Section 403(b) plans were historically important for tax-exempt employers, but under current tax laws, maintaining a 403(b) plan may no longer be viable or advisable for an employer. An employer that wants to pull out the 403(b) plan termination roadmap first needs to ask a basic question: can I get the engine started (will the investment vendors cooperate with this process)? If the answers to this question is “yes,” then the employer can follow the roadmap set forth in Revenue Ruling 2011-7.
Prior to 2007, an employer could not force an employee to take a distribution upon 403(b) plan termination. Regulations issued in 2007 made a plan termination a distributable event, but failed to provide much guidance regarding how to distribute individual and group annuity contracts. Under Revenue Ruling 2011-7, an employer may terminate a plan by adopting a binding resolution to (1) cease all future contributions under the plan, (2) terminate the plan, (3) vest all participants 100% in their benefits as of the termination date, and (4) direct that all benefits be distributed as soon as practicable after termination. The sponsor also must notify participants of the termination and of their rollover rights.
Further, both the distribution of fully paid annuity contracts and the distribution of individual certificates based on group annuity contracts are treated as distributions from the plan. Participants and beneficiaries will not be taxed on such distributions until amounts actually are paid from those contracts, provided that the contract continues to comply with the requirements of the 403(b) plan as of the date of distribution.
With respect to custodial accounts, the plan sponsor must make payments either in cash or in-kind equal to the value of the custodial account. Such amounts also may be distributed directly to an IRA established for the participant or an eligible retirement plan. In the case of an ERISA plan where the joint and survivor annuity rules apply, distribution from the plan must be made by the purchase of a fully-paid individual annuity contract providing for a qualified joint and survivor annuity. With respect to both the custodial account and annuity distributions, the ruling provides that such amounts are included in taxable income when distributed, unless they are rolled over to an IRA or other eligible retirement plan by a direct rollover or transfer within 60 days of distribution.
Although Revenue Ruling 2011-7 provides a roadmap to employers for terminating their 403(b) plans, the Revenue Ruling leaves open questions for investment vendors in cases where a plan is terminated but an annuity contract remains (i.e., cash has yet to be paid to participants). As mentioned previously, the Revenue Ruling requires the remaining annuity contract to comply with the requirements of the 403(b) plan as of the date of distribution of the contract. If there are changes in the law after this date but before the actual annuity contracts have been paid, employers will not be required to update those contracts to reflect the changes in the law. The investment vendors, however, will be responsible for administration of these contracts. If an investment vendor administers multiple plans that various employers terminated in different years, the investment vendor could end up needing to keep track of a variety of 403(b) plan requirements. Administratively, it may be difficult or next to impossible for investment vendors to keep track of these requirements. As such, they may be reluctant to assist with the termination of 403(b) plans.
Thus, an employer that wants to terminate a 403(b) plan may be able to do so, but it will need to gauge the investment vendors’ willingness to cooperate with the process. If an investment vendor is unable or unwilling to assist the employer with termination of the plan, the employer has two options in how to proceed. One option would be to wait for additional guidance to address the open questions before terminating the plan. In the meantime, the employer could continue the plan, or freeze the plan with respect to new participants and contributions. The second option would be to push ahead with the plan termination anyway. An employer may decide that despite the reluctance of the investment vendor to assist in the process, given the current guidance in the Revenue Ruling, the employer may have enough leverage to terminate its plan. If the employer reaches such a conclusion, it should work closely with its legal counsel and with its investment vendors in order to terminate the plan successfully.