distribution.
Certain distributions, however, may be made from a terminating 403(b) plan without triggering a taxable distribution to the plan participant. According to the Revenue Ruling, if the 403(b) plan delivers to the participant a fully paid individual annuity contract or an individual certificate for a group annuity contract, the amounts held in the individual or group contract are not taxable to the participant until such amounts are actually paid to the participant, provided that the contract continues to satisfy the applicable requirements set forth in Section 403(b) of the Code.
This Revenue Ruling provides helpful guidance for employers that wish to terminate their 403(b) plans. A major issue that is not addressed by the Revenue Ruling is how to ensure that an individual or group annuity contract remains in compliance with 403(b) in situations where the annuity contract or individual certificate is distributed upon plan termination. For example, how will a participant receive a loan from the annuity contract if the employer is no longer responsible for certifying the participant’s eligibility? Will the employer have any residual responsibilities under the contract following the plan’s termination. Further, are there any fiduciary issues under Title I of ERISA?