On July 26, 2007, the Internal Revenue Service (IRS) issued final regulations for 403(b) plans. These final regulations were expected for several years, and they are generally consistent with proposed regulations that were issued in November 2004. Most items under the final regulations can be addressed over the next two school years.
This Legal Alert deals only with two minor items that school districts need to address immediately. One change will become effective September 24, 2007, and one will become effective September 25, 2007.
Immediate Action Needed
School districts need to address two 403(b) items immediately:
- How the district will handle new limitations that affect an individual’s ability to purchase life insurance under the district’s 403(b) plan
- How the district will address new restrictions on 403(b) account transfers and exchanges.
Life Insurance Restrictions
All 403(b) funds need to be invested in a qualified annuity or custodial account. Historically, many insurers sold individual life insurance contracts to employees under the premise that those contracts would satisfy the 403(b) requirements. The final regulations clearly provide that such insurance contracts are not permitted under Internal Revenue Code (Code) Section 403(b). Fortunately, the IRS has provided substantial relief for contracts that are issued on or before September 23, 2007.
Under the final regulations, 403(b) funds cannot be used to purchase separate or stand-alone life insurance contracts that are issued after September 23, 2007. Put simply, the regulations simply restate the language of the Code itself which says that 403(b) funds need to be invested in an annuity contract or a custodial account.
Some life insurance policies that are purchased on or before September 23, 2007 and some annuity contracts that provide life insurance benefits can still be held in a 403(b) plan. In order for an employee to purchase any such contract, the contract must satisfy the IRS’s so-called “incidental benefit rule.” In very general terms, the incidental benefit rule says that an annuity contract or custodial account must be designed to provide retirement benefits. Any life insurance benefits must be incidental to that retirement benefit.
Under a very general analysis, a life insurance contract will be incidental to the retirement benefit only if less than 50% of an individual’s contributions are used to purchase whole life insurance benefits. This limit is further reduced to 25% of an individual’s contributions if the individual purchases term or universal life insurance benefits. The reality of the situation is that most school districts will never know whether a particular vendor or individual satisfies these requirements.
Consequences: If an individual or a vendor fails to satisfy these requirements, then all of that individual’s or vendor’s 403(b) contracts will be deemed to fail to satisfy the 403(b) requirements. No other individual or vendor will be affected by the failure.
Recommendation: We recommend that the school district send a short notice to its employees and approved vendors. The sample notices attached to the end of this Legal Alert are designed to address both of the issues addressed in this Legal Alert. We strongly recommend that districts use their own form instead of trying to negotiate, modify and execute different forms for different vendors.
Contract Exchanges/Transfers
Under current 403(b) rules, an individual can generally transfer money from one 403(b) provider to another on a tax-free basis. These transfers are often referred to as “90-24 transfers” because they were addressed in IRS Revenue Ruling 90-24.
90-24 transfers are not widely used in Wisconsin, but they are very beneficial when a district has approved of only one or only a few vendors and an individual employee would like to work with a different vendor. In other words, an employee could make his or her own decision to work with a vendor that was not specifically authorized or approved to work in that employee’s school district. The final regulations will prohibit these transfers after September 24, 2007.
Note: The final 403(b) regulations simply indicate that the prior rules will apply through September 24, 2007. As such, there is a question about whether this means that the transfer must be completed by September 24 or only that the paperwork must be completed by that date. Several IRS representatives have informally indicated that the paperwork simply needs to be completed by that date. As such, school districts may want to take a conservative approach and advise employees and vendors that the actual transfer must be completed on or before September 24, 2007.
Although never mentioned by name, 90-24 transfers will no longer be allowed after September 24, 2007. Instead, employees will be allowed to exchange one contract for another within the same 403(b) if:
- The district’s 403(b) plan allows such exchanges
- The participant has an accumulated benefit immediately after the exchange that is at least equal to the accumulated benefit immediately before the exchange
- The new contract includes distribution restrictions that are no less stringent than those imposed on the contract being exchanged
- The district enters into an information agreement with the vendor that receives the exchange to ensure that both the district and the vendor will provide each other with:
- “Information necessary for the resulting contract, or any other contract to which contributions have been made by the [district], to satisfy 403(b), including information concerning the participant’s employment . . . ;” and
- “Information necessary for the resulting contract, or any other contract to which contributions have been made by the [district], to satisfy other tax requirements.”
The regulations would seem to allow a district to adopt and/or sign formal plan amendments and vendor contracts (including information agreements) at any time before January 1, 2009. Even so, each district should think carefully before allowing such exchanges before the district has negotiated and signed the vendor contracts because it will lose much of its ability to negotiate the terms of such an arrangement if the vendors know that the district is now required to sign a new agreement.
Consequences: If an individual or a vendor fails to satisfy these requirements, then all of that individual’s or vendor’s 403(b) contracts will be deemed to fail to satisfy the 403(b) requirements. No other individual or vendor will be affected by the failure.
Recommendation: We recommend that the school district send a short notice to its employees and approved vendors. The sample notices attached to the end of this Legal Alert are designed to address both of the issues addressed in this Legal Alert. As above, we recommend that districts use their own form instead of trying to negotiate, modify and execute different forms for different vendors. We also strongly recommend that districts not try to review and negotiate individual information sharing agreements at this time. To the extent that a district is going to use this exemption, it should plan on negotiating those agreements before it allows any such exchange.
Conclusion
This Legal Alert is designed to address only two specific items under the final 403(b) regulations. This Legal Alert is also written specifically with respect to the unique issues and decisions that affect Wisconsin school districts. We will issue a second Legal Alert that provides a more complete summary of the final 403(b) regulations on September 21, 2007 and a third Legal Alert that describes several other unique tax issues for Wisconsin school districts on September 28, 2007.