IRS Issues Guidance on Distribution of ICAs in Kind When a 403(b) Terminates

The IRS in Revenue Ruling 2020-23 issued guidance on distribution of individual custodial accounts (ICAs) in kind when a 403(b) terminates. The IRS issued the guidance on Nov. 5.  

At issue is whether a 403(b) plan funded through 403(b)(7) custodial accounts in two situations has been terminated in accordance with the rules of Treas. Reg. §1.403(b)-10(a), and whether distributions made to participants or beneficiaries in connection with termination of the plan are includible in gross income.

Situation 1

Plan A is a defined contribution plan that includes nonelective employer contributions and elective deferrals. Section 205 of ERISA applies neither to Plan A generally nor to any participant under Plan A. The plan satisfies the requirements of Internal Revenue Code Section 403(b) and Treas. Regs. §§1.403(b)-2 through 1.403(b)-10. 

Plan A permits benefits to be paid only after termination from employment or upon plan termination. It is funded solely through the use of 403(b)(7) custodial accounts maintained under individual agreements. All amounts held under Plan A are attributable to employer contributions, including elective deferrals as defined in Treas. Reg. §1.403(b)-2(b)(7), and no amounts held under Plan A are attributable to designated Roth contributions or after-tax contributions. Neither the sponsoring employer, nor any other entity that is treated as the same employer under Internal Revenue Code Sections 414(b), (c), (m), or (o) on the date of plan termination, makes contributions to any 403(b) contract that is not part of Plan A, including during the period beginning on Jan. 1, 2021, and ending on the date that is 12 months after distribution of all assets from the plan.

On Jan. 1, 2021, the employer sponsoring Plan A acts to terminate it. That includes the employer executing a binding resolution to:

• cease future contributions to custodial accounts under Plan A; and
• terminate Plan A, effective Jan. 1, 2021 (the date of plan termination). 

The binding resolution also provides that: 

• all benefits held under Plan A are fully vested and nonforfeitable as of Jan. 1, 2021; and 
• all benefits be distributed as soon as practicable thereafter. 

Participants and beneficiaries in Plan A are notified of the plan termination. Distributions under the terms of the plan and the termination resolution are made as soon as administratively practicable after the date of plan termination. For a participant or beneficiary who affirmatively elects to receive a distribution, depending on the participant’s or beneficiary’s election, a distribution equal to that participant’s or beneficiary’s account balance is made to:

• that participant or beneficiary; 
• an IRA or annuity under established for that participant or beneficiary; or 
• another eligible retirement plan. 

Each custodial account provider permits any distribution that is an eligible rollover distribution, including to an IRA established by the same provider that permits investment in the same mutual funds in which the participant’s or beneficiary’s custodial account is or may be invested. The plan administrator does the following: 

• provides a notice to each participant describing their rollover rights;
• withholds in accordance with Internal Revenue Code Section 3405 and Treas. Reg. §1.403(b)-7(g); and 
• reports the distribution on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

For a participant or beneficiary who does not affirmatively elect to receive a distribution, a distribution under the terms of the plan and the termination resolution is made as soon as administratively practicable after the date of plan termination and is effectuated by the distribution of an ICA in kind to the participant, beneficiary who is an alternate payee or beneficiary of a deceased participant.

As part of the process of distributing an ICA in kind to a participant or beneficiary, the plan administrator notifies the participant or beneficiary that, after the distribution of the ICA in kind, the custodial account is being maintained as an ICA of the participant or beneficiary and is no longer part of Plan A. The distributed ICA is maintained by the custodian as a 403(b)(7) custodial account that adheres to the requirements of Code Section 403(b) in effect at the time of the distribution of the ICA until amounts are actually paid to the participant or beneficiary. In addition, the employer has no material retained rights under the distributed ICA after it has been distributed.

Situation 2

The facts are the same as in Situation 1, except that Plan A is funded not only by custodial accounts maintained under individual agreements, but also by custodial accounts maintained under group agreements. Regarding custodial accounts maintained under individual agreements, the facts are the same as in Situation 1.

Regarding custodial accounts maintained under group agreements, distributions under the terms of Plan A and the termination resolution are made as soon as administratively practicable after the date of plan termination. For a participant or beneficiary who affirmatively elects to receive a distribution, depending on the participant’s or beneficiary’s election, a distribution equal to the participant’s or beneficiary’s account balance is made either to the participant or beneficiary or to an IRA established for the participant or beneficiary or another eligible retirement plan.

For a participant or beneficiary whose account balance is held all or in part in custodial accounts maintained under a group agreement and who does not affirmatively elect to receive a distribution described in the prior paragraph, a distribution of an amount from the custodial accounts maintained under the group agreement is made as soon as administratively practicable after the date of plan termination and is effectuated by the distribution of an ICA in kind to each participant, beneficiary who is an alternate payee, or beneficiary of a deceased participant in the custodial accounts maintained under a group agreement. 

Distribution of an ICA in kind from the custodial accounts maintained under a group agreement is accomplished by distributing a document that evidences the ICA, including:

• the accumulated nonforfeitable value of the participant’s or beneficiary’s interest in the custodial accounts maintained under a group agreement; and 
• associated rights and responsibilities of the participant or beneficiary and custodian. 

A distributed ICA is maintained by the custodian as a 403(b)(7) custodial account that adheres to the requirements of Code Section 403(b) in effect at the time of the distribution of the ICA, until amounts are actually paid to the participant or beneficiary. In addition, the employer has no material retained rights under an ICA after it has been distributed.

Holding 

The IRS holds in Rev. Rul. 2020-23 that in Situation 1 and Situation 2, Plan A is terminated in accordance with the rules of Treas. Reg. §1.403(b)-10(a). It also holds that distribution of an ICA in kind to a participant or beneficiary is not includible in gross income until amounts are actually paid to the participant or beneficiary out of the ICA, so long as the ICA maintains its status as a 403(b)(7) custodial account. Any other amount distributed from a custodial account to a participant or beneficiary to effectuate plan termination is includible in gross income, except to the extent the amount is rolled over to an IRA or other eligible retirement plan by a direct rollover or by a transfer made within 60 days.

Comments Requested

On Nov. 5, the IRS also said in Notice 2020-8 that it is requesting comments regarding protection of annuity and spousal rights under Section 205 of ERISA regarding a terminating 403(b) plan funded through the use of custodial accounts.

The IRS explains that Rev. Rul. 2020-23 provides guidance allowing the distribution of an ICA in kind as part of the termination of a 403(b) plan that does not have a participant to whom the annuity and spousal rights provisions of Section 205 of ERISA apply, but issues remain regarding the application of Section 205 of ERISA in connection with a distribution of an ICA in kind under Section 110 of the SECURE Act for a Section 403(b) plan with at least one participant to whom Section 205 applies. That includes situations in which: 

• a participant cannot be reached;
• a participant does not elect to waive the QJSA and QPSA form of benefit, or;
• a married participant elects to waive the QJSA and QPSA form of benefit but the participant's spouse does not consent to the waiver.

The IRS and the Treasury Department request comments on the application of ERISA Section 205 annuity and spousal rights provisions in connection with a distribution in kind of an ICA under Section 110 of the SECURE Act, including any administrative or other burdens that may arise and potential methods or rules that could minimize or eliminate those burdens.

Comments should be submitted in writing on or before Feb. 3, 2021, and should include a reference to Notice 2020-80. Comments may be submitted in two ways: 

• Electronically via the federal eRulemaking Portal at http://www.regulations.gov (type “IRS IRS-2020-0032” in the search field on the regulations.gov homepage to find this notice and submit comments). 
• By mail to: Internal Revenue Service, Attn: CC:PA:LPD:PR (Notice 2020-80), Room 5203, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044.