The Internal Revenue Service has clarified, in Revenue Ruling 2011-7, how a section 403(b) retirement plan can be terminated, and whether distributions made to participants and beneficiaries in connection with such a termination are includable in gross income. Section 403(b) plans can be sponsored only by employers that are tax-exempt organizations under section 501(c)(3) of the Internal Revenue Code, or by state or local government employers for the benefit of public school employees.

Plan termination generally is a distribution event for participants and beneficiaries. However, from a practical standpoint, employers have had difficulty terminating section 403(b) plans without the consent of participants and beneficiaries because of the long history of the plans being funded with individual annuity contracts controlled by participants rather than employers. The new IRS guidance indicates that the following must occur for a section 403(b) plan to be considered terminated:

  • The plan permits benefit payments upon plan termination.
  • The employer approves a binding resolution that ceases all contributions to the section 403(b) plan and approves the termination of the plan. All contributions must fully vest upon termination.
  • Participants and beneficiaries are notified of the termination and the tax consequences of a distribution from the terminated plan. Amounts distributed to participants and beneficiaries at plan termination may be eligible to be rolled over to another retirement plan or a traditional or Roth IRA.
  • All plan assets, including “fully paid individual annuity contracts,” are distributed within 12 months following termination of the plan.
  • The employer does not make contributions to any other section 403(b) plan, including plans in existence before the termination, during the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan.

 

The Small Business Jobs Act of 2010, which was signed into law by President Obama on September 27, 2010, expands the current Roth contribution and conversion rules for 401(k), 403(b), and governmental 457(b) plans. Employers must quickly decide whether they wish to implement these changes in their defined contribution retirement plans.

In-Plan Roth Conversions. The Act allows employers to amend their plans to provide for Roth conversions within 401(k), 403(b), and governmental 457(b) plans.

New rules that went into effect January 1, 2010, allow all plan participants, regardless of their modified adjusted gross income, who are eligible to receive a plan distribution (typically because they have terminated employment or attained age 59½) to elect to roll over amounts from a 401(k), 403(b), or governmental 457(b) plan to a Roth IRA. Such rollovers are taxable in the year of distribution, although a special tax rule allows participants to defer the tax due on 2010 rollovers into 2011 and 2012.

The Act now permits plan participants to leave their money in their plan accounts and still take advantage of the Roth rollover rules if certain requirements are met. First, the plan must allow for "Roth contributions." Roth contributions are made on an after-tax basis, and investment earnings accumulate tax-free if the contributions are held in the plan for at least five years. Second, a participant must have had a distribution event under the terms of the plan. Some employers may wish to amend their plans to expand the distribution options to allow more participants to take advantage of Roth conversions. For example, a plan could be amended to allow for in-service withdrawals for all employees who have attained age 59½ or for the withdrawal of employer contributions that have been held in the plan for a fixed number of years. New distribution options may be limited to only those participants who request an in-plan Roth conversion.

Although it appears that the Internal Revenue Service will provide a remedial amendment period for plan sponsors to amend their plans for Roth conversions, plan sponsors should decide now whether they will allow such conversions so that participants can take advantage of the 2010 special tax rules.

Governmental 457(b) Plans May Now Permit Roth Contributions. The Act also allows governmental employers to amend their section 457(b) plans, effective January 1, 2011, to allow participants to designate their elective deferrals as Roth contributions. A similar plan feature already applies to 401(k) and 403(b) plans. Governmental employers that wish to allow Roth contributions as of January 1, 2011, should contact their plans’ vendors and start making payroll and human resources system adjustments now. Section 457(b) plan documents will need to be amended to reflect the ability to make Roth contributions.

 

If you have any questions about this alert, please contact Brian M. Pinheiro at 215.864.8511 or pinheiro@ballardspahr.com, or any member of Ballard Spahr's Employee Benefits and Executive Compensation Group. 
Copyright © 2010 by Ballard Spahr LLP.
www.ballardspahr.com
(No claim to original U.S. government material.)

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the author and publisher.

This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.

Upon the completion of these steps, the employer will no longer have any responsibility for the terminated section 403(b) plan or the annuity contracts under such plan. If the section 403(b) plan is subject to the Employee Retirement Income Security Act of 1974 (ERISA), as amended, a final Form 5500 must be filed with the U.S. Department of Labor for the plan year of termination.

With regard to individual annuity contracts, the employer must issue or distribute the actual contracts to participants and beneficiaries upon termination, although a participant or beneficiary can wait to receive payments from such contracts. Interestingly, the ruling provides that distributions from individual annuity contracts may be eligible to be rolled over to another retirement plan or a traditional or Roth IRA even though, after termination, the contracts are no longer part of a retirement plan.

Although this guidance is helpful to employers in deciding how to structure their retirement plan offerings going forward, some questions remain. For example, it is not clear what the IRS means by a “fully paid individual annuity contract.” It is expected that the IRS will issue more section 403(b) plan guidance in the months to come with its establishment of a determination letter application process for section 403(b) plans.

If you have questions regarding the termination of a section 403(b) retirement plan, please feel free to contact Brian M. Pinheiro, 215.864.8511 or pinheiro@ballardspahr.com, or any member of Ballard Spahr’s Employee Benefits and Executive Compensation Group.

Copyright © 2011 by Ballard Spahr LLP.
www.ballardspahr.com
(No claim to original U.S. government material.)

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, including electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the author and publisher.

This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.