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403(b) Plans: IRS Weighs in on Terminations

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Nonprofit employers can use several different strategies to shut down 403(b) retirement plans without saddling participants with big tax bills, Internal Revenue Service (IRS) officials say in Revenue Ruling 2011-7.

The revenue ruling, Section 403(b) – Taxability of Certain Annuity Contracts, relates to efforts by schools and other governmental sponsors of 403(b) defined contribution plans to terminate the plans, and whether distributions to participants resulting from a plan termination will end up in the participant’s taxable income.

IRS officials describe 4 situations:

  1. A governmental sponsor decides to shut down a plan that was funded entirely through the use of fully paid individual annuity contracts, provide that all benefits held in the plan are fully vested and nonforfeitable, and cash out by distributing fully paid individual annuities to many of the participants. In some cases, when contracts permit, the plan makes lump-sum payments. The plan lets plan participants know about rollover rights. The plan is a governmental plan that is not subject to the Employee Retirement Income Security Act (ERISA).
  2. The facts are the same as in Situation 1, except that the plan is funded by individual annuity contracts and also by a group annuity contract. The plan deals with the group annuity by issuing certificates stating the participants or beneficiaries have a fully paid interest in the group annuity contract. Some participants get lump-sum payments.
  3. The facts are the same as in Situation 2, except that the plan includes funds in mutual fund company custodial accounts as well as in individual annuities and a group annuity. The funds in the custodial accounts are distributed to the participant or beneficiary or rolled over into individual retirement accounts (IRA) set up by the participants or beneficiaries.
  4. The facts are the same as in Situation 3, except that the plan is a “money purchase pension plan,” or a defined contribution plan that is not a profit-sharing or a stock bonus plan, that is subject to the joint and survivor annuity and preretirement survivor annuity provisions of ERISA. If the assets held in a custodial account are supposed to be paid out in the form of an annuity, the sponsor provides a fully paid individual annuity.

In all 4 situations, “the delivery of a fully paid individual annuity contract to participants or beneficiaries, or of an individual certificate evidencing fully paid benefits under a group annuity contract, is not included in gross income until amounts are actually paid to the participant or beneficiary out of the contract, so long as the contract maintains its status as a Section 403(b) contract,” officials say in the revenue ruling. “The Section 403(b) status of any such contract is generally maintained if the contract thereafter adheres to the requirements of Section 403(b) that are in effect at the time of the delivery of such contract.”

If a plan makes distributions by providing lump-sum payments or other payments, those payments must be included in the participant’s taxable income, unless the participant rolls the payments into an IRA or other eligible retirement plan within 60 days after the distribution was made, officials say.