New Regulations Bring 403(b) Requirements Closer to Those of 401(k) Plans
School Advisor, 2005 Issue No. 2

Summary: For the first time in 40 years, the IRS has published comprehensive 403(b) guidance in the form of proposed regulations. The regulations require much more district involvement than was necessary in the past. They also require a written plan and generally place the burden on the district to ensure that the plan is administered in accordance with the terms of what will become, for many districts, their first 403(b) plan document. Additional guidance is provided on limitations on life insurance availability, asset transfers, distributions, and plan terminations. The IRS received many comments on these controversial proposed regulations, which actually may not be relied upon by taxpayers until finalized.

The Details: The IRS issued comprehensive proposed 403(b) regulations late in 2004. Only employees of 501(c)(3) exempt organizations and employees of public educational institutions are eligible to participate in 403(b) annuity and custodial accounts. Good or bad, in many ways the regulations bring the 403(b) requirements much closer to those of 401(k) plans.

For districts using one provider, the proposed regulations include both new forms of flexibility and requirements for increased employer involvement. For districts using multiple providers, the regulations will likely mean significant changes to the design and administration of your plan. The proposed regulations indicate that they are generally effective for taxable years beginning after 2005; however, the regulations specifically provide that organizations may not rely on the regulations until they are issued in final form.

Many of the provisions are controversial because of the additional responsibility for employers and providers and the loss of control and flexibility to participants. The consensus among employee benefit practitioners is that many of the proposal rules will be finalized, and a delayed effective date of sometime later in 2006, or even 2007, is most likely. The following are among the meaningful guidance contained in the proposed regulations:

• Written Plan. Now, every 403(b) arrangement must be maintained under a written plan. The question is: Can one document and one set of administrative procedures adequately cover the varying practices of multiple vendors? Many schools have found it easy to delegate control over their 403(b) programs, because annuity contracts and custodial account agreements have allowed the vendors to assert significant control. It appears that much of the ultimate responsibility for administrative matters may now revert to sponsoring employers. It is currently unclear what day-to-day administrative changes are likely to occur.
• Universal Availability Rule. The IRS is emphasizing compliance with the universal availability rule, which provides that salary deferral contributions must be offered, and publicized, to all employees, with limited exceptions. Exceptions include certain student employees, employees eligible for a 401(k) or an eligible 457(b) plan of the employer, and certain employees who normally work less than 20 hours per week. The regulations indicate that this last exception is valid only if: (1) for the 12-month period, beginning with employment commencement, the district reasonably expected the employee to work less than 1,000 hours, and for subsequent years, the employee worked fewer than 1,000 hours. The IRS has verbally indicated that this means that temporary employees, like camp workers, or individuals whose only services are coaching duties, who work consistently more than 20 hours a week, but only for a short period, need not be offered 403(b) participation. In addition, employees need not necessarily enter the plan on their date of hire; a monthly entry system should pass muster.
• Traditional Catch-Up Rule Must Be Applied Before the Age 50 Catch-Up. Contributions to 403(b) plans may qualify for two salary deferral catch-up contributions: (1) the traditional catch-up requiring 15 years of service and allowing an additional $3,000 per year, and (2) the age 50 catch-up allowing an additional $4,000 (2005, indexed). The regulations provide an ordering of the catch-up rules and consider the traditional catch-up to be utilized first. For example, if an individual — who is age 55, worked for a district for 23 years, and is eligible for the traditional catch-up because past contributions have been below the applicable limits — defers $16,000 in 2005 ($14,000 regular deferral plus $2,000 catch-up), then the $2,000 catch-up will be deemed a traditional catch-up, not an age 50 catch up. This is important because the maximum cumulative traditional catch-up is $15,000.
• Contributions for Five Years to Terminated Employees. An employer can make non-elective contributions to a 403(b) plan on behalf of a terminated employee for up to a five-year period following termination of employment.
  Contributions may be the lesser of (1) the employee’s last 12 months of compensation before termination, or (2) the annual dollar limit in effect for each year ($42,000 in 2005).
• Roth 403(b). Beginning in 2006, 401(k) and 403(b) plans may offer Roth contribution treatment. Similar to the Roth IRA, contributions will be made after tax, and distributions will be tax free, if certain requirements are met. The IRS has recently issued guidance and providers are in the process of implementing their procedures.
• Elimination of Life Insurance Investment. After February 14, 2005, the regulations eliminate stand alone incidental life insurance as a permitted plan component. It is possible that providers may develop products that contain enhanced death benefit features within an annuity contract format. Certain existing life insurance contracts are grandfathered.
• Transfers of Assets Between 403(b) Vendors. In the past, 403(b) vendors and employers frequently disagreed over the authority of the employer to move 403(b) assets to another vendor. Vendors often have taken the position that only employees can authorize such a transfer. The regulations make it clear that the employer may transfer funds without employee consent. Further, employee initiated transfers may occur only among employer authorized contracts and agreements.
• 403(b) Plan Termination. Historically, employers found it difficult to terminate their 403(b) arrangements, because 403(b) vendors held that employees owned their accounts; therefore, the primary relationship between vendor and employee had to continue. The regulations state that an employer in its written plan may permit termination of the 403(b) plan and the distribution of assets to the employees. At this point, it is uncertain how contract investment penalties and fees would be handled.

In conclusion, most plans are likely to incur major changes. This may be the ideal time to re-evaluate your retirement program design and the practicality of your administrative approach. Some districts will contemplate utilizing only one 403(b) provider in the future, in response to increased administrative responsibility. Clearly there are advantages and disadvantages to a one-provider approach. Most districts will begin to strategize over their options but will not take action until final regulations are published. The IRS has indicated a desire to finalize the regulations during 2005. If they are able to do so, then it is likely to be later this year rather than earlier.