Did you ever wonder what your friends with jobs in the public sector are doing with respect to their retirement? IRC Section 403(b) permits public schools and tax-exempt organizations that qualify under IRC Section 501(c)(3) to establish tax-sheltered annuities or custodial account plans for their employees. Similar in tax treatment to the 401(k) plan for the traditional corporate employee, the 403(b) plan allows employees to defer salary before income tax is paid and the money grows tax-deferred until the money is withdrawn. Upon withdrawal there is taxation, and also penalties for early withdrawals that qualify as triggering events for distribution (i.e., financial hardship, disability, separation from service). Section 403(b) plans are also known as tax-sheltered or tax-deferred annuities, or annuity contracts.
Before this year, termination of a 403(b) plan was one area that had previously not been well defined. Plan termination is generally a distribution event for participants and beneficiaries, but employers have had issues when terminating the plans without the consent of participants or beneficiaries because often plans are funded with individual annuity contracts controlled by participants and not employers. In February 2011, the IRS issued long-awaited guidance on the termination of 403(b) plans. See Revenue Ruling 2011-7. Under this recent revenue ruling, the IRS clarified how a 403(b) plan can be terminated and whether the distributions to participants and beneficiaries in connection with the termination are includable in gross income. Specifically, the following must occur for a 403(b) plan to be terminated:
In addition, the revenue ruling clarifies that certificates issued under a group annuity contract will be considered as the distribution of a "fully paid individual insurance contract" as long as all the other rules are met. Furthermore, the distributed annuity contract will still be considered a 403(b) contract and distributions from individual annuity contracts may be eligible to be rolled over to another retirement plan or a traditional or Roth IRA even though after termination the contracts are not a part of the retirement plan.
While all of this clarity is helpful, several issues were not addressed by the revenue ruling. For example, it is not clear whether the distribution of a custodial account can be treated as a "fully paid individual insurance annuity contract." Furthermore, the IRS did not provide guidance on what is meant by a "fully paid" contract. The good news is that a determination letter application process specifically for 403(b) plans is in the works. Hopefully the process of letter rulings and determinations between the taxpayers and the IRS will shed additional light on the areas not fully addressed by the revenue ruling.
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