With the issuance of comprehensive regulations for the first time since 1964, the compliance world for 403(b) plans is drastically changing. Clearly, the Internal Revenue Service is beginning to treat 403(b) plans in a very similar fashion as 401(k) plans. With regulations becoming effective January 1, 2009, employers with 403(b) plans and their advisors must gear up for a radical change in the way they approach compliance with the complex rules now governing their plans.
This article summarizes the basics of the new rules and makes some important observations. We emphasize the need and importance of having a comprehensive plan document that controls the operation of the plan since that document must be in place by the end of 2008. With these new rules, the IRS has now put considerably more responsibility in the hands of the employers maintaining 403(b) plans. The consequences of noncompliance have become much more significant.
In general, a 403(b) plan is a special type of retirement plan available to employees of certain tax-exempt and educational organizations. Employers must "fund" the plan using either annuity contracts or custodial accounts. Special rules apply to church plans.
While 403(b) plans are now very similar to 401(k) qualified plans, there are important differences. As noted above, 403(b) plans are limited to employees of certain tax-exempt and educational organizations, while 401(k) plans are available to all employers (except state and local governments). 403(b) plans are limited in the investment vehicles they may use to fund the plan, while 401(k) plan have fewer funding restrictions. The nondiscrimination rules differ in that the ADP test for elective deferrals does not apply to 403(b) plans, but plans are subject to a special "universal availability" rule for elective deferrals. There are other differences as well, including the tax consequences of failing the rules, the available definitions of compensation, special deferral limits and the employer aggregation requirements.
In determining whether an employer would be better served maintaining a 403(b) plan or a 401(k) plan, all of the above factors must be taken into account. However, with the imposition of the new rules under the 403(b) regulations, employers should reconsider the most appropriate plan design - 403(b) plan or 401(k) plan - for their employees.
The new regulations require 403(b) plans to comply with the applicable requirements in both form and operation. This means that every 403(b) plan must have a written plan document. In the past, it has not been clear whether a 403(b0 plan needed a written plan document. Now we know for sure.
Under the new rules, the plan document must include all of the material provisions relating to eligibility, benefits, applicable limits, funding vehicles, the timing and form of benefit distribution and the minimum distribution requirements. The plan also must set forth certain optional features, such as the availability of in-service withdrawals, loans, transfers and rollovers.
A 403(b) plan must take the form of a defined contribution plan, with individual accounts for the participants. The plan must also allocate the responsibilities for performing the administrative functions, including processing and approving withdrawals. The plan cannot assign responsibilities to the participants.
While the regulations allow for a 403(b) plan to be comprised of multiple documents, at the very least, an "umbrella" document coordinating the multiple documents is appropriate. For ease of administration and to avoid conflicts between multiple documents, a comprehensive single document may be the best approach.
The IRS has issued a "model plan" 403(b) document for use by public schools. The IRS states that the language in this model plan may be used by other 403(b) plans. However, the model document and its provisions will have limited usefulness because of the plan design features. Only very restrictive plan designs will fit onto the model.
Like 401(k) plan. 403(b) plans are subject to the 415 limit and the elective deferral limit. However, special rules do apply to 403(b) plans.
The annual 415 limit ($46,000 for 2008) applies to all "annual additions" made to the plan on behalf of participants. Annual additions include employer contributions, matching contributions, pre-tax and after-tax employee contributions, Roth contributions and forfeitures allocated to a participant's account. Rollovers do not count towards this limit. While all annual additions to all 403(b) plans maintained by the employer must be aggregated in determining whether a participant satisfies the 415 limit, annual additions to a 401(a) qualified plan maintained by the employer generally are not taken into account under the 403(b) plan.
The elective deferral limit ($15,500 for 2008) applies to the pre-tax and Roth deferrals that a participant makes to a 403(b) plan. For this limit, deferrals made to a 401(k) plan are taken into account.
In addition to the age-50 catch-up elective deferral contributions ($5,000 in 2008), some 403(b) plans allow a special catch-up elective deferral for employees of "qualified organizations." Not all tax-exempt organizations fall within the definition of qualified organization so not all 403(b) plans are allowed to incorporate this special catch-up allowance. A plan must specify whether it wishes to allow participants to make age-50 catch-up contributions and/or special catch-up contributions.
Since tax-exempt employers generally are not "owned" in a similar fashion as for-profit employers, the IRS provides special controlled group rules for tax-exempt organizations. Generally, employers are considered controlled if at least 80% of the directors or trustees of one organization are either representatives of, or directly or indirectly controlled by, the other organization. These rules will come into play in determining whether contributions are aggregated for certain purposes under the 403(b) plan.
A special rule under 403(b) allows employers to continue to make contributions on behalf of a former employee. Under this rule, a former employee is deemed to have monthly compensation, based on his or her most recent period of service, for the five years after termination of employment. This does not allow a participant to continue to make elective deferrals into the plan, but does allow the employer to make contributions without violating the contribution limitations. A plan must specify that the employer intends to continue to make employer contributions on behalf of former employees.
As previously mentioned, 403(b) plans are exempt for the ADP nondiscrimination test applicable to elective deferrals made to a 401(k) plan. Thus, there is no restriction, up to the elective deferral limit ($15,500 in 2008), on elective deferrals that go into a 403(b) plan on behalf of highly compensated employees. However, a special universal availability rules applies to 403(b) plans.
Under the universal availability rule, a 403(b) plan must permit all employees (with limited exclusions) to make elective deferrals if any eligible employee may make elective deferrals. This includes the right to make Roth contributions. This rule differs from the coverage rule applicable to 401(k) plans.
Generally, church plans are exempt from the nondiscrimination and universal availability rules applicable to 403(b) plans.
The distribution requirements for a 403(b) plan differ slightly depending on whether the plan is funded with annuity contracts or custodial accounts. For all 403(b) plans, elective deferral accounts cannot be distributed until the earliest of: (1) severance from employment; (2) death; (3) a permissible hardship; (4) disability; or (5) the attainment of age 59 ½.
For a custodial account 403(b) plan, contributions other than elective deferrals can only be distributed upon severance of employment, death, disability and attainment of age 59 ½. These restrictions on the distribution of contributions other than elective deferrals do not apply to annuity contract 403(b) plans. Annuity contract 403(b) plans may distribute on the occurrence of any specified event. Whether a custodial account or annuity contract 403(b) plan, the plan must specify the permissible distribution events.
Like 401(k) plans, 403(b) plans are subject to the minimum distribution rules that generally require that participants begin receiving distributions from the plan by April 1 following the year the participant attains age 70 ½ or retires, if later.
The regulations now clarify that an employer may terminate a 403(b) plan. Termination will allow for distribution of the plan's assets without on the otherwise applicable distribution events. Upon distribution, a participant is able to rollover the 403(b) distribution to any eligible plan, including another 403(b) plan, a qualified plan or an IRA.
The regulations set forth several rules applicable to contract exchanges and transfers between plans. Under new requirements, contract exchanges within a 403(b) plan are permitted provided the plan allows for such an exchange, no benefits are lost by the participant, the new 403(b) contract imposes the same distribution restrictions that applied under the prior contract and the employer enters into an information sharing agreement with the issuer of the other contract under which the employer and the issuer will provide each other with certain compliance information.
The rules for 403(b) plans have become more complex and compliance more important. The IRS is likely to focus more efforts on ensuring that 403(b) plans meet their legal and regulatory requirements, which may include increasing 403(b) plan audits. There is discussion of the IRS starting a plan approval procedure similar to the one for prototype and volume submitter qualified plans. This would help ensure that the plan documents satisfy the plan documentation requirements. In the meantime, 403(b) plan sponsors and their advisors must now focus their attention on the new rules and try their best to comply.
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