Those of us who deal with Section 403(b) plans (a/k/a tax sheltered annuity plans) rejoiced when Treasury published Final Regulations under Code Section 403(b) back in 2007. Those regulations addressed many questions that either had not been dealt with, or had been dealt with only through a collection of periodic IRS administrative pronouncements. High on the list of previously unanswered questions was whether (and how) a Section 403(b) plan could be terminated. The Final Regulations do explain how to terminate a 403(b) plan, but a number of questions remained particularly in the case of plans that contain individual annuity contracts. IRS Revenue Ruling 2011-7 answers many of those questions and also offers some helpful clarifications of the rules contained in the Final Regulations.
For one thing, Rev. Rul. 2011-7 provides a useful exception to the general rule that an employer wishing to terminate a 403(b) plan must “make no contributions to any Section 403(b) contract that is not a part of the plan” for the period beginning on the plan termination date and ending 12 months after all assets of the terminated plan have been distributed. Under the exception the “no contributions” rule would not apply if, at all times during the period beginning 12 months before the termination and ending 12 months after the distribution of all assets from the terminated plan, fewer than 2% of the employees eligible under the terminating 403(b) plan as of the termination date were eligible under another 403(b) plan.
The ruling reaffirms that a plan will not be considered terminated unless all accumulated benefits are distributed to all participants and beneficiaries as soon as administratively practicable after the termination date. However, the ruling states that the distribution of a fully paid individual annuity contract will be considered a distribution for purposes of terminating a 403(b) plan. This makes sense because the plan sponsor will have effectively disposed of its obligation to pay the benefit by arranging for the payment by the issuer of the annuity contract.
Finally, Rev. Rul. 2011-7 clarifies the timing of the taxation of terminating distributions. In the case of a distribution in the form of an individual annuity contract (or a certificate evidencing fully paid benefits under a group annuity contract), the benefit will not be taxed until amounts are actually paid to the participant or beneficiary under the contract. Any other terminating distributions (lump payments, installments, etc.) would be subject to income tax at the time of payment unless the participant or beneficiary elects a direct rollover to an IRA or eligible retirement plan, or completes a transfer to an IRA or other eligible retirement plan within 60 days after the distribution – i.e., the normal rules apply.
The purest of technicians will complain that Rev. Rul. 2011-7 leaves unanswered one important question: can individually owned custodial accounts be treated the same way as individual annuity contracts in the context of a termination where the employer has no control? One would think the answer would be yes, though further guidance from the IRS will be necessary to confirm that. Nevertheless, Rev. Rul. 2011-7 provided very helpful guidance to employers who want to terminate 403(b) plans that contain individual annuity contracts. Of course, getting the insurance company that issued the contracts to cooperate is another matter!