It is going on 8 years now since since the IRS fundamentally changed the 403(b) world with the issuance of regs which were designed to make 403(b) plans more like 401(k) plans, and to formally impose more employer accountability on the operations of those plans. Though those regs brought very valuable change in many ways, and the attempt to hold employers more accountable is really crucial to the success of the retirement system, they were also overreaching in many other ways. We continue to see the negative impact from some of the more myopic and unfortunate portions of those rules, often showing up in the most mundane but important ways. Or, as Doonesbury once well put it in one of my favorite strips, “Even in Utopia there’s Myopia, Sir.”
Perhaps the most persistent of the regs’ shortcomings is the failure to adequately recognize, and deal with, the fact that individuals- and not plan sponsors-control vast aspects of plan operations under individually owned annuity contracts and custodial accounts. This results in circumstances (often in the otherwise most simple matters) which offer no easy solutions, compelling us to seek unique procedures addressing some of this regulatory myopia’s most difficult effects. We often must look to “dusty” and unfamiliar sections of the Code and ERISA for solutions.
One of the more useful tools we have found is one to deal with “small amounts” in former employees 403(b) annuity contracts. It really is indicative of the sort of thinking in which one must engage to adequately to deal with some of the more intractable 403(b) problems we face almost daily.
This particular problem arises for plans with contracts of former participants which cannot be excluded from plans under DOL FAB 2009-2 and Rev Proc 2007-71 which also have balances less than $5,000. 401(k) plans can easily distribute these small amounts, under 401(a)(31). But 403(b) plans have a challenge. Though the “small amount” rules of 401(a)(31) do apply to 403(b) plans, how do you distribute small amounts out of an individually owned contract over which the plan has no ability to force a cash rollover? These contracts typically need the participants consent to distribute even the “small amount.” This has a two very real impacst for many plans:
- That former participant’s “small amount” contract is counted toward the participant counts in determining determining eligibility for the small plan exception to the annual audit.
- It also can cause a serious “form and operation” problem with the plan document: just about every 403(b) plan document I’ve looked at blindly incorporates 401(k)’s “small amount” distribution terms into the plan. This term virtually always mandates the distribution and rollover of those amounts, as 401(a)(31) requires that the employer have no discretion in making the distribution if the term is in the document. However, the inability to force the distribution causes an operational failure, which can only be fixed by plan amendment-meaning a submission to EPCRS.
This really means is that you need look to an entirely different method other than 401(a)(31) to manage these small amounts, to the extent that there is no employer ability to force a cash distribution from a contract. That method would be to “distribute” those small annuity contracts from the plan as an “in-kind” distribution, not as a mandatory roll-over under 401(a)(31)(B). Because the distribution of an annuity contract is NOT (and really cannot be) a rollover, 401(a)(31)(B) can’t work.
The analysis is an interesting one. You start with the basic premise: forcing the small distribution from a plan before retirement age is generally not permitted without a statutory exception. For ERISA purposes, ERISA Section 203(e) covers this. It specifically permits the mandatory distribution of an accrued benefit of less than $5,000. ERISA does not require the distribution to be in cash, nor that it be accomplished through a rollover. This means that it is permissible to force an in-kind distribution of a “small” annuity contract from the plan under ERISA.
For Code purposes, we rely upon one of the basic differences between 401(a) and 403(b): though 411(a)(11)(A) prohibits a forced distribution (except, as a practical matter, as provided under 401(a)(31)), 411 does not apply to 403(b) plans. 403(b)(1)(C), on the other hand, only requires that “the employees rights under the contract are nonforfeitable.” Any individual 403(b) annuity contract (or custodial account, for that matter) must be, by its terms, nonforfeitable in order to qualify as an 403(b) annuity contract.
Therefore, making a distribution of a small annuity contract is a viable alternative to 401(a)(31). Note that ERISA 203(e) will not apply to governmental and church 403(b)plans-which also raises the possibility of forcing out larger amounts. You do not save on the Form 5500 and audit fees (there are none), but it offers some interesting planning opportunities for plan sponsors.
There are a few details to make this all work, of course, (for example, a plan document would want both 401(a)(31) and the above machination) and the IRS is still resisting treating custodial accounts as annuity contracts for distribution purposes. But at least the rules are forcing us to take a fresh look at rules for which we have otherwise fallen into “conventional wisdom” in our dealings.
A few other notes:
- Our thanks to Chris Carosa and Fiduciary News for listing us as one of the “10 Insider Blogs Every 401k Plan Sponsor & Fiduciary Must Read.” Thank you Chris for the high compliment.
- Chris noted in his review that I do have an opinion on matters. There is a fascinating piece on Legal Blogging and self-censorship by Kevin O’Keefe in the aftermath of the Paris killings I do invite you to read. I do write much- my favorite Christmas gift from Conni was a beautiful fountain pen with a nib which absolutely dances on the page-and do so cherish and value the opportunity to express my opinions.
- Finally, for the curious among you, the following is the full Doonesbury strip from which I have quoted, above:
Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.