At Last: Final 403(b) Regulations Released

In 1964, the IRS released the first 403(b) regulations.  The IRS then took forty years to propose updates to those regulations. And finally, on July 23, 2007, the IRS finalized the 2004 proposed regulations. The 403(b) plan industry now has an up-to-date body of regulations for clearer guidance.

Because the final regulations will affect every existing 403(b) plan in some way, the IRS has given 403(b) plan administrators and plan providers time to prepare for changes. The final regulations are generally applicable for taxable years beginning after December 31, 2008. (Certain churches, collective bargaining situations, and governmental 403(b) plans have later effective dates.) Considering the number of clarifications and changes that the final regulations introduce, 403(b) plan administrators will need the time. 

Regulations Require Written Plan Document
Keeping 403(b) plans compliant has been a concern for the IRS. In the preamble to the final regulations, the IRS mentions that the new requirement for a written plan should help employers and investment providers comply with IRC Sec. 403(b) and a plan’s specific terms. First introduced with the proposed regulations, the written plan requirement has raised many concerns about how to create and maintain such a document. Fortunately, the IRS has clarified some of the issues based on the comments received

  • The plan administrator (generally, the employer) will have a single governing plan document (or combination of documents) to provide to all investment issuers rather than a separately designed document with each.
  • The document must contain all material terms and conditions for eligibility, benefits, applicable limitations, the contracts offered under the plan, and the time and form under which benefit distributions would be made. The document can (but is not required to) contain other optional provisions. Certain documents, such as insurance contracts and custodial accounts, can be incorporated into the plan document and, consequently, the plan by reference. If there are conflicts between such elements of plan documentation, the primary plan document’s provisions will control.
  • The plan is permitted to designate the administration of the 403(b) plan, including responsibility for compliance, to another person or the employer. This designation should be included in the written document.
  • The IRS will provide guidance (timing uncertain), including model plan provisions that may be used by public school employers.
  • Employers must generally adopt a written plan no later than January 1, 2009. But there are exceptions for certain church plans and for union plans.

Moving Plan Assets
The IRS relaxed its proposed changes to the 403(b) plan transfer rules based on industry concerns that eliminating this investment change option would be detrimental to 403(b) plan participants. Under the final regulations, a nontaxable exchange or transfer of assets is still permitted for 403(b) plans, provided that 1) the transfer is a change of contracts (investments) within the same plan, 2) the transfer is from one plan to the plan of another employer, or 3) the transfer is to repay, or to purchase permissive service credits in a governmental defined benefit plan. Transfers based on Revenue Ruling 90-24 will no longer be permitted after September 24, 2007.

Transfers to investment providers both within and outside the approved vendor group will still be permitted, but only in cases where the employer and investment provider have a written agreement to share employee and plan information pertaining to eligibility, loans, hardship distributions, etc. Additionally, the plan must choose to allow the transfer, the benefit cannot be reduced by the transfer, and the same distribution restrictions must apply in the new contract. These requirements appear to maintain the 90-24 transfer concept, while ensuring compliance with plan provisions.

Plan-to-plan transfers will be allowed as long the employee requesting the transfer is an employee or former employee of the employer who sponsors the receiving plan. Such a transfer differs from a direct rollover. In addition, both the distributing and receiving plan must permit the transfer. Neither the employees’ benefits nor the distribution restrictions can be diminished by the transfer.

A transfer that fails to meet the terms of these regulations will be treated as a taxable distribution if a distribution-triggering event has occurred or as a taxable conversion to a nonqualified annuity if a distribution-triggering event has not occurred.

Plan Termination
Termination of a 403(b) plan will now be considered a distribution-triggering event. When a plan is terminated, accumulated benefits may now be distributed, rather than having to wait for another triggering event, such as age 59½ or separation from service. This will allow timely rollover to an IRA or another eligible retirement plan. Successor-plan rules similar to those that apply to 401(k) plans will apply to 403(b) plans.

Universal Availability of Elective Deferrals
Under prior rules, employers could exclude certain classes of employees from participating in the plan. Effective on the first day of the plan year that begins after December 31, 2009, plans can no longer exclude the following classes of employees from making elective deferrals:

  • employees covered by a collective bargaining agreement (union employees);
  • employees who elect to participate in a governmental plan described in IRC Sec. 414(d) instead of a 403(b) plan (Sec. 414(d) is a general heading that includes federal, state, and local government employees and plans to which the Railroad Retirement Act applies);
  • visiting professors; and
  • religious order employees who have taken a vow of poverty.

Additionally, the regulations state that if a plan permits designated Roth contributions, this option, like the deferral option, must also be universally available.

Excess Corrections
A contribution that does not qualify as a 403(b) contribution because it exceeds the IRC Sec. 415 limit—an annual additions excess—will generally be considered a contribution under IRC Sec. 403(c), which governs nonqualified annuities. Separate accounting will be required for a 403(b) excess that becomes a 403(c) amount.

The final regulations continue to allow plans to correct IRC Sec. 402(g) deferral excesses by distribution. An excess deferral, including the allocable net income, should be removed by April 15 of the following year or as described in IRC Sec. 402(g).

The IRS Employee Plans Compliance Resolution System (EPCRS) correction program will be updated to reflect the final 403(b) regulations.

Effect of Plan Failures
If an employer that offers a 403(b) plan is not eligible to do so or fails to have the required written document, then no employee investments made under the plan qualify as 403(b) plan investments. Any operational failure that is solely within an annuity contract or investment of a given employee, however, will not adversely affect the contracts or investments of other employees.

Separate Accounts Required
Separate accounting is required in several situations. Notably, separate accounting is required where vesting on employer contributions must be earned. If separate accounting of amounts in excess of the IRC Sec. 415(c) limit is not done, then none of the amounts under the contract are considered to qualify for the tax preferences given 403(b) plans. Separate accounting is also required for designated Roth contributions to 403(b) plans. Separate accounting has long been required for pre-1989 and after-tax contributions made to 403(b) plans if employees wish to take distributions before a triggering event.

Catch-Up Deferral Contributions
If an employee is eligible for both the special 403(b) catch-up contribution under IRC Sec. 402(g)(7) and the age 50 catch-up contribution, the special 403(b) catch-up is deemed made first.

Miscellaneous Issues

  • Hardship distributions from 403(b) plans will generally follow the same rules as 401(k) plan hardship distributions, including applying the same safe harbors.
  • Separate contracts of incidental life insurance will no longer be allowed with 403(b) plans. The IRS has established an exception for contracts issued up to 60 days after publication of the regulations (July 26, 2007). These contracts are grandfathered in the existing plan. Incidental death and disability benefits are permitted.
  • The final regulations state that severance from employment occurs when an employee no longer works for an eligible employer or works in a capacity that is not employment with an eligible employer. IRS examples include an employee transferring from a not-for-profit to a for-profit hospital or an employee who ceases to work for a public school but who still is employed by the state.
  • Pre-1989 pretax deferrals (not earnings) and after-tax employee contributions may be distributed before a distribution trigger occurs.
  • If the employer makes matching contributions to the plan (an ERISA-governed plan), the matching contributions are subject to the same IRC Sec. 401(m) nondiscrimination requirements and testing as 401(k) plan matching contributions.
  • The final 403(b) regulations reiterate provisions of the proposed regulations that state that qualified domestic relations order (QDRO) procedures apply to 403(b) plans.
  • A payer is required to give a 403(b) plan participant adequate notification of the option to roll over an eligible rollover distribution (ERD) to another plan or to an IRA, and to withhold and remit to the IRS 20 percent of any such ERD amount that is paid to a plan participant instead of being rolled over.

Most of these rule changes make 403(b) plans even more similar to 401(k) plans. Yet, 403(b) plan administrators, investment providers, third-party administrators, and plan participants will need time to adjust to the many changes.