The minute differences between 403(b) plans and 401(k) plans are often inconvenient, at best, and sometimes they produce serious conundrums in plan administration which can be difficult to resolve.

Prominent among these is the issue of “small amount” cash-outs from 403(b) plans. The ability to cash out small amounts for terminated participants is especially important for a number of “small plan” filers, who are on the cusp of having to comply with the large plan audit rules because of long lost terminated employees with individual contracts who are still counted int the plan’s census-even after eliminating those you can under Rev. Proc. 2007-71.

Consider this. Reg 1.403(b)-7(b)(5) provides that “In accordance with section 403(b)(10), a section 403(b) plan is required to comply with section 401(a)(31) (including automatic rollover for certain mandatory distributions) in the same manner as a qualified plan.”   So, 403(b) plans regularly adopt the mandatory cash out provisions, under which terminated participants are cashed out of their benefits of $1,000 or less, and amounts of less than $5,000 are directly rolled over to an IRA. Simple enough, one would think.

However, there is a significant technical issue: what do you do when  these “small amounts” are held either in individual contracts where the employer has no control, or in certificates under group annuity contracts where the terms of the contract which require participant consent to any distribution.  This has the potential to create a “form and operation” problem if the document simply requires a force-out (using, for example, the IRS’s 403(b) LRM language), but the investment contract does not permit  the plan administrator to either cash out or rollover out those amounts? It also raises the question on how do you reduce your terminated participant accounts to avoid an audit?

  • You could try to distribute the annuity contract (or now the custodial account). That would satisfy the $1,000 rule, but would fail the rule governing amounts between $1,000 and $5,000, which requires a rollover. This is because the distribution of an annuity contract or a custodial account is not a rollover.
  • You could, instead, draft language (as many have done) which apply the mandatory cash out rule only in instances where the underlying investment vehicle permits the sponsor to liquidate the assets. This seems to address the “no employer discretion” rule the IRS applies in applying the force-out rule, but this does not address the small filer problem.

This really means is that you need look to an entirely different method other than 401(a)(31)(B) to manage these small amounts, to the extent that there is no employer ability to force a cash distribution from a contract.

The analysis is an interesting one.  You start with the basic premise: under ERISA, forcing the small distribution from a plan before retirement age is generally not permitted without a statutory exception. ERISA Section 203(e) covers this. It specifically permits the mandatory distribution of an accrued benefit of less than $5,000. ERISA, however,  does not require the distribution to be in cash, nor  that it  be accomplished through a rollover, nor does it require uniform treatment for all participants or prohibit employer discretion.  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,  given that annuity distributions  (or selective distribution) will fail 401(a)(31)(B), is there anything else in the Code that would prevent you from taking these steps when you actually are creating your own, uniquely designed  distribution rule to which 401(a)(31(B) does not apply?  It appears that you can do this because of one of the those basic differences between 401(a) and 403(b):   411(a)(11)(A) (which is the Code’s “anti-alienation” rule) prohibits a forced distribution except, in pertinent part,  as provided under 401(a)(31)). However, 411 does not apply to 403(b) plans. There is no “anti-alienation” rule under the Code which applies to 403(b) plans.   The closest thing to “anti-alienation” in the Code which applies to 403(b) plans is 403(b)(1)(C), which only requires that “the employees rights under the contract are nonforfeitable.”  By distributing an annuity contract, or selectively distributing amounts from contracts where the employer has a right to liquidate, a plan meets the 403(b) rule.

Therefore, making a distribution of a small annuity contract (or selectively liquidating) seems to be a viable  solution to this problem.

There are a few details to make this all work, of course, (for example, there could be  plan document issues); and I’m not sure the IRS has ever considered this issue. There is always the possibility that the IRS could take a more limited view of things.  But I’m not sure there’s another solution to this issue, short of guidance on how the cash out rule applies in these circumstances.