Summary

For the first time in 40 years, the IRS has published comprehensive 403(b) guidance in the form of final regulations. The regulations require much more district involvement than was necessary in the past. The regulations also require a written plan and generally place the burden on the district to make sure that the plan is administered in accordance with the terms of what will become, for many districts, their first 403(b) plan document. The regulations generally follow the proposed regulations with some important differences.

A delayed effective date of January 1, 2009 has generally been established to have a written plan document and necessary policies and procedures in place.

In addition, the IRS has begun inquiries as to whether schools are satisfying the 403(b) universal availability rule. Therefore, if all employees of your district do not have the opportunity to make elective deferrals by salary reduction to your 403(b), now is the time to carefully analyze the excluded employees for compliance with the existing rules and the new, more restrictive rules.

Here Are The Details

The IRS issued comprehensive final 403(b) regulations in July 2007. The effective date of the regulations is January 1, 2009. 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 multiple providers, the regulations will likely mean significant changes to the design and administration of plans.

The following are highlights of the final 403(b) regulations:

Written Plan. Now, every 403(b) arrangement must be maintained under a written plan. The regulations indicate that it is expected that a single-plan document will be adopted for any program with multiple investment providers. The written plan docment is expected to allocate responsibilities among the employer, the entity offering investment options and any other party involved.

Plans will now have to be operated in accordance with the terms of the plan document. Many schools have found it easy to delegate control over their 403(b) programs, because annuity contracts and custodial account agreements have allowed the providers to assert significant control. Much of the ultimate responsibility for administrative matters will now revert to sponsoring employers, although sponsors will continue to rely on providers for many administrative tasks. Many administration functions, such as plan loans and financial hardship requests, will require coordination between providers, and likely will required district involvement.

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 district, 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 (2) for each plan year ending after the close of the 12-month period beginning on the date the employee’s employment commenced, the employee worked fewer than 1,000 hours of service in the preceding 12-month period. The IRS has verbally indicated that this means that temporary employees, like camp workers, or individuals whose only services are coaching duties, who consistently work 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, for instance, a monthly entry system should pass muster.

Other exceptions have been eliminated under the final regulations. Therefore, beginning in 2009 employees covered under collective bargaining agreements, employees making a one-time election to participate in an alternative retirement program, and certain visiting professors must be offered the ability to make salary deferral contributions, unless otherwise excludable.

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 $5,000 (2007, 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 $20,500 in 2007 ($15,500 regular deferral plus $5,000 catch-up), then $3,000 of the 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. The final regulations confirm that 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 ($45,000 in 2007).

Roth 403(b). The final regulations confirm that Roth contributions may be made to a 403(b) plan. Similar to the Roth IRA, contributions will be made after-tax, and distributions will be tax-free, if certain requirements are met.

Elimination of Life Insurance Investment. After September 24, 2007 the regulations eliminate stand-alone life insurance contracts as a permitted plan component. Death benefits that are part of a qualified annuity contract continue to be permitted. Certain existing life insurance contracts are grandfathered.

Transfers of Assets Between 403(b) Providers. In the past, 403(b) providers and employers frequently disagreed over the authority of the employer and employee to move 403(b) assets to another provider. The regulations make it clear that exchanges among providers authorized under the plan and transfers to other plans maintained by participant’s current and former employers may, but need not, be permitted by the district. Exchanges after September 24, 2007 must be covered under an information-sharing agreement. See transfer and exchange rules on page 4.

New Distribution Rules. The final regulations indicate that administrative procedures would be inadequate if the plan allowed an employee to self-certify that they met the requirements for events such as loans, hardship distributions, and separation from employment distributions.

403(b) Plan Termination. Historically, employers found it difficult to terminate their 403(b) arrangements, because 403(b) providers held that employees owned their accounts; therefore, the primary relationship between provider 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 403(b) arrangements are likely to incur major changes, and this is the ideal time to reevaluate your program design and the practicality of your administrative approach.