403(b) Terminations: Important Considerations

John Iekel 

There are a variety of important considerations concerning terminations and freezes of a plan—and that includes 403(b) plans. In an ASPPA webcast, “Plan Freezing and Terminations,” Kelsey Mayo, American Retirement Association’s Director of Regulatory Policy and a partner with the Poyner Spruill LLP law firm, addressed priorities related to terminations of 403(b) plans. 

Before 2009, Mayo said, 403(b) plans could be frozen, but there was “no clear pathway to terminating the entire plan.” The Internal Revenue Code, she noted, did not provide for plan termination as distributable event, and there was no way for a participant to roll over distributions from discontinued plan. That changed in 2009, she said, with the issuance of regulations that provide for distribution upon plan termination. 

Generally, said Mayo, the same procedures used for terminating 401(k) plans apply to 403(b) plans; however, no determination letter is available upon the termination of a 403(b) plan. In addition, she said, the following apply: 

• For most 403(b) plan terminations, the employer cannot contribute to any other 403(b) plan. 
• A 403(b) plan is not considered a successor if fewer than 2% of the employees eligible as of the date of plan termination are eligible under the other 403(b) plan.
• An employer cannot close a 403(b) and move the assets to 401(k) plan. Only certain church plans can merge/transfer between 401(k) and 403(b) plans. Otherwise, Mayo said, participants have to make the rollover election, or can move the funds elsewhere.

When 403(b) plans are terminated, the last two steps in the process—notifying the participants about termination and distribution options and distributing the assets as soon as practicable—are the parts of the process “where we see the most interesting things,” observed Mayo.  

Distributions

Permissible distribution options include: 

• lump sum distribution of custodial accounts (cash or in kind);
• lump sum distribution of annuity account balance;
• distribution of fully paid individual insurance annuity contracts; 
• distribution of individual certificates representing fully paid interest in a group annuity; and 
• distribution of individual custodial accounts.  

There are options for distributing the funds at termination that are unique to 403(b) plans, Mayo said. 

Distribution of annuity contracts. Distribution of annuity contracts qualifies as a terminating distribution, Mayo said. However, she noted that many plans include individual annuity contracts, which can be “particularly troublesome in old contracts under voluntary plans,” and also means that one needs to ensure the employer can force the distribution and that amendments to a contract with a vendor may be required. “Take a close look and identify old contracts,” said Mayo, when annuity contracts are involved. 

The 403(b) rules in effect at time of distribution must be followed regarding delivery of annuity contracts, Mayo noted. She added that they are not taxable to the participant distribution, and therefore, no withholding or tax distribution reflected on 1099-R.  And lump sum distributions due to plan termination may be taken, and rollovers of any eligible rollover distribution may be made. 

Individual custodial accounts (ICAs). IRS Revenue Ruling 2020-23 allows distribution of ICAs, Mayo reminded attendees. But she had some words of caution concerning such distributions—problems related to ERISA could arise. 

And Mayo noted that ICAs can be distributed as a terminating distribution; however, the participants must be given a choice, and such an action can be the default only when nothing else is chosen. Also, under the rules for ICAs: 

• participants must be notified that the ICA is not part of the plan;
• the employer has no material rights under the ICA; and 
• the ICA must comply with 403(b) rules in effect at time of termination.

Avoiding Potential Problems 

Mayo had suggestions regarding problems that could arise with 403(b) plan terminations. She recommended ensuring that plan forfeitures are used. And she had words of caution regarding contract termination fees. “Be really careful” about them, she warned.