It sometimes helps to go back to the basics when assessing the impact of changes to the law, including some of the most seemingly obscure of them. One of the most obscure of 403(b) rules lies in the structural difference between 403(b) and 401(a) plans. This has really only arisen in the past in matters related to 403(b) failures-which have been well addressed by the IRS in the 403(b) regulations.
Think about this: the tax favored status of the contributions to a 401(a) plan, and of the earnings on the fund held by the plan, are derived by the tax exempt status of the trust which receives and holds those funds under Code Section 501(a). Here is the actual languagefrom 501(a):
(a) Exemption from taxation An organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503.(a) .
The 401(a) trust is an actual tax exempt organization. As a tax exempt organization, it is subject to the same basic rules which apply to any other tax exempt entity, that is, it must have a not-for-profit-exempt purpose. An example on how this comes into play is that a 401(a) plan’s investments can be subject to Unrelated Business Income Tax under Section 512 if it invests in partnership or other business interests in such a way that is deemed to be, under the tax regs, as engaging in business activities for a profit.
Compare this to the 403(b) plan. The favorable tax status granted to 403(b) plan participants does not derive from the tax exempt status of any particular organization or entity. Instead, the statutory language makes it clear that it is derived from the contributions being made to an annuity contract, a custodial account or retirement income account that meets the rules under 403(b). There is no requirement under 403(b) that the custodian of these funds (whether it be an insurance company or any other qualified financial institution) be treated as a tax exempt entity under 501(a) as a condition of the tax favored status of those contributions or earnings thereon. Even where the 403(b) assets are held by a custodial account, by a trust account which is designed to be a 403(b) custodial account, or by a retirement income account at a financial institution that also “custodies” 401(a) funds, the “tax status” of that trust is generally meaningless. The tax status of the funds are determined under 403(b), not 501(a). Functionally, you see this difference in the 403(b) regulations where 403(b) plans themselves do not suffer “tax qualification” failures: it is each contract which is governed by the failure which governs the actual tax effect.
To apply the 401(a) UBIT example, this means that a 403(b) plan’s investments is not subject to Unrelated Business Income Tax under Section 512. This has generally been a distinction without a difference because 403(b) plans (except, perhaps, church retirement income accounts) could not invest in partnerships or other business interests in such a way that is deemed to be engaging in business activities for a profit. It could only be invested in mutual funds and annuity contracts.
So how, may you ask, is any of this relevant? Its relevance arises when we assess how to implement the tremendous changes that we see on the horizon, whether it be implementing unique lifetime income vehicles, PEPs, collective trusts, or any other of the sort of the innovative programs being developed which are designed to enhance retirement security. A number of these changes will require a close look at the manner in which the organizational “status” of the investment or the custodian will come into play. As importantly, this serves as a reminder that these dramatic changes all require close attention to this sort of detail. After all, once again, a 403(b) in not a 401(a)…..