In late July 2007, the Internal Revenue Service dropped a bombshell in the form of new 403(b) regulations, which present great challenges for public school districts and community colleges. The challenge for employees participating in 403(b) plans is the new environment created by the requirement that 403(b) programs in existence since 1961 suddenly are required to be part of one plan.
Because the final regulations and the subsequent revenue procedure were put into place well before certain other necessary guidance was available (such as a plan document prototype program, and correction procedures specially focused on the changes in the final regulations), various organizations filed comment letters with the IRS (among them were the Association of School Business Officials International) requesting an extension of the general effective date of the final regulations.'
Unfortunately, the IRS responded with Notice 2009-3 on December 11, 2008, which we might describe as “too little” and “too late.” In that notice, the IRS notes:
1. An employer can wait until December 31, 2009, to actually adopt the written plan IF
2. During 2009, the employer conforms and operates the 403(b) plan under a “reasonable interpretation” of the final regulations AND
3. The employer uses the principles of the Employee Plans Compliance Resolution System revenue procedure (the current version is outlined in Revenue Procedure 2008-50) to correct any operational failures occurring in 2009.
Thus, the simple adoption of the written plan is likely the easiest of the employer’s new responsibilities to meet. All of the other requirements of the final regulations apply as of the original effective date, and failure to adopt and conform to the terms of a written plan as of January 1, 2009, as originally required could create some real headaches for employers. For example, screening and eliminating the insurance companies and mutual fund companies that cannot or won’t cooperate with the employer’s new compliance responsibility should have taken place before January 1, 2009. Any employee making contributions on and after January 1, 2009, to an insurance or mutual fund company that is not subsequently included in the written plan risks “loss of the exclusion”—meaning the account is not a 403(b) account and is subject to disqualification.
Also, failure to conform to the terms of the plan is potentially a disqualification “failure.” Thus, if the written plan has not yet been adopted, there could be some real difficulties conforming to terms that may or may not be in place.
The regulations make it difficult in many cases to comply, because there were millions of individually owned 403(b) accounts in existence prior to the general effective date of the final regulations (January 1, 2009, for most employers). The real challenge lies in identifying accounts that may have been accumulated through one’s current employer with issuers that have not had “payroll slots” in recent years—and/or accounts that may have been properly transferred to issuers that never held a payroll slot with the employer. In other words, there was no possible way for the employer to identify all of the accounts that may have been “informally” attached to the employer’s plan.
Some employers have made hasty decisions since the new rules were implemented. Even more unfortunate, some of those decisions were based on advice from consultants who did not know that public education employers are exempt from any requirements under Title I of the Employment Retirement Income Security Act (ERISA). Additionally, some employers have noted they have terminated their 403(b) plans; however, they may not have complied with the requirements in doing so. Employers will want to be aware of these issues following implementation.
Here are answers to some important questions you might have.
Are public education employers fiduciaries because of the final 403(b) retirement regulations?
No! Only state statutes could impose such responsibilities, and it has been reported that in most states such responsibilities are generally applied under state trust laws. Because 403 b) assets—unlike401(a) pension plans, 401(k) plans, and 457(b) deferred compensation plans— are not required to be held in trust, there generally is no applicability of such state statutes. Obviously, every employer will want to be familiar with the statutes in its specific state; however, if a state statute imposes a fiduciary role on the public school district, the final regulations have nothing to do with that.
But exercise caution. Unless the employer wishes to be viewed as having assumed a fiduciary role, it may be important not to take actions that could create a fiduciary role. Such actions being seen include the appointment of an investments committee to monitor and assume oversight of the investments in the 403(b) plan, and choosing a single source provider of investments where the selection criteria are based on such things as performance. Any employer considering such actions should consult experienced legal ounsel.
Do the regulations cause public school districts and community colleges to be subject to ERISA?
Absolutely not! Governmental employers are exempt from ERISA coverage for any and all of their retirement plans. Thus, there is no action that a public education employer could take that would cause ERISA to apply, including the making of nonelective employer contributions to the 403(b) plan.
Can 403(b) plans be successfully terminated to avoid compliance?
Some employers have asked whether the 403(b) plan can simply be terminated to avoid compliance with the final regulations. However, one of the major issues in successfully terminating a 403(b) plan is that all assets must be distributed from the plan as soon as administratively practical. While the regulations do not speak to the meaning of “as soon as administratively practical,” verbal comments by the IRS tell us that assets should be distributed within a period of one year following plan termination.
The problem in distributing these assets is that the bulk of them may be held in annuity contracts or custodial accounts, which are individually owned by each employee who is participating. The underlying contractual language in those accounts may (and often does) prevent the insurance or mutual fund company from distributing those accounts without the authorization of each participant. (This is thought to include all non-grandfathered “orphan” accounts held by current and former employees and their beneficiaries.) Thus, any employer that has decided to terminate a 403(b) plan must ascertain that, in fact, every account held in the plan has been properly distributed.
Once assets have been distributed, each participant is eligible to roll over the values (companies must provide a direct rollover option for employees) to an Individual Retirement Account or to another workplace plan, if one exists. However, if all assets are not finally distributed, those employees who did elect to roll over their accounts without another qualifying event, such as attainment of age 59? or severance of employment, will have an ineligible rollover (subject to taxes and potential penalty taxes), because the IRS will consider the plan not to have been successfully terminated.
What is ahead in 2009 and beyond?
Employers will want first to carefully deal with the important steps necessary to ensure a compliant 403(b) plan. Then they should plan to oversee the activities that the providers of annuity contracts and custodial accounts are engaged in to cooperate with the compliance. Even if the employer chose to use a third party administrator to handle the transactions necessary for compliance, it will be important to monitor their activities as well. While all of the employers’ oversight activities will become easier over time, there will be problems to be resolved. Additionally,employers should continuously communicate with their employees who have been impacted by the final regulations. The message from employer to employees should be that all of the changes necessary to comply are being accomplished to protect the tax status of all of the 403(b) accounts held under the plan.
Historically, 403(b) assets in the K14 market segment have been held in individually owned annuity contracts and custodial mutual fund accounts, and employers have not assumed the role of total responsibility for all transactions taking place in 403(b) programs. The treasury department and the IRS decided that is necessary to “reconstruct” 403(b) arrangements to ensure compliance with certain rules and requirements. Previously, the issuers of annuities and custodial accounts had managed such transactions as loans and hardship withdrawals, following the Internal Revenue Code and related regulation—however, there was no “overall” monitoring of transactions such as loans and hardship withdrawals among various issuers and across lines among various plans sponsored by the employer. (For that reason, the IRS has reported a lack of compliance as they conduct audits of 403(b) arrangements.)
Some Relief in Guidance
Relief came in the form of Revenue Procedure 2007-71 posted in late November 2007 in which the IRS provided some grandfathering of “old” 403(b) accounts. Unfortunately, the guidance did not grandfather all accounts in existence before the general effective date of the regulations, however, it does help by specifically eliminating any employer responsibility for the following 403(b) accounts:
1) Any account transferred under the rules of Revenue Ruling 90-24 on or before Sept. 24, 2007 is not required to be made a part of the current employer’s plan. This is true whether a current employee or a former employee held the account. Thus, employers have no responsibility whatsoever for these accounts, and employees or former employees holding these accounts may deal directly with the insurance or mutual fund company for any and all transactions. It is important to note; however, that no additional contributions can be made to these grandfathered accounts—if new contributions are made, then, the grandfathering is lost.
2) Any account held by a current employee with an insurance or mutual fund company that received no contributions for any employee on or after Jan. 1, 2005, and, on Jan. 1, 2009 is not a part of the employer’s plan. In other words, the issuer would have relinquished the payroll slot on or before Dec. 31, 2004. Again, employees can deal directly with the issuers for transactions and the employer has no responsibility for these accounts (again, provided that no additional contributions are made).
Thus, all other 403(b) accounts held by current or former employees (or their beneficiaries) are not grandfathered, and employers were required to make a reasonable good faith effort to include them in the 403(b) plan effective on Jan. 1, 2009.
Best Practices to Avoid “Failures”
It is hoped that readers will have already adopted, and are following the terms of the plan put into place. If not, it is hoped that employers, at the very least, screened and eliminated the issuers that signaled they cannot or will not cooperate with the employer’s compliance practices and procedures. If neither of those things has occurred, the best possible action is to implement the written plan, and de-select the issuers that cannot be included in the plan. Then we can hope for additional guidance on the status of any accounts in which contributions were made to issuers on and after Jan.1, 2009 to any provider that the employer later could not include in the written plan. Under 1.403(b)-3 of the final regulations, and, in the absence of additional guidance, it would appear those accounts will not receive the “exclusion” for those contributions, and thus, would be taxable.
“Failure” Means ?
The good news for district administrators and governing board members is that there are only three potential plan failures which would cause disqualification of the employer’s entire 403(b) plan:
1) Failure to adopt and operate under the terms of the written plan, and,
2) Failure to make the voluntary salary reduction contributions available to virtually every employee. The most simple way to avoid this is to permit all common law employees to participate if they will contribute $200 or more per year. Many part time employees will not choose to participate in any event, however, by opening the opportunity to all employees, there is no risk of a violation. And, an important part of this requirement is to provide meaningful opportunity for employees to enroll or make changes in contributions levels or providers of product and investment options. Thus, employers will want to be sure that opportunity is given, more often, of course, is better for employees.
3) Ineligible employer—meaning that the employer was not eligible to adopt a 403(b) plan in the first place. Note that, in fact, public education employers absolutely are eligible to adopt 403(b) plans.
Eleanor Lowder is a master certified retirement specialist and author. She does not provide legal or tax advice, nor should anything in this article be used to avoid the payment of income taxes. She can be reached at firstname.lastname@example.org.