Treasury Issues Proposed Regulations for Section 403(b) Plans

The Treasury Department has issued long-awaited proposed regulations under Internal Revenue Code (IRC) Section 403(b).¹ The preamble indicates that these regulations are proposed to be effective for plan years beginning after December 31, 2005 (with transition periods for collectively bargained and church plans, but not governmental plans) and cannot be relied upon until finalized. Comments on the proposed regulations are due by February 14, 2005 and a public hearing is scheduled for February 15, 2005. The number and depth of comments are likely to be substantial, and could lead to significant changes in the regulations before they are finalized.

OVERVIEW AND HIGHLIGHTS

The current regulations under §403(b) have not been updated in 40 years, although the governing rules have changed considerably during that time. Consequently, one important function of the proposal is to revise the regulations to conform to numerous amendments made to §403(b) by legislation (including GUST² and EGTRRA)³ and to incorporate a number of items of interpretative guidance issued by the Internal Revenue Service outside of the regulations (such as revenue rulings). In that respect, the proposed regulations aim to clarify and reflect the current law applicable to §403(b) plans. For example, the prior regulations on the maximum exclusion allowance (MEA) provisions are eliminated because EGTRRA repealed the MEA test for §403(b) plans.

A big focus of the proposed regulations is to set out and amplify the legal changes to §403(b) plans that make them much more like other types of defined contribution plans, especially §401(k) and governmental §457 plans. The proposed regulations specifically clarify that the rules applicable to §401(k) plans also apply to §403(b) plans in the following ways:

• The frequency with which elective deferrals can be made, changed or revoked (including automatic enrollment) is the same for both types of plans.
• Elective deferrals to both §401(k) and §403(b) plans are subject to a coordinated limit under IRC §402(g) and are counted as annual additions for purposes of limitations under IRC §415(c).
• Excess elective deferrals and excess annual additions would have to be corrected in the same manner for both types of plans.
• Employees' salary reduction contributions to a §403(b) plan would have to be transferred to the applicable funding vehicle within a reasonable period of time, such as 15 business days following the end of the month the compensation would have otherwise have been paid, which is comparable the requirements for §401(k) plans under Department of Labor (DOL) regulations.
• §403(b) plans are subject to qualified domestic relations order (QDRO) rules under IRC §414(p).
• Eligible rollover distributions from §403(b) plans that are not rolled over to an eligible retirement plan are subject to mandatory 20 percent income tax withholding.

In addition to the §403(b) changes, the proposal would make an important change in the operation of many of the qualification rules as they apply to all tax-exempt and public sector plans, by redefining "employer" for non-profit organizations that do not have stockholders.

KEY CHANGES IN THE PROPOSED REGULATIONS

This Compliance Alert discusses key changes that would be made by the proposed regulations. To go directly to one of the provisions listed below, click on the underlined text:

• Plan Documents
• Catch-Up Contributions
• Clarification of Definition of "Health and Welfare Agency"
• Withdrawals
• Transfers
• Plan Termination
• Life Insurance
• Vesting
• Nondiscrimination Rules
• Temporary Regulation on FICA Withholding

In addition to IRC §403(b) changes, the proposed regulation would expand the definition of a "controlled group" (which is treated as a single employer) for all tax-exempt organizations and for all pension-related purposes. For more information about this proposal, click here.

Plan Documents

One significant change, which has been a hot topic of discussion since the release of the proposed regulations, is the proposed requirement that a §403(b) program be maintained under a written defined contribution plan that, in both form and operation, satisfies the regulatory requirements of §403(b) and other applicable law and contains all material terms of the program. The preamble clarifies that the plan document does not have to be a single document, but rather this requirement could be satisfied by a group of documents. It also suggests that complying with the plan document rules for qualified plans would meet this new standard.

The full impact of this requirement is not clear. For example, it is unclear whether an individual annuity contract could satisfy all or part of the written plan document requirements, or whether a separate plan document would be necessary. Also, the proposed regulation does not address the possible impact of this plan-document requirement on contracts owned directly by individuals who have been treated as maintaining their own plan for §415 purposes or, whose contracts are no longer part of an employer-run program because of transfers.

In addition, the extent to which the written plan document requirements will cause §403(b) plans of private, tax-exempt employers to be subject to ERISA Title I rules is an open question. Currently, DOL regulations and rulings enable employers offering §403(b) programs to avoid application of ERISA Title I rules (such as requirements for reporting, vesting, coverage, fiduciary duties, etc.) by keeping their involvement in the funding and administration of the §403(b) plan to a minimum. The gist of the DOL position is that the employer can offer a program and facilitate its use through payroll deduction savings opportunities, for example, as long as the employer does not endorse the plan. What constitutes "endorsement" at a level that brings a plan under ERISA is a case-by-case determination, according to the Preamble to the proposed §403(b) regulation. The Treasury Department has specifically requested comments on the ERISA implications of the proposed regulations. (To return to the bulleted list of proposed changes, click here.)

Catch-Up Contributions

Participants in a §403(b) plan who are age 50 or older can make catch-up contributions under IRC §414(v). In addition, employees of qualified organizations (schools, hospitals, church organizations, and health and welfare agencies) who have at least 15 years of service with an eligible employer may make special §403(b) catch-up contributions. The proposed regulations clarify that for a participant who is eligible to make both types of catch-up contributions, contributions in excess of the elective deferral limit are first treated as a special §403(b) catch up and then as an age 50 catch up, to the extent the age 50 catch up amount exceeds the special §403(b) catch-up amount. Thus, a participant could possibly make both types of catch-up contributions in one plan year, to the extent all contributions in total do not exceed the IRC §415 limits. This method of coordinating catch-up contributions is different from the method for §457 plans, which can only accept one type of catch-up contribution (age 50 catch up or special §457 catch up) in a particular plan year. (To return to the bulleted list of proposed changes, click here.)

Clarification of Definition of "Health and Welfare Agency"

The proposed regulations also define "health and welfare agency," which is not defined in prior regulations, to mean an agency whose primary activity is to provide medical care or a §501(c)(3) organization whose primary activity is prevention of cruelty to individuals or animals or providing personal services to the needy. (To return to the bulleted list of proposed changes, click here.)

Withdrawals

The proposed regulations would add new restrictions on withdrawal of employer contributions, permitting distribution only upon severance of employment or occurrence of certain events, such as disability, attainment of a particular age or a fixed number of years. Current law does not restrict withdrawal of employer contributions. (To return to the bulleted list of proposed changes, click here.)

Transfers

Under current regulations, participants in a §403(b) plan can transfer their funds from a §403(b) contract or account to another §403(b) provider, subject only to restrictions under the plan rules. The proposed regulations would only permit transfers between §403(b) providers in two situations: (1) between different providers within the same employer-sponsored plan; or (2) from the §403(b) plan of a former employer to the §403(b) plan of a current employer. To carry out an EGTRRA amendment to §403(b), the proposed regulations would also permit in-service transfers from a §403(b) plan to a governmental defined benefit plan for the purchase of permissive service credit. (To return to the bulleted list of proposed changes, click here.)

Plan Termination

The proposed regulations describe the requirements for a §403(b) plan termination, including a ban on the employer's making contributions to another §403(b) plan for at least 12 months after termination and a requirement that all accumulated benefits be distributed to participants as soon as administratively practicable after termination. (To return to the bulleted list of proposed changes, click here.)

Life Insurance

The proposed regulations specifically state that a §403(b) contract could no longer include life insurance contracts or contracts providing other types of incidental benefits, subject to a transition rule for life insurance contracts in place before February 15, 2005. (To return to the bulleted list of proposed changes, click here.)

Vesting

Under the proposed regulations, it appears that accumulated benefits under an annuity contract (but not a custodial account) may still be subject to a vesting schedule. However, the portion of a contract that is not vested at any time is treated as a §403(c) contract, which is subject to the rules under IRC §83 (whereby the value of a contract is not included in gross income until the employee's interest in the contract becomes substantially vested). Once the value of the annuity contract becomes vested, it is treated as a §403(b) contract. (To return to the bulleted list of proposed changes, click here.)

Nondiscrimination Rules

Employer contributions and employee after-tax contributions to a §403(b) plan must satisfy various nondiscrimination rules, including those set forth under IRC §401(a)(4) (contributions and benefits), §410(b) (coverage) and §401(m) (matching contributions), in addition to the compensation limit under §401(a)(17). The proposed regulations provide that §403(b) plans can no longer rely on the safe harbors set forth in Notice 89-23 to satisfy these nondiscrimination requirements, but rather must comply with each of these nondiscrimination rules in the same manner as qualified plans. Please note that church plans and governmental plans are not subject to these nondiscrimination requirements, except that governmental plans must satisfy the compensation limit under IRC §401(a)(17).

Elective deferrals to a §403(b) plan must satisfy a universal availability test. That is, the ability to make elective deferrals to a §403(b) plan must be generally available to all employees not specifically excluded. The proposed regulations make some important clarifications to the universal availability test, including:

• The universal availability requirement applies separately to each entity not part of a common payroll;
• The exclusion of employees who normally work less than 20 hours per week is only satisfied if the employee is expected to work less than 1,000 hours in a year or worked less than 1,000 hours in the previous year; and
• An employee must be given an "effective opportunity" to make elective deferrals, which requires receiving a notice of the availability of the election and at least one opportunity to make or change elections each year.

(To return to the bulleted list of proposed changes, click here.)

Temporary Regulation on FICA Withholding

In conjunction with the proposed regulations under IRC §403(b), the Treasury Department also issued a temporary regulation that requires FICA tax withholding from employee contributions made pursuant to a one-time irrevocable election and mandatory contributions made as a condition of employment. This temporary regulation was effective November 16, 2004. (To return to the bulleted list of proposed changes, click here.)

Expanded Concept of "Employer"

Appended to the extensive proposed rules under IRC §403(b) is a two-page proposal to amend the regulation defining a "controlled group" under IRC §414(c). That proposal would expand the definition of "corporations, trades or businesses under common control" to include tax exempt organizations that are affiliated but not linked by ownership, if one of the organizations can control the other by appointing at least 80 percent of its trustees or directors. This concept would apply to all tax-exempt and governmental organizations, not just charities and schools, effective January 1, 2006.

As with all issues involving the interpretation or application of laws, employers offering §403(b) programs should rely on their legal counsel for authoritative advice on the proposed §403(b) regulations. The Segal Company can be retained to work with plan sponsors and their attorneys to evaluate the impact of the proposed regulations and help prepare comments to highlight any concerns raised by the proposal.

Compliance Alert, The Segal Company’s periodic electronic newsletter summarizing important developments affecting benefit plan compliance, is for informational purposes only. It is not intended to provide authoritative guidance. On all issues involving the interpretation or application of laws and regulations, plan sponsors should rely on their attorneys for legal advice.

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