Terminating a 403(b) Plan – It’s Not So Easy
In Revenue Ruling 2011-7 issued earlier this year, the Internal Revenue Service (“IRS”) provided sponsors of 403b plans with some much-needed guidance regarding how to terminate their plans, since many 403b plan sponsors have been reconsidering whether they want to continue to maintain such plans in light of the final regulations that were issued by IRS in 2007 covering 403b plans. Until this guidance was issued, the IRS’s position was, generally, that a 403b plan could not be terminated, so the guidance is a welcomed step. However, there are issues that have not been addressed by IRS in the guidance and issues that plan sponsors may need to address in order to terminate their plans.
Steps to Plan Termination
The guidance outlines the steps a plan sponsor needs to take to effectively terminate their plan and distribute plan assets. Below is a brief discussion of each of the steps and potential issues that a plan sponsor must consider.
Adopt a Binding Resolution to Terminate the Plan
On or before the date of termination, the plan sponsor must adopt a binding resolution establishing the termination date, freezing contributions to the plan, discontinuing the purchase of annuity contracts or mutual funds, fully vesting all plan participants, approving the distribution of plan benefits, and approving the termination of the plan.
This would seem to be relatively simple except that the IRS assumes that a plan’s document(s) allow the plan sponsor to terminate its plan. However, this is frequently not the case, so plan sponsors must review their plan document to be sure it allows for the termination of the plan. If the plan document does not contain termination provisions, then the plan sponsor should consult with their plan advisor to determine if the language authorizing the plan’s termination can be added to allow for the plan’s termination.
Freezing/Stopping Plan Contributions
The plan sponsor must stop contributions to the 403b plan beginning on the termination date. In addition, if the plan sponsor has a related entity (determined on a controlled group basis) with a 403b plan no contributions may be made to that plan for the period that begins with the termination date and ends twelve months after all benefits have been distributed from the terminated plan. The preceding rule may be disregarded if during the period beginning twelve months before the plan termination and ending twelve months after the distribution of all assets from the terminated plan less than two percent of the employees who were eligible to participate in the terminated plan are eligible to participate in the plan of the related entity.
Plan participants and beneficiaries must be notified of the plan’s termination and the related tax consequences. The form of the tax notice is described in Internal Revenue Code section 402(f).
Distribute Plan Assets
Plan assets must be distributed to plan participants and beneficiaries as soon as administratively feasible. IRS generally considers this requirement to be met if all plan assets are distributed within twelve months of the plan’s termination. It should be noted that 403b plans covered by ERISA must comply with the qualified joint and survivor annuity requirements to the extent applicable, meaning if the annuity contracts offered under the plan provide for survivor annuity options, then the required notifications must be provided. Many 403b annuity contracts state that if the plan is an ERISA plan then such notices will be provided, but plan sponsors should check with the annuity provider to coordinate notification. The IRS’ guidance also leaves some open issues for plan sponsors as follows:
- Individual annuity contracts – If the plan provides individual annuity contracts, then the notice requires the distribution of fully paid individual insurance annuities to each plan participant and beneficiary. The guidance states that such distributions will not be taxable until amounts are actually taken from the annuity contract. The guidance is not clear regarding what should be done by the plan sponsor if plan participants already hold individual contracts in their own name, which is fairly typical. Whether the plan sponsor would simply be able to notify the participants and contract providers that the contracts are no longer part of a 403b plan is an open question.
- Group annuity contracts – If the plan is funded with group annuity contracts, the IRS guidance contemplates the assets being distributed by issuing individual certificates (as opposed to contracts) evidencing entitlement to fully paid contract benefits to plan participants and beneficiaries. The guidance states that there are no tax consequences to the plan participant until amounts are actually withdrawn from the contract. From a practical point of view, it may take a very long time (more than twelve months) to issue such certificates because the required paperwork for old contracts is notoriously difficult for the issuing companies to find. Thus, the question is open whether a delay of more than 12 months from the termination date in issuing the certificates would cause the plan termination to be invalid.
- Custodial accounts – Many plans are funded by mutual fund custodial accounts that are maintained either as individual or group agreements. The IRS guidance assumes that such accounts will be distributed in cash, in-kind, or as a direct rollover from the 403b Plan to an IRA or another eligible retirement plan by a plan participant of beneficiary. The IRS guidance states that amounts distributed from a custodial account will be taxable unless rolled over to an IRA or another eligible retirement plan within 60 days. The IRS’ guidance is not clear regarding what happens if a participant or beneficiary fails to make an election to receive a distribution, i.e., will it cause the termination to fail?
File a Final Form 5500
403b Plans covered by ERISA must file a final Form 5500 by the last day of the seventh month after the date of final distribution of assets from the plan.
Other Issues to Consider in Terminating a Plan
The IRS failed to address some important items, which are discussed below and could cause a plan to fail to terminate. Plan sponsors that have these issues may want to delay terminating their plans until IRS issues additional guidance.
- Plans with grandfathered accounts excluded under Department of Labor’s (“DOL”) Field Assistance Bulletin 2009-2 need to consider whether these accounts may also be excluded from a plan’s termination.
- Plans that allow loans to participants need to determine with the vendor whether the loans can be transferred to the individual annuity account or contract. If they cannot, then tax guidance is need from IRS. Also, it needs to be determined how loan payments will be made, if they were being made by payroll deduction prior to the plan’s termination.
- IRS has not addressed the treatment of 403b contracts that include life insurance nor plans that have Roth 403b contributions or after-tax contributions. There needs to be additional tax guidance on the treatment of these items before distributions from accounts with these features can be correctly reported for tax purposes.
- The treatment of lost or nonresponsive plan participants needs to be addressed.
Given the number of open issues related to the termination of 403b plans at this time, many plan sponsors will want to delay attempting to terminate their plan until additional clarification is issued from IRS and possibly also the DOL. For those plan sponsors that urgently want to terminate their plans, it would be extremely practical to consult with professional advisors to review the particular circumstances of their plan to determine if a plan termination is feasible under current guidance before proceeding with the termination.