FIS Relius
So Now We Can Terminate a 403(b) Plan, But How Do We Do It? 3/22/2005
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403(b) plans have always occupied a unique place in the retirement plan universe – somewhere between a qualified plan and an IRA. Unlike a qualified plan, an individual participant may establish a mutual fund custodial account or annuity contract (“individual accounts”) over which the employer has no control or responsibility other than to forward the elective deferrals and other contributions. Some practitioners have described this format of 403(b) plan as operating like an IRA because (1) the participant’s relationship is with the financial institution offering or holding the investments and not with the employer, and (2) the participant can continue the 403(b) account irrespective of termination of employment and irrespective of the employer’s continued existence. Other employers operate their 403(b) plans more like a qualified plan in that they establish a pooled arrangement (e.g., group annuity contract or pooled mutual fund accounts). Both 403(b) formats continue to be perfectly acceptable under the new 403(b) regulations. However, the format becomes significant if the employer decides to terminate the plan.

Prior to the issuance of the new 403(b) regulations, the 403(b) rules did not address plan termination, because there was little need to do so. When the IRS drafted the regulations 40 years ago, the IRS considered Code §403(b) as creating a program rather than a plan. Furthermore, participants almost universally established individual accounts over which the employers had no control or responsibility. Therefore, the IRS felt no need to establish procedures for terminating 403(b) “plans” since, other than the statutory distribution restrictions, a participant had effective control over his or her portion of the plan. In recent years, as 401(k) arrangements became more popular, 403(b) plan sponsors began to pattern 403(b) plans after 401(k) plans (i.e., as pooled arrangements). Congress also made statutory changes which brought 403(b) plans closer in line with 401(k) plans. Employers also began making employer contributions to such plans. Inevitably, employers establishing such plans needed or wanted to terminate the plans. Although no practitioners questioned an employer’s ability to cease contributions to such plans, the 403(b) rules did not specify plan termination as a distribution event. Without the ability to make complete distributions from the plan, employers would have to continue filing Form 5500. In short, the plan termination was more akin to freezing the plan and there was no way for an employer to end its plan responsibilities. Note: Generally, only 403(b) plans that include employer contributions need to file a Form 5500 (i.e., elective-deferral only 403(b) plans generally are exempt). Furthermore, church and government 403(b) plans are exempt from filing Form 5500 irrespective of whether the plans include employer contributions.

The new 403(b) regulations, for the first time, address plan termination. Unfortunately, the new regulations fail to recognize the different 403(b) formats (pooled or individual accounts) and are not coordinated with the Department of Labor’s Form 5500 requirements. Under the new regulations, an employer may incorporate provisions into its 403(b) plan to permit plan termination and distribution of the participants’ accounts. The plan may permit distributions upon plan termination only if the employer does not make contributions to another 403(b) during the 12-month period following the distribution of all assets from the terminated plan. However, if, for the 12-month period beginning before the termination and ending 12 months after the final distribution of assets from the terminated plan, fewer than 2% of the employees who were eligible under the 403(b) plan are eligible under the other 403(b) plan, the employer may disregard the other 403(b) plan and proceed with distributing under the terminating 403(b) plan. These “successor plan” rules parallel the rules applicable to terminating 401(k) plans. In order for the IRS to consider a 403(b) plan terminated, the employer also must distribute the account balances to all participants as soon as administratively practicable after the termination of the plan. A distribution may include a delivery of a fully paid individual 403(b) annuity contract (or individual mutual fund custodial account).

In order for an employer sponsoring a 403(b) plan using a pooled format to terminate its plan and file a final Form 5500, the employer must complete the following steps:

  1. Adopt a resolution to terminate the plan.
  2. Maintain a plan with a provision permitting plan termination and distribution upon plan termination (if the plan does not include such a provision, the employer may amend the plan).
  3. Observe the successor plan rule: make no contributions to another 403(b) plan for 12 months following termination (or, comply with the “2% rule” rule).
  4. Distribute all of the 403(b) accounts (cash), or distribute paid-up individual annuity contracts or individual mutual fund custodial accounts.
  5. File final Form 5500 with the DOL.

Where the employer maintains a 403(b) plan with an individual account format, the procedures are less clear on how to effect a termination. Specifically, the regulations do not describe how an employer makes distributions from accounts over which it has no control or responsibility. In discussing the issue with the IRS, the IRS indicated that it is unlikely to provide more detail than what is already included in the regulations. Since the Form 5500 is the principal issue, we might look to the DOL for guidance. However, the DOL has been aware of the issue for years and apparently is not inclined to provide guidance any time soon. Therefore, practitioners are left to fashion their own procedures for terminating an individual account 403(b) plan. For an individual account 403(b) plan, we recommend that the employer take the following steps:

  1. Notify its 403(b) participants that it is terminating the plan and that they qualify for distribution as long as the distribution occurs within an administratively practicable time period following the identified termination date. Note: If the financial institution does not recognize the distribution date, the employer has no authority to force the distribution (i.e., the participant is on his/her own if the financial institution will not cooperate). Irrespective of whether the participant or the financial institution effects a distribution, the employer should be able to consider itself in compliance with the distribution requirement because the participants already have individual accounts.
  2. The employer may complete all of the other steps described above without the cooperation of the participants or the financial institution.
  3. As a precaution, the employer may want to include an attachment to the final Form 5500 describing the steps it followed in terminating the plan and requesting the DOL to contact them if they thought the steps were incorrect or incomplete.

The new regulations are not effective until taxable years beginning after December 31, 2005.

We are discussing 403(b) plan termination and other new rules introduced by the new 403(b) regulations in the 403(b) Plan Workshops currently being conducted in a limited number of cities.