This article originally ran on March 3, 2015.
By Robert Toth
(Editor’s Note: Thank you, Bob Toth, for sharing this article from your “Business of Benefits” site. We know our members will appreciate the straightforward explanation and potential solution to one of the problems encountered when employers and providers attempt to comply with final 403(b) regulations.)
It is going on eight years now since the IRS fundamentally changed the 403(b) world with the issuance of regulations which were designed to make 403(b) plans more like 401(k) plans, and to formally impose more employer accountability on the operations of those plans. Though those regs brought very valuable change in many ways, and the attempt to hold employers more accountable is really crucial to the success of the retirement system, they were also overreaching in many other ways. We continue to see the negative impact from some of the more myopic and unfortunate portions of those rules, often showing up in the most mundane but important ways. Or, as Doonesbury once well put it in one of my favorite cartoon strips, “Even in Utopia there’s Myopia, Sir.”
Perhaps the most persistent of the regs’ shortcomings is the failure to adequately recognize, and deal with, the fact that individuals — and not plan sponsors — control vast aspects of plan operations under individually owned annuity contracts and custodial accounts. This results in circumstances (often in the otherwise most simple matters) which offer no easy solutions, compelling us to seek unique procedures addressing some of this regulatory myopia's most difficult effects. We often must look to “dusty” and unfamiliar sections of the federal income tax Code and ERISA for solutions.
One of the more useful tools we have found is one to deal with “small amounts” in former employees 403(b) annuity contracts. It really is indicative of the sort of thinking in which one must engage to adequately to deal with some of the more intractable 403(b) problems we face almost daily.
This particular problem arises for plans with contracts of former participants which cannot be excluded from plans under Department of Labor Field Assistance Bulletin 2009-2 and IRS Revenue Procedure 2007-71, which also have balances less than $5,000. These small amounts can easily be distributed by 401(k) plans, under Code Section 401(a)(31). But 403(b) plans have a challenge. Though the “small amount” rules of Section 401(a)(31) do apply to 403(b) plans, how do you distribute small amounts out of an individually owned contract over which the plan has no ability to force a cash rollover? These contracts typically need the participants’ consent to distribute even the “small amount.” This has a two very real impacts for many plans:
- That former participant’s “small amount” contract is counted toward the participant counts in determining eligibility for the small plan exception to the annual audit.
- It also can cause a serious “form and operation” problem with the plan document: just about every 403(b) plan document I've looked at blindly incorporates Code Section 401(k)’s “small amount” distribution terms into the plan. This term virtually always mandates the distribution and rollover of those amounts, as Section 401(a)(31) requires that the employer have no discretion in making the distribution if the term is in the document. However, the inability to force the distribution causes an operational failure, which can only be fixed by plan amendment-meaning a submission to EPCRS.
This really means that you need look to an entirely different method other than Section 401(a)(31) to manage these small amounts, to the extent that there is no employer ability to force a cash distribution from a contract. That method would be to “distribute” those small annuity contracts from the plan as an “in-kind” distribution, not as a mandatory roll-over under Section 401(a)(31)(B). Because the distribution of an annuity contract is not (and really cannot be) a rollover, Section 401(a)(31)(B) can’t work.
The analysis is an interesting one. You start with the basic premise: forcing the small distribution from a plan before retirement age is generally not permitted without a statutory exception. For ERISA purposes, ERISA Section 203(e) covers this. It specifically permits the mandatory distribution of an accrued benefit of less than $5,000. ERISA does not require the distribution to be in cash, nor that it be accomplished through a rollover. This means that it is permissible to force an in-kind distribution of a “small” annuity contract from the plan under ERISA.
For tax Code purposes, we rely upon one of the basic differences between Sections 401(a) and 403(b): though Section 411(a)(11)(A) prohibits a forced distribution (except, as a practical matter, as provided under Section 401(a)(31)), Section 411 does not apply to 403(b) plans. Section 403(b)(1)(C), on the other hand, only requires that “the employees’ rights under the contract are nonforfeitable.” Any individual 403(b) annuity contract (or custodial account, for that matter) must be, by its terms, nonforfeitable in order to qualify as a 403(b) annuity contract.
Therefore, making a distribution of a small annuity contract is a viable alternative to Section 401(a)(31). Note that ERISA Section 203(e) will not apply to governmental and church 403(b)plans — which also raises the possibility of forcing out larger amounts. You do not save on the Form 5500 and audit fees (there are none), but it offers some interesting planning opportunities for plan sponsors.
There are a few details to make this all work, of course, (for example, a plan document would want both Section 401(a)(31) and the above machination) and the IRS is still resisting treating custodial accounts as annuity contracts for distribution purposes. But at least the rules are forcing us to take a fresh look at rules for which we have otherwise fallen into “conventional wisdom” in our dealings.
Robert Toth is Principal, Law Office of Robert J. Toth, Jr., LLC.