The Department of the Treasury recently issued final regulations with respect to tax-sheltered custodial accounts and annuity contracts governed under Section 403(b) of the Internal Revenue Code (referred to collectively as "403(b) arrangements"), that are generally effective in taxable years beginning after December 31, 2008 (one year later than the original effective date in the proposed regulations). As was the case in the proposed regulations, these final regulations are a comprehensive update of the existing law governing 403(b) arrangements, the primary purpose of which is to organize and consolidate the Section 403(b) guidance issued over the past 43 years, to override prior guidance that no longer applies and to reduce the extent to which 403(b) arrangements differ from other salary reduction arrangements (e.g., 401(k) and 457(b) plans). The final regulations provide employers sponsoring such arrangements with much-needed guidance to ensure compliance with Code Section 403(b) and offer such employers significant flexibility in complying with this guidance. This article highlights the possibilities the new regulations offer to sponsors of 403(b) arrangements and their service providers and provides a roadmap of the most important legal and practical issues addressed by the final regulations.
403(b) Arrangements Generally
A tax-sheltered annuity arrangement under section 403(b) of the Internal Revenue Code (the "Code") is a retirement plan for employees of public schools, employees of certain tax-exempt organizations (i.e., Code Section 501(c)(3) organizations) and certain church employees and ministers. Under a 403(b) arrangement, employers may purchase for their eligible employees annuity contracts or establish custodial accounts invested only in mutual funds for the purpose of providing retirement income. Annuity contracts must be purchased from a state-licensed insurance company and the custodial accounts must be held by a custodian bank or IRS-approved non-bank trustee/custodian. The annuity contracts and custodial accounts may be funded by employee salary deferrals, employer contributions, or both. Although not subject to the qualification requirements of section 401 of the Code, some of the requirements that apply to qualified plans also apply, with modifications, to 403(b) arrangements. For example, the final regulations provide that employer contributions and certain elective deferrals made to such 403(b) arrangements are only excluded from a participant's gross income if certain availability, nondiscrimination and distribution requirements are satisfied.
Written Plan Requirement
The final regulations retain the requirement set forth in the proposed regulations that all 403(b) arrangements must be issued pursuant to a written plan document that includes specific terms and conditions and must be in place by January 1, 2009. This master plan document must include all material provisions on eligibility, benefits, contribution limits, available investment contracts and accounts, loans, hardship withdrawals, distributions, fund transfers, rollovers and allocation of compliance responsibilities. This is a significant change from existing law, given that, under the current guidance, only 403(b) arrangements that are subject to the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), are required to have a written plan document; now all 403(b) arrangements are required to be maintained pursuant to a written plan.
In an important response to comments to the proposed regulations, the preamble to the final regulations clarifies that the plan document need not be a single written instrument and may incorporate documents by reference. Accordingly, under the final regulations, an employer can create a wraparound document that lists and incorporates by reference the terms of the investment vehicles available under the plan. (The Department of Labor confirms in Field Assistance Bulletin 2007-02 that it expects most 403(b) arrangements that intend to comply with the DOL's safe harbor exemption, discussed below, to utilize such an arrangement). In addition, the plan document itself may allocate responsibilities for administration and compliance matters to others; however, the regulations retain the requirement that the plan sponsor is responsible for monitoring such individuals. The final regulations impose the additional requirement that documents incorporated by reference not conflict with the plan and that, to the extent there is a conflict, the plan will control. Accordingly, employers and other sponsors of 403(b) arrangements should now (to the extent they do not already do so) routinely request copies of all documents related to their 403(b) arrangements and instruct vendors that the terms and conditions of their documents are subordinate to the terms of the master plan document.
Written Plan Requirement and ERISA Plans
When the proposed regulations were issued and the notion of implementing a written plan document requirement for all 403(b) arrangements was initially discussed, some practitioners feared the imposition of a written plan requirement would negate the effectiveness of the DOL's "safe harbor" regulation, which provides an exemption from Title I of ERISA for certain 403(b) arrangements maintained by tax-exempt employers. The safe harbor states that a 403(b) arrangement, funded solely through salary reduction agreements or agreements to forego an increase in salary, are not "established or maintained" by an employer under section 3(2) of ERISA and, therefore, are not "employee pension benefit plans" subject to Title I of ERISA, provided that certain factors are present. These factors are as follows: (1) participation of employees is completely voluntary, (2) all rights under the annuity contract or custodial account are enforceable solely by the employee or beneficiary of such employee, or by an authorized representative of such employee or beneficiary, (3) the involvement of the employer is limited to certain optional specified activities, and (4) the employer receives no direct or indirect consideration or compensation, in cash, or otherwise, other than reasonable reimbursement to cover expenses properly and actually incurred in performing the employer's duties pursuant to the salary reduction agreements. One of the practitioners' primary concerns was that the imposition of a plan document requirement would increase an employer's administrative and operational involvement in 403(b) arrangements such that it could not comply with the requirements set forth above.
One day after the release of the final regulations, the DOL issued Field Assistance Bulletin 2007-02, which provides guidance on the effect of the final 403(b) regulations on the status of 403(b) arrangements under the DOL safe harbor. FAB 2007-02 explicitly provides that the fact an employer creates a master plan does not in and of itself make the 403(b) arrangement subject to ERISA. However, the DOL does recognize that the final regulations give employers "considerable flexibility in shaping the extent and nature of their involvement" in such 403(b) arrangements and cautions that the question of whether such an arrangement is within the safe harbor is a factual question that can only be resolved on a case-by-case basis.
Prior to the issuance of the proposed 403(b) regulations, neither the Code nor IRS guidance permitted sponsors of 403(b) arrangements to terminate such arrangements and to distribute all 403(b) plan assets unless each of the participants also has a distributable event (e.g., termination of employment). Instead, practically speaking, sponsors of 403(b) arrangements were generally left with only one option: freeze the 403(b) arrangement and stop contributions from being made to such arrangement. The final regulations adopt the provisions of the proposed regulations to explicitly allow an employer to amend its 403(b) arrangement to contain a termination provision that both permits termination of the arrangement and authorizes distribution of all benefits accumulated under the arrangement on account of such termination. Distributions may be rolled over to another 403(b) arrangement, a 401(k) plan (if permitted thereunder) or an individual retirement account. However, the final regulations only permit distributions on termination of a 403(b) arrangement if the employer (taking into consideration all entities treated as the employer on a controlled-group basis as of the date of termination) does not make contributions to another, separate 403(b) arrangement within twelve months of the date of termination of the 403(b) arrangement.
The final regulations also include a special transition date rule which provides that employers sponsoring 403(b) arrangements may terminate such arrangements prior to the effective date of the regulations (generally, January 1, 2009) if such 403(b) arrangements satisfy all of the other requirements of the final regulations, with the exception of the "in writing" requirement.
The Universal Availability Rule
403(b) arrangements that allow employee contributions must satisfy the "universal availability" requirement, which provides that if any one employee of an employer that offers a 403(b) arrangement is permitted to make elective deferrals, all employees of that employer must also be permitted to make such elective deferrals.
The preamble to the proposed regulations requested comments regarding exclusions of certain employees for purposes of this rule that have been permitted under transitional guidance issued by the IRS in 1989. Pending regulatory guidance, Notice 89-23 had permitted the exclusion of the following classes of employees for purposes of a Section 403(b) arrangement's application of the universal availability rule:
- Employees covered by a collective bargaining agreement.
- Employees who make a one-time election to participate in a governmental plan, instead of a 403(b) arrangement.
- Certain visiting professors.
- Employees of a religious order who have taken a vow of poverty.
The final regulations do away with the above exclusions and therefore require that employers take such employees into account in their application of the universal availability rule. However, there is a transition rule which generally permits 403(b) arrangements that currently exclude one or more of the above classes of employees to continue excluding such employees until taxable years beginning on or after January of 2010.
Transfers and Exchanges
The final regulations set forth more liberal conditions under which one annuity contract may be exchanged for another contract on a nontaxable basis and such exchange will be treated as a mere change of investment within the same plan, if certain conditions are satisfied. Such conditions include: (1) the 403(b) arrangement provides for the exchange, (2) the participant's accumulated benefit after the exchange is as great as the benefit prior to the exchange, (3) the original contract imposes distribution restrictions at least as stringent as those under the new contract and (4) the employer enters into an information-sharing agreement with the issuer of the new 403(b) contract.
These additional requirements (in particular the requirement to enter into an information-sharing agreement) are intended to address situations where assets have been transferred to an insurance carrier or mutual fund that has no subsequent connection to the plan or the employer, in an attempt to increase practical compliance with the distribution restrictions and universal availability requirements under Section 403(b) of the Code. The final regulations also permit the IRS to issue revenue rulings authorizing exchanges in other cases in which the resulting contract has procedures that are determined to be reasonably designed to ensure compliance with certain specific requirements of section 403(b).
The final regulations clarify the controlled-group rules applicable to tax-exempt employers. The controlled-group rules would generally provide that if two or more employers are linked by 80 percent or greater common ownership (i.e., brother-sister entities with a common parent or parent-subsidiary entities), regardless of whether the organizations are incorporated, they are treated for employee benefit purposes as a single employer. Private letter rulings in the past indicated that, because of the lack of "common ownership" in tax-exempt organizations, there should be a different test to govern such entities, and generally found that common control would exist between a tax-exempt organization and another organization if at least 80 percent of the directors or trustees of one organization were either representatives of, or directly or indirectly controlled by, the other organization. The 2004 proposed regulations also set forth this "80 percent board control" test and permitted tax-exempt organizations to choose to be aggregated (so-called "permissive aggregation") if they maintained a single plan covering one or more employees from each organization and the organizations regularly coordinated their day-to-day exempt activities. These rules were subject to an overall anti-abuse rule. The final regulations explicitly retain the "80 percent board control" test and the other controlled-group rules described in the 2004 proposed regulations.
Limitation on Contributions
The final regulations retain the rule in the proposed regulations that the Section 403(b) exclusion from income applies only to the extent that the employer contributions for a participant do not exceed the Code Section 415 limits for defined contribution plans ($45,000 in 2007; $46,000 in 2008). The regulations provide that, to the extent such limits are exceeded, the excess will be treated as a nonqualified annuity contract and the remaining portion of the contract will be a (compliant) 403(b) arrangement, provided that the issuer of the contract separately accounts for the portion which represents the excess and for the Section 403(b) portion. The final regulations also retain the requirement that the Section 402(g) limitations on elective deferrals (i.e., $15,500 in 2007 and 2008) apply to Code Section 403(b) elective deferrals, which rules are generally the same as the rules for cash or deferred arrangements under Section 401(k) of the Code.
Catch-Up Contributions and Roth Contributions
A 403(b) arrangement may provide for a catch-up contribution for a participant who is age 50 or older (up to $5,000 in 2007) and an additional, special catch-up contribution for a participant who has at least fifteen years of service. Under the special section 403(b) catch-up limit, the section 402(g) limit is increased by the lowest of the following three amounts: (i) $3,000; (ii) the excess of $15,000 over the amount not included in gross income for prior taxable years by reason of the special section 403(b) catch-up rules, plus elective deferrals that are designated Roth contributions, or (iii) the excess of (A) $5,000 multiplied by the number of years of service of the employee with the qualified organization, over (B) the total elective deferrals made for the employee by the qualified organization for prior taxable years. For this purpose, a "qualified organization" is an eligible employer that is a school, hospital, health and welfare service agency (including a home health service agency). The final regulations clarify that if a participant is eligible for both types of catch-up contributions, the employer must apply the special fifteen years of service contribution first.
The final regulations also provide that Roth contributions can be made to a 403(b) arrangement.
Employers and other sponsors of 403(b) arrangements will be generally relieved by the decisions the Department of Treasury reaches in the final 403(b) regulations. While these comprehensive regulations will require such employers and sponsors to substantially modify their existing practices, they offer clarity on a number of issues that were left uncertain after the passage of the proposed regulations.