NOTE: I STRONGLY CAUTION READERS THAT THE FOLLOWING IS MERELY A SUGGESTED APPROACH WHICH COULD BE SENSIBLY USED BY THE IRS IF IT WERE TO CHOOSE TO RECOGNIZE THE DSTRIBUTION OF INDIVIDUAL CUSTODIAL ACCOUNTS FROM 403(b)(7) PLANS, AND TO LEAD TO FURTHER DISCUSSION. IT IS NOT REFLECTIVE OF THE IRS’S (NOR, AS FAR AS I KNOW, THE DOL’S) CURRENT POSITION, OR EVEN ONE IT IS CONSIDERING. THE FOLLOWING IS NOT INTENDED TO PROVDE LEGAL OR TAX ADVICE, AND SHOULD NOT BE USED AS A BASIS TO JUSTFY A DISTRIBUTION OF A 403(b)(7) CUSTODIAL ACCOUNT.
I, like many others, struggle with the notion of advocating for the ability to terminate a 403(b) retirement plan. However, any retirement plan needs to be able to be sanely unwound -often for a number of critical, exigent reasons unrelated to the plan itself. We now find ourselves in a growing number of difficult circumstances where the right solution is to terminate a 403(b) plan, but find ourselves unable to do so.
The IRS’s ongoing position is that an individual 403(b)(7) custodial account cannot be distributed from a 403(b) plan upon its termination, while a “fully paid” annuity contract is permitted to be distributed- as it will not deem the custodial account to be an annuity for these purposes. This has the practical effect of preventing termination of any 403(b) plan which is funded with individual custodial accounts. As time wears on, and this position begins to get long in the tooth, its “unworkableness” becomes more and more apparent as it causes difficulties beyond the actual plan itself.
I have never fully understood the legal concerns that the IRS has with treating the custodial account as a deemed annuity and thus a distributable asset from the plan, but will fully admit that this arises from my perspectives on these contracts bred by my particular experience with them.
Could it be that the IRS is uncomfortable with the notion of treating the custodial account as an annuity means treating the custodian contract of a plan as being, itself, a plan asset? If so, this concern is eminently understandable. It seems counterintuitive, at best, that a part of the fundamental structure of a plan be considered a plan asset. It makes much better sense that the underlying securities (or the cash generated from their sales) held by the custodian is the asset that can be distributed; and that its not really possible to distribute a portion of the structure of the plan. An individual custodial account cannot possibly be a financial instrument that can be recognized as an “in-kind” plan asset: its part of the plan itself.
Like many things 403(b), however, these sorts of issues are novel and of first impression when applied to such plans, requiring that we return to some very basic concepts.
I would hope that the following analysis would be useful.
Lets start with the distribution of an annuity contract from a 401(a) plan. The tax regulations have long recognized that an annuity contract is a financial instrument (as opposed to cash) which can be distributed from a 401(a) plan (see 1.401(a)-20, Q&A 2); that it can have an account balance or a cash value (see 1.401(a)31, Q&A 17 which requires a qualified plan distributed annuity to allow a direct rollover of funds from the annuity contract to another plan or IRA); and the IRS has issued a number PLRs to that effect (see, for example PLR 200951039, which describes a variable annuity contract issued from a plan).
So it becomes a relatively straightforward proposition to permit the distribution of an individual annuity contract from a terminating 403(b) plan (putting aside for now the issue of what is a “fully paid” annuity contract). Even though it can be seen as constituting a part of the actual structure of a plan, its distribution is accorded no different legal or tax effect than is granted to annuity contracts distributed from a 401(a) plan. And just as a qualified plan distributed annuity continues to be subject to 401(a) (as administered by the insurance company, see for example 1.401(a)-20 Q&A 17), the distributed annuity 403(b) contract continues to be subject to the terms of 403(b) (see Rev. Rul. 2011-7).
But what of individually owned 403(b) custodial accounts which, like the annuity contracts they are deemed to be by the Code, seem to be an integral part of the plan’s structure? Could it also be comfortably considered a financial instrument capable of being distributed by a 403(b) plan on termination in the same manner as an annuity?
I invite consideration of the following:
-The individually owned custodial account is a financial instrument, a legally binding contract which is signed by the participant (not the plan) and the custodian, like the individual annuity contract. It has specific terms and conditions on the exercise of the rights by the participant/owner over the underlying securities it holds. For example, the custodial accounts limit the distribution of its assets to those distributions permitted under 403(b)-11, and needed No-Act approval from the SEC to do so-as had the annuity contract. The legal right and title to those contracts under state law run to the participant (though also being subject to ERISA standards for ERISA plans), as does the rights under an individual annuity contract. It would be hard to argue that these are not ”bundle of rights” which constitutes property rights under traditional state property law analysis, as with an annuity contract.
-The individual custodial account is fundamentally different than the traditional 401(a) custodial account, here with rights to the underlying assets themselves not only running directly to the participant, but the rights of participants can vary greatly within the same plan.
-Given the state law property rights granted to the individual owner of the custodial accounts, and that the DOL uses ordinary notions of property law to determine whether or not something is a plan asset (see, for example AO 94-31-though the DOL has yet to take a position on this in the 403(b) custodial account context), and that annuity contracts are generally considered plan assets, it becomes hard to argue that the individually owned custodial account is not also a plan asset. And just because it is a plan asset which holds other plan assets (like annuity contracts with separate accounts), this does not disqualify its own plan asset "status." I suspect that, if the custodial account were abused by a participant or vendor in some sort of way, the DOL would be the first to acknowledge that it is a plan asset.
-The custodial account can, and has historically has been able to, legally exist and operate independently from the existence of a plan and a plan sponsor, with the custodian acting in the same manner as an insurer under a 403(b) annuity contract which is not related to a plan.
-This financial instrument is recognized as a security by the SEC. The SEC’s own position recognizes the interests embodied in the 403(b) custodial account as a security owned by the participant, which further lends weight to the argument that it is an asset which can be distributed. In Release 33-6188, it stated these interests are securities, though “as a matter of administrative practice…the staff does not require such interests to be registered." This is not a reference to the underlying securities held by the custodial account, as those interests are specifically required to be registered.
Admittedly, this presents a one sided view, but it is one which is both legitimate and could form the basis of permitting the distribution of the individual custodial account upon plan termination. Supporting this from a logistical view of things is that there are already a significant number of such custodial accounts described above in the marketplace which exist outside a plan. These came to be by virtue of 90-24 transfers occurring before 9/24/2007. Note that I do not address-nor advocate-the application of this approach to distributions from ongoing plans. There are a number of other complications which arise from that circumstance. Note, too, that I suggest that this analysis is only possible under 403(b) (and not under 401(a)) because of the specific language of 403(b)(7).
I would hope that this approach, recognizing the individual custodial account as the financial instrument it is, would make some sense to our regulators in deciding upon its termination distribution.