The SECURE ACT introduced a concept which was not known well beyond a handful of 403(b) practitioners, that is the “distribution” of 403(b) individual custodial accounts from 403(b) plans. The lack of understanding of what this actually means has even lead one commentator in a highly respected trade organization’s technical piece to claim that this rule transforms 403(b) custodial accounts into IRAs.
Well, that is an easy one to settle: the “distributed” 403(b) custodial contract is NOT an IRA. It is simply a 403(b) contract which no longer has any relationship to a plan.
To more fully understand this, you really need to look at a bit of history. As we’ve noted in the past, 403(b) contracts have really been around since 1918 or so, where they were considered to be the tax-favored purchase of a retirement annuity for a teacher by a school. Unlike 401(a) arrangements-which are based on the concept of an employer run trust-403(b) plans are substantively based on an individual’s ownership of the retirement annuity, not by a formal pan with a trust structure.
Over the years, a number of employer based rules have come into play in the 403(b) market, one of which being the tax rule that a 403(b) plan cannot be fully terminated until all of the assets of a plan have been distributed within 12 months of the plan’s termination. Failing that, any distributions which were actually made during that 12 month period would lose their status as a qualifying rollover distribution, and those moving terminated 403(b) assets to an IRA would suffer all manner of tax penalties.
But how do you deal with the fact that a significant amount of 403(b) assets are held in investment contracts over which the plan sponsor has NO right to liquidate and distribute the assets (like in a 401(a) plan) upon plan termination? Well the 2007 403(b) regulations addressed this, by saying that a plan could “distribute” an annuity contract upon plan termination in a non-taxable “in-kind” distribution without liquidating the assets, which would then help fulfill this 12 month distribution requirement.
But then the IRS did something very odd. In spite of clear statutory language which treats 403(b)(7) custodial accounts in the same manner as 403(b)(1) annuity contracts, the IRS let it be widely known that it felt that 403(b) custodial accounts could NOT be “distributed” in the same manner as an annuity contract. This had the effect of freezing plan terminations if you could not convince ALL of your participants (even ex-employees) to liquidate and take a distribution of their investments being held in those custodial accounts.
SECURE Act Section 110 fixed this. 403(b) individual custodial accounts can now be distributed in the same manner as annuity contracts. What does this mean? According to the statute, those funds maintain their status as 403(b) contracts, not IRAs, and are subject to the 403(b) rules in effect at the time of the “distribution.”
Vendors have actually been doing this for decades (though I suspect many financial institution lawyers have not been aware of these practices over the years), out of necessity when a tax-exempt sponsor would disappear.
If done correctly, these distributions should be effective for ERISA purposes, as well as for Tax Code purposes. The question now becomes how do you actually distribute these contracts? There are a number of choices you have, and we are hopeful that the IRS will actually provide guidance on this point-and recognize as valid the good faith efforts in the past to distribute these contracts.
One last point: this rule, in effect, only can apply to individual a custodial contracts as opposed to those group custodial contracts which have become so popular in the past decade or so. The first reason is a practical one: virtually all master custodial accounts give the plan sponsor the right to liquidate participant assets upon plan termination, obviating the need to actually distribute a custodial account. The second reason is actually a legal one: a group custodial account is a contract between the employer and the vendor, not the participant. There is no vendor-participant contract to actually distribute, and I’ve never seen a group custodial account provide for the “spin-off” of an individual custodial account-unlike a group annuity contract, which will provide for the spin-off of an individual annuity certificate.
Here’s the verbiage from the statue:
SEC. 110. TREATMENT OF CUSTODIAL ACCOUNTS ON TERMINATION OF SECTION 403(b) PLANS.
Not later than six months after the date of enactment of this Act, the Secretary of the Treasury shall issue guidance to provide that, if an employer terminates the plan under which amounts are contributed to a custodial account under subparagraph (A) of section 403(b)(7), the plan administrator or custodian may dis- tribute an individual custodial account in kind to a participant or beneficiary of the plan and the distributed custodial account shall be maintained by the custodian on a tax-deferred basis as a section 403(b)(7) custodial account, similar to the treatment of fully-paid individual annuity contracts under Revenue Ruling 2011– 7, until amounts are actually paid to the participant or beneficiary. The guidance shall provide further (i) that the section 403(b)(7) status of the distributed custodial account is generally maintained if the custodial account thereafter adheres to the requirements of section 403(b) that are in effect at the time of the distribution of the account and (ii) that a custodial account would not be considered distributed to the participant or beneficiary if the employer has any material retained rights under the account (but the employer would not be treated as retaining material rights simply because the custodial account was originally opened under a group contract). Such guidance shall be retroactively effective for taxable years beginning after December 31, 2008.