403(b)
FINAL REGULATIONS
A
PRACTICAL GUIDE FOR SCHOOL CORPORATIONS
What the final
403(b) regulations mean for public school corporations and what actions schools
will need to take to comply have been the subject of many a seminar, article,
vendor phone call, and hallway conversation since the proposed 403(b)
regulations were first issued in November, 2004. Now that the final regulations have finally
been issued, however, schools can begin to take constructive steps toward
managing their 403(b) programs, achieving compliance, and reducing risk. With a general effective date of
Ready, Get Set, GO!
We recommend that schools consider taking the following steps with respect to their 403(b) plans over the next few months:
1. Ensure that your school is complying with the universal availability rule. While the IRS "clarified" what schools should be doing to satisfy the universal availability rule in the final 403(b) regulations, this rule is currently in effect and it is critical (particularly given the IRS’ ongoing audit efforts of Indiana schools in this area) that schools take immediate action to ensure compliance. See below for more information regarding this rule and our July 9, 2007 e-bulletin on the IRS’ audit activity.
2. Create and adopt a 403(b) plan document. Although the IRS has indicated that a plan document can consist of stapling various documents together, we recommend that schools establish their own single plan document that they control rather than becoming tied to a particular vendor’s document. The IRS is expected to issue model plan language that school corporations can use in preparing a plan document. We can assist in adapting the model language to your school. See below for more information regarding the plan document rules.
3. Evaluate your school’s current vendors. Schools are legally responsible for their 403(b) plans both in terms of form (written plan document) and operation (administering the plan in accordance with the plan document and applicable law). A school may contract for and delegate administrative and compliance duties to a vendor or vendors if documented in the plan and an appropriate contract, but the school will be the initial legally responsible entity for plan failures. Since compliance going forward will be a team effort between the school and its vendors (as is already the case for your school’s 401(a) plan), it is very important to make sure your school partners with strong, capable vendors:
· At a minimum, your school should eliminate existing vendors under your 403(b) plan that cannot or will not agree in writing to comply with the final 403(b) regulations, accept the delegation of appropriate administrative and compliance responsibilities, abide by your 403(b) plan document, and indemnify the school for failures.
· Since schools will be responsible for coordinating multiple vendors with respect to such things as contribution limits, loans, and hardships distributions, in many cases schools will want to narrow vendors even further to facilitate compliance and reduce their administrative burden.
· Schools may also want to take this opportunity to fully evaluate vendors on capabilities other than the ability to simply comply with the 403(b) rules, such as whether the vendor offers strong investment products, competitive fees, and good service, or to negotiate a better arrangement with current vendors (through elimination of surrender charges, for example). In the past, many vendor evaluations (if conducted at all) have been run by a broker or advisor who had a product to sell. Schools should instead consider conducting a request for proposal (RFP) with an independent financial consultant. This process could include establishing a committee with both administrator and teachers representatives to oversee the RFP and make vendor selections.
4. Adopt the necessary administrative procedures for compliance. Schools are responsible for ensuring that the 403(b) plan is being operated in accordance with the plan document. To the extent that there are multiple vendors under the 403(b) plan, a school will either need to retain a third party administrator or establish administrative procedures for coordinating the multiple vendors. Even with a single vendor, a school will generally need to be involved in such things as monitoring contribution limits, certifying hardships and distribution events, suspending elective deferrals when a hardship distribution is made, and qualifying domestic relations orders. Procedures might include the need for new or updated administrative forms, school policies to implement plan terms, and payroll programming.
5. Communicate the changes and why they are being made well and often. Your employees will understandably have a lot of questions regarding why changes are being made to the school’s 403(b) plan, particularly with respect to the available vendors under that plan. Schools should anticipate and be prepared to answer these questions. Schools should consider a “roll-out” meeting with employees to explain the reason why changes are being made, the process that the school underwent in determining what changes were necessary, and how the changes impact them. This would also be a good time to educate employees regarding the value of investing through a 403(b) plan.
Note that although your school is required to be in full compliance
both in form and operation by no later than
What it All Means For Your School
Some of the key changes and clarifications under the final 403(b) regulations of which your school should be aware include:
Ø Plan Document Requirement. The 403(b) plan administrator – generally, the school - is responsible for ensuring that the terms and conditions of the 403(b) plan are set forth in a written plan document that satisfies 403(b) both in form and operation.
· The plan document must contain all material terms regarding eligibility, entry dates, benefits, approved vendors under the plan, contribution limits, and distribution rules. The plan document must also contain information regarding any optional terms, such as the availability of hardships, loans or transfers.
· The plan document must comply with the final regulations and be administered in accordance with its terms.
· The plan document requirement may be satisfied by compiling various documents (e.g. as annuity contracts, school policies, salary reduction agreements) or by incorporating other documents by reference. However, there cannot be any conflict or inconsistency between the documents and the documents must contain all material terms describing the plan. The IRS "expects" that a single plan document will be adopted for any 403(b) plan, even one with multiple vendors.
· The plan document may allocate administrative and compliance responsibility to a vendor or other third party, but no compliance responsibility can be allocated to participants. Although the school can delegate such duties, it is still ultimately legally responsible for compliance.
NOTE: The written plan document must be adopted by
no later than December 31, 2008. Failure
to timely adopt a written plan document will result in all contributions held
under the 403(b) plan becoming immediately taxable.
Ø
Universal
Availability Rule. Although 403(b)
plans sponsored by public schools are exempt from most of the nondiscrimination
rules applicable to non-governmental employers, they must comply with the
“universal availability rule” with respect to salary deferrals (not employer
contributions). The universal
availability rule states that to the extent a school permits one employee to make salary
contributions (either traditional pre-tax or Roth after-tax) to a 403(b) plan,
it must permit all employees an
"effective opportunity" to participate in the 403(b) plan.
·
A school may exclude certain groups of employees
from participating in its 403(b) plan without violating this rule - most significantly,
employees who normally work less than 20 hours a week, which the final
regulations interpret as a 1,000 hour a year requirement. If a school chooses to exclude employees on
this basis, it must track hours and exclude all
employees who work less than 1,000 hours from participating in the 403(b)
plan; in other words, the school cannot permit all part-time employees to
participate but then exclude substitute teachers.
· A school will not be treated as giving all employees an effective opportunity to participate in the 403(b) plan unless it notifies employees of their ability to make or change an election to contribute to the 403(b) plan at least once a year. Additionally, although a school may condition matching contributions to the 403(b) plan or to a 401(a) plan on a participant making elective deferrals under the 403(b) plan, no other rights or benefits may be conditioned on participating in the 403(b) plan.
NOTE: The universal availability rule applies only
to common law employees – if your school has outsourced certain services to
another organization or has independent contractors, these individuals are not
eligible to participate in the 403(b) plan and this rule does not apply.
NOTE: If a school fails to give all employees
(except those permissibly excluded) an effective opportunity to participate in
the 403(b) plan, all contracts and accounts held under the 403(b) plan become
taxable. While the IRS permits schools
to correct this failure under its voluntary correction procedures, the correction
requires that the school make an employer contribution to the 403(b) plan on
behalf of each impermissibly excluded employee.
Since schools are permitted to condition the right to make salary
deferrals on electing contributions of at least $200 annually, most schools
will want to avoid the administrative complexities and potential non-compliance
in excluding employees under the 1,000 hour rule, and instead provide
eligibility only to employees who elect to contribute at least $200 to
participate in the 403(b) plan.
Ø
Transferring
Plan Assets. 403(b) plan
participants generally have had the ability to transfer their account or
contract held by the school’s “approved” vendors under the 403(b) plan to any
other vendor they wanted, without any employer involvement. This was called a “90-24 transfer.” No
“90-24 transfers” may be made after
·
The contract exchange is permitted by the 403(b)
plan document (but note that the document is not required to permit
contract exchanges),
·
The participant’s benefit is not reduced,
·
The distribution restrictions under the new
contract or account are at least as stringent as those under the old contract
or account, and
·
The school and vendor enter into an “information
sharing” agreement to ensure that the school and vendor each have the information
they need to comply with 403(b), e.g.
information regarding the participant’s employment status, hardship
withdrawals, and plan loans.
NOTE: If a contract exchange is made after
NOTE: Since
the old 90-24 transfer rules do not apply after
Ø
Coordination
of Catch-Ups. The final regulations
confirm that the age 50 catch-up ($5,000 for 2007) applies only after the
employee has contributed an amount equal to both the basic salary deferral
limit ($15,500 for 2007) and the 15 years of service catch-up limit (up
to $3,000 per year, with a $15,000 maximum), if any. Part-time employment or full-time employment
for less than the entire work period (e.g. academic year for teachers) must be
aggregated to determine years of service under the 15 years of service
catch-up.
NOTE: Not all
employees with 15 years of service with the school will be eligible for a 15
years of service catch-up. The amount of
the 15 years of service catch-up is subject to a formula, and is dependent on
both the total amount of elective deferrals that the employee has made to the
403(b) plan while employed by the school and the employee's years of service
with the school.
Ø
Excess
Contributions. Salary deferrals that
exceed the basic salary deferral limit plus any applicable catch-up limits for
a year are taxable, and must be distributed from the 403(b) plan by the
following April 15. Contributions that
exceed the total contribution limit for 403(b) plans (the lesser of $45,000
(for 2007) or 100% of compensation) are also taxable, and must be held in a separate
contract that is subject to the rules for nonqualified annuities. If excess contributions are not timely
segregated, all of the affected participant’s accounts and contracts under the
403(b) plan (rather than just the excess contribution) will become
taxable.
NOTE: Excess
contributions may be corrected under the IRS’ voluntary compliance program,
which the IRS is updating to more comprehensively address corrections of 403(b)
plan failures.
Ø
Roth
Contributions. The final regulations
confirm that 403(b) plans can allow after-tax Roth contributions beginning
in 2006. Roth contributions are treated
the same as traditional pre-tax contributions for most purposes under the
403(b) plan, and are counted against the salary deferral contribution limits. Roth contributions are required to be held at
least five years from the date that the first Roth contribution is made to the
403(b) plan in order to be tax-free at distribution.
NOTE: Currently,
Roth contributions may negatively impact the ability to make 15 years of
service catch-ups. The IRS has indicated
that this result was unintended and will be corrected in future legislation.
For more information regarding Roth contributions, see http://www.irs.gov/pub/irs-pdf/p4530.pdf.
Ø Post-Retirement Contributions. Post-retirement contributions to a 403(b) plan can generally take two forms:
· Former employees can electively defer compensation that they receive from the school up to the later of 2 ½ months after severance from service or the end of the year in which they separate from service, but only to the extent that the compensation is either regular pay or accumulated unused sick or vacation pay. Salary deferrals cannot be made from severance pay received after separation from service.
·
Employer contributions can be made for the five
year period beginning at the end of the taxable year of an employee’s severance
from service. Contributions can be made
each year up to the total contribution limit of the lesser of 100% of
compensation or $45,000 (for 2007). The
final regulations clarify that any contribution to a 403(b) plan under this
rule on behalf of a former employee must be employer
contributions and that post-retirement contributions cannot continue after
the participant’s death.
NOTE: Although
these requirements are clarifications of existing law, they are very important
in that the IRS is concerned that schools are permitting employees to elect
whether to have dollars contributed to a 403(b) plan at retirement, or to
instead receive the dollars in cash or have them contributed to another type of
benefit plan. Any such election with
respect to post-retirement contributions, whether direct or indirect, is
prohibited.
NOTE: 403(b) plans are unique in that they are
the only type of retirement plan to which post-retirement contributions can be
made. This can be a very valuable
feature for schools that want to restructure existing unfunded benefit promises,
establish early retirement incentives,
reward long-service, etc.
Ø Loans and Hardship Withdrawals. The final regulations require that plan loans and hardship distributions follow the same rules applicable to 401(k) plans. For example, hardship withdrawals can only be made to the extent that the employer certifies that there is a financial hardship, cannot exceed certain amounts, and salary deferrals must be suspended for six months following the withdrawal. Loans cannot be made if the participant’s total amount of outstanding plan loans exceed stated limits, and loans must be timely repaid or they result in taxable “deemed” distributions. The new rules do not permit employees to self-certify that these requirements are satisfied.
NOTE: Since
schools will be responsible for certifying that a participant is eligible for a
loan or hardship distribution, there must be coordination between the school
and all of the vendors to ensure that these rules are satisfied. Schools might consider eliminating the right
to take loans from the 403(b) plan since loans are typically an area of
significant non-compliance for which the school will have legal
responsibility.
Ø Distributable Events. School contributions made to a 403(b) plan may no longer be distributed from a 403(b) plan at any time. Rather, school contributions may only be distributed upon a participant’s severance from employment, or, if the plan provides, upon the prior occurrence of some event, such as a fixed number of years, a stated age, or disability. 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. Therefore, for example, an employee who terminates employment with a school but then is employed by the state department of education is treated as having a severance from employment.
NOTE: These
rules are not applicable to after-tax or rollover contributions.
NOTE: Distribution restrictions already apply to
salary deferrals and amounts contributed to a custodial account (mutual funds). Salary deferrals may not be distributed from
a 403(b) plan until severance from service, death, disability, age 59 ½, or
financial hardship. Contributions to a
custodial account may not be distributed from a 403(b) plan until severance
from service, death, disability, or age
59 ½.
Ø
Plan
Failures. If a school fails to
timely adopt a written plan document or the universal availability rule is not
satisfied, all contracts and accounts of all participants under the 403(b) plan
become taxable. An operational failure
that occurs within a participant’s account or contract will result in the
disqualification of all contracts or accounts of that participant held under
the 403(b) plan.
NOTE: Many plan failures can be corrected under
the IRS’ voluntary compliance program, which the IRS is updating to more
comprehensively address corrections of 403(b) plan failures.
Ø Timely remittal of contributions to vendors. Contributions must be transferred by the school to vendors within a period that is no longer than reasonable for proper plan administration. The final regulations give an example of a reasonable period being within 15 business days following the end of the month in which the amounts would otherwise have been paid to the participants. ERISA covered (non-governmental) plans may have a shorter period in which contributions must be remitted to vendors.
Ø Vesting. Vesting is permitted with respect to school contributions made to a 403(b) plan, but separate accounting is required for unvested amounts.
Ø QDROS. The final regulations clarify that the qualified domestic relation order rules under Code Section 414(p) apply to 403(b) plans.
NOTE: This
means that schools will have responsibility for “qualifying” domestic relations
orders and ensuring adequate procedures to do so.
Ø Accounts and Contracts. Annuity contracts or custodial agreements must contain specific provisions in order to comply with the final regulations, including that the contract is issued under an employer plan, that the contract is nontransferable (annuities only), the salary deferral contribution limits, the direct rollover provisions, the minimum distribution requirements, and the limits on incidental benefits.
Ø
Plan
Termination. Historically, 403(b)
plans could not be terminated. The final
regulations state that 403(b) plans can be terminated, and plan assets can be
distributed to and rolled over by participants.
A school can terminate a 403(b) plan before
While compliance
with the final 403(b) regulations may seem challenging given schools’ limited
resources, a well-thought out process will enable your school to both achieve
compliance with the final regulations and reduce its risk under the final
regulations by properly allocating plan responsibility and managing plan
vendors without undue drain to your resources.
If you have any questions
regarding the final regulations or need help bringing your 403(b) plan into
compliance, please contact Mary Beth Braitman, Tara Schulstad Sciscoe, or Jim Kemper.
This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.