The purposes of these proposed regulations are to update the current regulations under section 403(b) to delete provisions that no longer have legal effect due to changes in law, to include in the regulations a number of items of interpretive guidance that have been issued under section 403(b) since the 1964 regulations,^[1] and generally to reflect the numerous legal changes that have been made in section 403(b). A major effect of the legal changes in section 403(b) has been to diminish the extent to which the rules governing section 403(b) plans differ from the rules governing other arrangements that include salary reduction contributions, i.e., section 401(k) plans and section 457(b) plans for State and local governmental entities. Thus, these regulations will reflect the increasing similarity among these arrangements.

Since the existing regulations were issued in 1964, a number of revenue rulings and other guidance under section 403(b) have become outdated as a result of changes in law. In addition, as a result of the inclusion in these proposed regulations of much of the guidance that the IRS has issued regarding section 403(b), it is anticipated that these regulations, when finalized, will supersede a number of revenue rulings and notices that have been issued under section 403(b). Thus, the IRS anticipates taking action to obsolete many revenue rulings, notices, and other guidance under section 403(b) when these regulations are issued in final form.^[2] However, the positions taken in certain rulings and other outstanding guidance are expected to be retained. For example, it is intended that a revenue ruling will be issued that substantially replicates and consolidates the existing rules^[3] for determining when employees are performing services for a public school.^[4]

The existing regulations include special rules for determining the amount of the contributions made for an employee under a defined benefit plan, based on the employee’s pension under the plan. These rules are generally no longer applicable for section 403(b) because the limitations on contributions to a section 403(b) contract are no longer coordinated with accruals under a defined benefit plan. (See also the discussion of defined benefit plans below under the heading Miscellaneous Provisions.) However, the rules for determining the amount of contributions made for an employee under a defined benefit plan in the existing regulations under section 403(b) are also used for purposes of section 402(b) (relating to nonqualified plans funded through trusts) and, accordingly, these rules are proposed to be deleted from the regulations under section 403(b). New proposed regulations under section 402(b) would authorize the Commissioner to issue guidance for determining the amount of the contributions made for an employee under a defined benefit plan under section 402(b). See also the request for comments on this guidance under the heading Comments and Public Hearing.

The proposed regulations also include controlled group rules under section 414(c) for entities that are tax-exempt under section 501(a).

Section 403(b) provides an exclusion from gross income for certain contributions made by certain types of employers for their employees to specific types of funding arrangements. There are three categories of funding arrangements to which section 403(b) applies: (1) annuity contracts (as defined in section 401(g)) issued by an insurance company; (2) custodial accounts that are invested solely in mutual funds; and (3) retirement income accounts which are only permitted for church employees. The exclusion applies only if certain general requirements are satisfied. For purposes of most of these requirements, section 403(b)(5) provides that all section 403(b) contracts purchased for an individual by an employer are treated as purchased under a single contract. Other aggregation rules apply for certain specific purposes, including the aggregation rules under section 402(g) for purposes of satisfying the limitations on elective deferrals (which apply both on an individual basis and to all contributions made by an employer) and the controlled group rules of section 414(b) and (c) for purposes of the general nondiscrimination rules and the contribution limitations of section 415 (which generally apply on an employer-by-employer basis).

Section 403(b)(1)(C) requires that the contract be nonforfeitable except for the failure to pay future premiums. The proposed regulations define nonforfeitability based on the regulations under section 411(a) and clarify that if an annuity contract issued by an insurance company is purchased that would satisfy section 403(b) except for the failure to satisfy this nonforfeitability requirement, then the contract is treated as a contract to which section 403(c) applies. Section 403(c) provides that the value of a nonqualified contract is included in gross income under the rules of section 83, which generally does not occur before the employee’s rights in the contract become substantially vested. Under the proposed regulations, on the date on which the employee’s interest in that contract becomes nonforfeitable, the contract may be treated as a section 403(b) contract if the contract has at all prior times satisfied the requirements of section 403(b) other than the nonforfeitability requirement. Solely for this purpose, if a participant’s interest in a contract is only partially nonforfeitable in a year, then the portion that is nonforfeitable and the portion that fails to be nonforfeitable are bifurcated.

Section 403(b)(12) requires a section 403(b) contract to make elective deferrals available to all employees (the universal availability rule) and requires other contributions to satisfy the general nondiscrimination requirements applicable to qualified plans. These rules are discussed further below under the heading Section 403(b) Nondiscrimination and Universal Availability Rules.

Section 403(b)(1)(E) requires a section 403(b) contract to satisfy the requirements of section 401(a)(30) relating to limitations on elective deferrals under section 402(g)(1). The proposed regulations provide that a contract only satisfies this requirement if the contract requires all elective deferrals for an employee to satisfy section 402(g)(1), including elective deferrals for the employee under the contract and any other elective deferrals under the plan under which the contract is purchased and under all other plans, contracts, or arrangements of the employer that are subject to the limits of section 402(g). This rule is the same as the rule for section 401(k) arrangements.

A section 403(b) contract is also required to provide that it will satisfy the minimum required distribution requirements of section 401(a)(9), the incidental benefit requirements of section 401(a), and the rollover distribution rules of section 402(c).

The proposed regulations address the requirement that annual additions to the contract not exceed the applicable limitations of section 415(c) (treating contributions as annual additions). In accordance with the last sentence of section 415(a)(2), if an excess annual addition is made to a contract that otherwise satisfies the requirements of section 403(b), then the portion of the contract that includes the excess will fail to be a section 403(b) contract (and instead will be a contract to which section 403(c) applies) and the remaining portion of the contract that includes the contribution that is not in excess of the section 415 limitations is a section 403(b) contract. This rule under which only the excess annual addition is subject to section 403(c) does not apply unless, for the year of the excess and each year thereafter, the issuer of the contract maintains separate accounts for the portion that includes the excess and for the section 403(b) portion, i.e., the portion that includes the amount not in excess of the section 415 limitations.

The proposed regulations require that these conditions for the exclusion be satisfied both in form and operation in the section 403(b) contract. Because several of these requirements are based on plan documents — in particular the requirements that elective deferrals satisfy a universal availability rule and that other contributions satisfy the nondiscrimination rules applicable to qualified plans — the proposed regulations require that the contract be maintained pursuant to a plan. For this purpose, it is intended that the plan would include all of the material provisions regarding eligibility, benefits, applicable limitations, the contracts available under the plan, and the time and form under which benefit distributions would be made. This rule does not require that there be a single plan document. For example, this requirement would be satisfied by complying with the plan document rules applicable to qualified plans.

The Treasury Department and the IRS have consulted with the Department of Labor concerning the interaction between Title I of the Employee Retirement Income Security Act of 1974 (ERISA) and section 403(b) of the Code. The Department of Labor has advised the Treasury Department and the IRS that Title I of ERISA generally applies to “any plan, fund, or program...established or maintained by an employer or by an employee organization, or by both, to the extent that...such plan, fund, or program...provides retirement income to employees, or...results in a deferral of income by employees for periods extending to the termination of covered employment or beyond.” ERISA, section 3(2)(A). However, governmental plans and church plans are generally excluded from coverage under Title I of ERISA. See ERISA, section 4(b)(1) and (2). Therefore, section 403(b) contracts purchased or provided under a program that is either a “governmental plan” under section 3(32) of ERISA or a “church plan” under section 3(33) of ERISA are not generally covered under Title I. However, section 403(b) of the Code is also available with respect to contracts purchased or provided by employers for employees of a section 501(c)(3) organization, and many programs for the purchase of section 403(b) contracts offered by such employers are covered under Title I of ERISA as part of an “employee pension benefit plan” within the meaning of section 3(2)(A) of ERISA. The Department of Labor has promulgated a regulation, 29 CFR 2510.3-2(f), describing circumstances under which an employer’s program for the purchase of section 403(b) contracts for its employees, which is not otherwise excluded from coverage under Title I, will not be considered to constitute the establishment or maintenance of an “employee pension benefit plan” under Title I of ERISA.

These proposed regulations are generally limited to the requirements imposed under section 403(b). In this regard, the proposed regulations require that a section 403(b) program be maintained pursuant to a plan, which for this purpose is defined as a written defined contribution plan which, in both form and operation, satisfies the regulatory requirements of section 403(b) and contains all the material terms and conditions for benefits under the plan. The Department of Labor has advised the Treasury Department and the IRS that, although it does not appear that the proposed regulations would mandate the establishment or maintenance of an employee pension benefit plan in order to satisfy its requirements, it leaves open the possibility that an employer may undertake responsibilities that would constitute establishing and maintaining an ERISA-covered plan. The Department of Labor has further advised the Treasury Department and the IRS that whether the manner in which any particular employer decides to satisfy particular responsibilities under these proposed regulations will cause the employer to be considered to have established or to maintain a plan that is covered under Title I of ERISA must be analyzed on a case-by-case basis, applying the criteria set forth in 29 CFR 2510.3-2(f), including the employer’s involvement as contemplated by the plan documents and in operation.

To the extent that these proposed regulations may raise questions for employers concerning the scope and application of the regulation at 29 CFR 2510.3-2(f), the Treasury Department and the IRS are requesting comments. See below under the heading Comments and Public Hearing

All employee pension benefit plans covered under Title I of ERISA, including plans that involve the purchase of section 403(b) contracts, must satisfy a number of requirements, including requirements relating to reporting and disclosure, eligibility, vesting, benefit accrual, advance notice of contribution reductions, qualified joint and survivor annuities, minimum funding, fiduciary standards, fidelity bonds, and claims procedures. Authority to interpret many of the requirements in Parts 2 and 3 of Title I of ERISA (specifically those relating to eligibility, vesting, benefit accrual, minimum funding, and qualified joint and survivor annuities) has been transferred to the Treasury Department and the IRS. See Reorganization Plan No. 4 of 1978, 43 FR 47713, October 17, 1978. As a result, those section 403(b) contracts of a section 501(c)(3) organization that are part of an employee pension benefit plan are subject to requirements parallel to those imposed under sections 401(a)(11) through 401(a)(15), 410, 411, 412, and 417 of the Internal Revenue Code and the regulations promulgated thereunder, since regulations and other guidance issued under those Code sections are applicable for purposes of the parallel requirements in ERISA. Further, although specific references are made to Title I in these proposed regulations, this does not imply that other Title I issues are not applicable.

Section 1450(a) of SBJPA provides that the rules applicable to cash or deferred elections under section 401(k) are to apply under section 403(b) for purposes of determining the frequency with which an employee may enter into a salary reduction agreement, the salary to which such an agreement may apply, and the ability to revoke such an agreement. Based in part on this provision, and taking into account the guidance that has been issued since SBJPA,^[5] the proposed regulations would clarify the extent to which section 403(b) elective deferrals are like elective deferrals under proposed and final rules under section 401(k). Specifically, the rules are fundamentally similar with respect to the frequency with which a deferral election can be made, changed, or revoked, including automatic enrollment (plan provisions under which elective deferrals are automatically made for employees unless they elect otherwise), the ability for a deferral election that has been made in one year to be carried forward to subsequent periods until modified, the rule under which irrevocable elections are not treated as elective deferrals, and the requirement that employees have an annual effective opportunity to make, revoke, or modify a deferral election. The rules are also fundamentally similar with respect to the compensation with respect to which the election can be made, e.g., allowing a deferral election to be made for compensation up to the day before the compensation is currently available. Likewise, the proposed regulations explicitly provide that, for purposes of sections 402(g) and 403(b), an elective deferral with respect to a section 403(b) contract is limited to contributions made pursuant to a cash or deferred election, as defined in regulations under section 401(k).

These proposed regulations also include a rule comparable to the anti-conditioning rule at section 401(k)(4). Finally, the proposed regulations include rules similar to those for section 401(k) plans regarding plan limitations to comply with section 401(a)(30) and to pay out section 403(b) elective deferrals in excess of the related section 402(g) limitation.  

As a result, under the proposed regulations, the three major differences between the rules applicable to section 403(b) elective deferrals and the rules applicable to elective deferrals under section 401(k) are:

The regulations clarify that if the requirements of section 403(b) fail to be satisfied with respect to an employer contribution, then the contribution is subject either to the rules under section 403(c) (relating to nonqualified annuities) if the contribution is for an annuity contract issued by an insurance company, or is subject to the rules under section 61, 83, or 402(b) if the contribution is to a custodial account or retirement income account that fails to satisfy the requirements of section 403(b).

Issues have been raised about the application of section 403(b) to tax-exempt entities that have State or local government features. These proposed regulations do not attempt to address when an entity is a State (treating a local government or other subdivision as a State) and when it is a section 501(c)(3) organization that is not a State.^[7] Thus, for example, these regulations do not provide guidance on the conditions under which a tax-exempt charter school is, or is not, a State entity.

Based on the wording of section 401(k)(4)(B)(i) and (ii), an entity that is both a section 501(c)(3) organization and an instrumentality of a State cannot have a section 401(k) plan. Under sections 457(b)(6) and 457(g), an entity that is both an instrumentality of a State and a section 501(c)(3) organization can have an eligible plan under section 457(b) only if it is funded. However, under section 403(b)(1)(A)(i) and (ii), an entity that is both an instrumentality of a State and a section 501(c)(3) organization could cover any of its employees, regardless of whether they are performing services for a public school.

The exclusion provided under section 403(b) applies only to the extent that all amounts contributed by the employer for the purchase of an annuity contract for the participant do not exceed the applicable limit under section 415 and, with respect to section 403(b) elective deferrals, only if the contract is purchased under a plan that includes the limits under section 402(g), including aggregation under all plans of the employer. The proposed regulations require a section 403(b) contract to include this limit on section 403(b) elective deferrals, as imposed by section 402(g).

A section 403(b) contract may provide for additional catch-up contributions for a participant who is age 50 by the end of the year, provided that those age 50 catch-up contributions do not exceed the catch-up limit under section 414(v) for the taxable year (which is $3,000 for 2004). In addition, an employee of a qualified organization who has at least 15 years of service (disregarding any period during which an individual is not an employee of the eligible employer) is entitled to a special section 403(b) catch-up limit. Under the special section 403(b) catch-up limit, the section 402(g) limit is increased by the lowest of the following three amounts: (i) $3,000; (ii) the excess of $15,000 over the total special section 403(b) catch-up elective deferrals made for the qualified employee by the qualified organization for prior taxable years; or (iii) the excess of (A) $5,000 multiplied by the number of years of service of the employee with the qualified organization, over (B) the total elective deferrals made for the qualified employee by the qualified organization for prior taxable years. For this purpose, a qualified organization is an eligible employer that is a school, hospital, health and welfare service agency (including a home health service agency), or a church-related organization. In the case of a church-related organization, all entities that are in such a church-related organization are treated as a single qualified organization, so that years of service and any section 403(b) catch-up elective deferrals previously made for a qualified employee for any such church are taken into account for purposes of determining the amount of section 403(b) catch-up elective deferrals to which an employee is entitled under any section 403(b) plan maintained by another entity in the same church-related organization. A health and welfare service agency is defined as either an organization whose primary activity is to provide medical care as defined in section 213(d)(1) (such as a hospice), or a section 501(c)(3) organization whose primary activity is the prevention of cruelty to individuals or animals, or which provides substantial personal services to the needy as part of its primary activity (such as a section 501(c)(3) organization that provides meals to needy individuals).

The proposed regulations provide that any catch-up contribution for an employee who is eligible for both an age 50 catch-up and the special section 403(b) catch-up is treated first as a special section 403(b) catch-up to the extent a special section 403(b) catch-up is permitted, and then as an amount contributed as an age 50 catch-up (to the extent the age 50 catch-up amount exceeds the maximum special section 403(b) catch-up).

Any contribution made for a participant to a section 403(b) contract for a taxable year that exceeds either the section 415 maximum annual contribution limit or the section 402(g) elective deferral limit constitutes an excess contribution that is included in gross income for that taxable year (or, if later, the taxable year in which the contract becomes nonforfeitable). The proposed regulations provide that a section 403(b) contract or the section 403(b) plan may provide that any excess deferral as a result of a failure to comply with the section 402(g) elective deferral limit for the taxable year with respect to any section 403(b) elective deferral made for a participant by the employer will be distributed to the participant, with allocable net income, no later than April 15 or otherwise in accordance with section 402(g).

For purposes of determining a participant’s includible compensation and years of service — used both for the special section 403(b) catch-up contributions and for employer contributions for former employees — an employee’s number of years of service include each full year during which the individual is a full-time employee of the eligible employer plus a fraction of a year for each part of a year during which the individual is a full-time or part-time employee of the eligible employer. A year of service is based on the employer’s annual work period, not the employee’s taxable year. Thus, in determining whether a university professor is employed full-time, the annual work period is the school’s academic year. In determining whether an individual is employed full-time, the amount of work actually performed is compared with the amount of work that is normally required of individuals performing similar services from which substantially all of their annual compensation is derived. An individual is treated as performing a fraction of a year of service for each annual work period during which he or she is a full-time employee for part of the annual work period or for each annual work period during which he or she is a part-time employee either for the entire annual work period or for a part of the annual work period.

In measuring the amount of work of an individual performing particular services, the work performed is determined based on the individual’s hours of service (as defined under section 410(a)(3)(C)), except that a plan may use a different measure of work if appropriate under the facts and circumstances. For example, a plan may provide for a university professor’s work to be measured by the number of courses taught during an annual work period if that individual’s work assignment is generally based on a specified number of courses to be taught.

In determining years of service, any period during which an individual is not an employee of the eligible employer is disregarded, except that, for a section 403(b) contract of an eligible employer that is a church-related organization, any period during which an individual is an employee of that eligible employer and any other eligible employer that is within the same church-related organization with that eligible employer is taken into account on an aggregated basis. In the case of a part-time employee or a full-time employee who is employed for only part of the year, the employee’s most recent periods of service are aggregated to determine his or her most recent one-year period of service, as follows: the employee’s service during the annual work period for which the last year of service’s includible compensation is being determined is taken into account first; then the employee’s service during the next preceding annual work period based on whole months is taken into account; and so forth, until the employee’s service equals, in the aggregate, one year of service.

Under section 403(b)(3), a former employee is deemed to have monthly includible compensation for the period through the end of the taxable year of the employee in which he or she ceases to be an employee and through the end of each of the next five taxable years of the employee.The amount of the monthly includible compensation is equal to 1/12 of the former employee’s includible compensation during the former employee’s most recent year of service.Accordingly, a plan may provide that nonelective employer contributions are continued for up to five years for a former employee, up to the lesser of the dollar amount in section 415(c)(1)(A) or the former employee’s annual includible compensation based on the former employee’s compensation during his or her most recent year of service.

The proposed regulations do not address the extent, if any, to which the exclusion from gross income provided by section 403(b) applies to contributions made for former employees (e.g., whether a contribution may be made for a former employee if the contribution is with respect to compensation that would otherwise be paid for a payroll period that begins after severance from employment) other than as provided under the five-year rule at section 403(b)(3), described above under the heading Special Rule for Former Employees. The Treasury Department and the IRS expect to issue separate guidance on this issue, potentially addressing this question with respect to not only section 403(b), but also sections 401(k), 457(b) (for eligible governmental plans), and 415(c).

Section 403(b)(12)(A)(i) requires that employer contributions and employee after-tax contributions made under a section 403(b) contract satisfy a specified series of requirements (the nondiscrimination requirements) in the same manner as a qualified plan under section 401(a). These proposed regulations do not adopt the good faith reasonable standard of Notice 89-23 for purposes of satisfying the nondiscrimination requirements of section 403(b)(12)(A)(i). These nondiscrimination requirements include rules relating to nondiscrimination in contributions, benefits, and coverage (sections 401(a)(4) and 410(b)), a limitation on the amount of compensation that can be taken into account (section 401(a)(17)), and the average contribution percentage rules of section 401(m) (relating to matching and after-tax contributions). The nondiscrimination requirements are generally tested using compensation as defined in section 414(s) and are applied on an aggregated basis taking into account all plans of the employer. See the discussion below under the heading Controlled Group Rules For Tax-Exempt Entities.

The nondiscrimination requirements do not apply to section 403(b) elective deferrals. In addition, the only nondiscrimination requirement that applies to a governmental plan, within the meaning of section 414(d), is the limitation on compensation (section 401(a)(17)).

Under section 403(b)(12)(A)(ii), a universal availability requirement applies under which all employees of the eligible employer must be permitted to elect to have section 403(b) elective deferrals contributed on their behalf if any employee of the eligible employer may elect to have the organization make section 403(b) elective deferrals. Under the proposed regulations, the universal availability requirement is not satisfied unless the contributions are made pursuant to a plan and the plan permits elective deferrals that satisfy the universal availability requirement. The proposed regulations generally provide that the universal availability requirement applies separately to each common law entity, i.e., to each section 501(c)(3) organization, or, in the case of a section 403(b) plan that covers the employees of more than one State entity, to each entity that is not part of a common payroll. The proposed regulations allow an employer that historically has treated one or more of its various geographically distinct units as separate for employee benefit purposes to treat each unit as a separate organization if the unit is operated independently on a day-to-day basis.

The proposed regulations include the statutory categories that are exceptions to the universal availability rule, and provide that, if any employee listed in any excludable category has the right to have section 403(b) elective deferrals made on his or her behalf, then no employees in that category may be excluded. The categories generally are: employees who are eligible to participate in an eligible governmental plan under section 457(b) which permits contributions or deferrals at the election of the employee or a plan of the employer offering a qualified cash or deferred election under section 401(k); employees who are non-resident aliens; employees who are students performing services described in section 3121(b)(10); and employees who normally work fewer than 20 hours per week. Additionally, Notice 89-23 included transition rules for certain other exclusions that are not in the statute: employees who make a one-time election to participate in a governmental plan instead of a section 403(b) plan; employees covered by a collective bargaining agreement; visiting professors for up to one year under certain circumstances; and employees affiliated with a religious order who have taken a vow of poverty. The proposed regulations do not adopt these transition rules. See the reference to these exclusions below under the heading Comments and Public Hearing.

The nondiscrimination and the universal availability requirements do not apply to a section 403(b) contract purchased by a church, which is specially defined for this purpose, and generally does not include a university, hospital, or nursing home.

The nondiscrimination and universal availability requirements are in addition to other applicable legal requirements. Specifically, these requirements do not reflect the requirements of Title I of ERISA that may apply with respect to a section 403(b) plan, such as the ERISA vesting requirements. Another example is that, while employees who normally work fewer than 20 hours per week may be excluded under the universal availability rule, employers who maintain plans that are subject to Title I of ERISA should be aware that Title I of ERISA includes limitations on the conditions under which employees can be excluded from a plan on account of not working full time and that these limitations would generally not permit an exclusion for employees who normally work fewer than 20 hours per week. See section 202(a)(1) of ERISA and regulations under section 410(a) of the Code (which interpret section 202 of ERISA).

The proposed regulations reflect the statutory rules regarding when distributions can be made from a section 403(b) contract. Thus, amounts held in a custodial contract attributable to employer contributions (that are not section 403(b) elective deferrals) may not be paid to a participant before the participant has a severance from employment, becomes disabled (within the meaning of section 72(m)(7)), or attains age 59¹/₂. This rule also applies to amounts transferred out of a custodial account (i.e., to an annuity contract or retirement income account), including earnings thereon. In addition, distributions of amounts attributable to section 403(b) elective deferrals may not be paid to a participant earlier than when the participant has a severance from employment, has a hardship, becomes disabled (within the meaning of section 72(m)(7)), or attains age 59¹/₂. Hardship is generally defined under regulations issued under section 401(k).

The proposed regulations would reflect the requirements of section 402(f) relating to the written explanation requirements for distributions that qualify as eligible rollover distributions, including conforming the timing rule to the rule for qualified plans.

Where the distribution restrictions do not apply, a section 403(b) contract is permitted to distribute retirement benefits to the participant after severance from employment or upon the prior occurrence of an event, such as after a fixed number of years, the attainment of a stated age, or disability. The proposed regulations include a number of exceptions to the timing restrictions, e.g., the rule for elective deferrals does not apply to distributions of section 403(b) elective deferrals (not including earnings thereon) that were contributed before January 1, 1989.

The proposed regulations define severance from employment in a manner that is generally the same as the proposed regulations under section 401(k),^[8] but provide that a severance from employment occurs on any date on which the employee ceases to be employed by an eligible employer that maintains the section 403(b) plan. Thus, a severance from employment would occur when an employee ceases to be employed by an eligible employer even though the employee may continue to be employed by an entity that is part of the same controlled group but that is not an eligible employer, or on any date on which the employee works in a capacity that is not employment with an eligible employer. Examples of the situations that constitute a severance from employment include: an employee transferring from a section 501(c)(3) organization to a for-profit subsidiary of the section 501(c)(3) organization; an employee ceasing to work for a public school, but continuing to be employed by the same State; and an individual employed as a minister for an entity that is neither a State nor a section 501(c)(3) organization ceasing to perform services as a minister, but continuing to be employed by the same entity.

The proposed regulations include rules similar to those in the existing regulations relating to the minimum distribution requirements of section 401(a)(9), but with some minor changes (for example, omitting the special rules for 5-percent owners). Thus, section 403(b) contracts must satisfy the incidental benefit rules. Existing revenue rulings provide guidance with respect to the application of the incidental benefit requirements to permissible nonretirement benefits such as life, accident, or health benefits.^[9]

The proposed regulations include rules reflecting that loans can be made to participants from a section 403(b) contract.

The proposed regulations include limited rules relating to qualified domestic relations orders (QDROs) under section 414(p). Section 414(p)(9) provides that the QDRO rules only apply to plans that are subject to the anti-alienation provisions of section 401(a)(13), except that section 414(p)(9) also provides that, except to the extent set forth in regulations — there are currently no regulations under section 414(p) — the section 414(p) QDRO rules apply to a section 403(b) contract. These proposed section 403(b) regulations clarify that the section 414(p) QDRO rules apply to section 403(b) contracts for purposes of applying section 403(b).

The proposed regulations include a number of rules regarding the taxation of distributions and benefits from section 403(b) contracts, including the statutory provision that only amounts actually distributed from a section 403(b) contract are generally includible in the gross income of the recipient for the year in which distributed under section 72, relating to annuities. The regulations also reflect the rule that any payment that constitutes an eligible rollover distribution is not taxed in the year distributed to the extent the payment is directly rolled over or transferred to an eligible retirement plan. The payor must withhold 20 percent Federal income tax, however, if an eligible rollover distribution is not rolled over in a direct rollover. Another provision requires the payor to give proper written notice to the section 403(b) participant or beneficiary concerning the eligible rollover distribution provision. Notice 2002-3, 2002-1 C.B. 289, provides a sample of the safe-harbor notice that the payor may furnish to satisfy this requirement.

As described above, section 403(b) only applies to contributions made to certain funding arrangements, namely: amounts held in an annuity contract, in a custodial account that is treated as an annuity contract under section 403(b)(7), or in a church retirement income account that is treated as an annuity contract under section 403(b)(9). The proposed regulations require that contributions to a section 403(b) plan be transferred to the insurance company issuing the annuity contract (or the entity holding assets of any custodial or retirement income account that is treated as an annuity contract) within a period that is not longer than is reasonable for the proper administration of the plan, such as transferring elective deferrals within 15 business days following the month in which these amounts would otherwise have been paid to the participant.

The proposed regulations provide that, except where a custodial or retirement income account is treated as an annuity contract, an annuity contract means a contract that is issued by an insurance company qualified to issue annuities in a State and that includes payment in the form of an annuity, but does not include a contract that is a life insurance contract, as defined in section 7702, an endowment contract, a heath or accident insurance contract, or a property, casualty, or liability insurance contract. The regulations include a special transition rule relating to life insurance contracts issued before the effective date.

Rev. Rul. 67-361, 1967-2 C.B. 153, and Rev. Rul. 67-387, 1967-2 C.B. 153, provided for certain State plans to be treated as qualifying as annuities under section 403(b). Rev. Rul. 82-102, 1982-1 C.B. 62, revoked this interpretation (in connection with the 1974 enactment of section 403(b)(7) which allowed custodial accounts), but provides section 7805(b) relief for arrangements established in reliance on these rulings, i.e., for arrangements established on or before May 17, 1982. The proposed regulations contemplate that the section 7805(b) relief provided by these rulings would be continued. This relief would be limited to State section 403(b) plans established on or before May 17, 1982 satisfying either of the following requirements: (i) benefits under the contract are provided from a separately funded retirement reserve that is subject to supervision of the State insurance department or (ii) benefits under the contract are provided from a fund that is separate from the fund used to provide statutory benefits payable under a State retirement system and that is part of a State teachers retirement system to purchase benefits that are unrelated to the basic benefits provided under the retirement system, and the death benefit provided under the contract cannot at any time exceed the larger of the reserve or the contribution made for the employee.

The proposed regulations define a custodial account as a plan, or a separate account under a plan, in which an amount attributable to section 403(b) contributions (or amounts rolled over to a section 403(b) contract) is held by a bank or a person who satisfies the conditions in section 401(f)(2), if amounts held in the account are invested in stock of a regulated investment company (as defined in section 851(a) relating to mutual funds), the special restrictions on distributions with respect to a custodial account are satisfied, the assets held in the account cannot be used for, or diverted to, purposes other than for the exclusive benefit of plan participants or their beneficiaries, and the account is not part of a retirement income account, as described below. This requirement limiting investments to mutual funds is not satisfied if the account includes any assets other than stock of a regulated investment company.

The proposed regulations include a number of special rules for church plans. Under section 403(b)(9), a retirement income account for employees of a church-related organization is treated as an annuity contract for purposes of section 403(b) and these regulations. Under the proposed regulations, the rules for a retirement income account are based largely on the legislative history to TEFRA. The proposed regulations define a retirement income account as a defined contribution program established or maintained by a church-related organization under which (i) there is separate accounting for the retirement income account’s interest in the underlying assets (i.e., it must be possible at all times to determine the retirement income account’s interest in the underlying assets and distinguish that interest from any interest that is not part of the retirement income account), (ii) investment performance is based on gains and losses on those assets, and (iii) the assets held in the account cannot be used for, or diverted to, purposes other than for the exclusive benefit of plan participants or their beneficiaries. For this purpose, assets are treated as diverted to the employer if the employer borrows assets from the account. A retirement income account must be maintained pursuant to a program which is a plan and the plan document must state (or otherwise evidence in a similarly clear manner) the intent to constitute a retirement income account.

If any asset of a retirement income account is owned or used by a participant or beneficiary, then that ownership or use is treated as a distribution to that participant or beneficiary. The proposed regulations provide that a retirement income account that is treated as an annuity contract is not a custodial account (even if it is invested in stock of a regulated investment company).

A life annuity can generally only be provided from an individual account by the purchase of an insurance annuity contract. However, in light of the special rules applicable to church retirement income accounts, the proposed regulations permit a life annuity to be paid from such an account if certain conditions are satisfied. The conditions are that the amount of the distribution form have an actuarial present value, at the annuity starting date, that is equal to the participant’s or beneficiary’s accumulated benefit, based on reasonable actuarial assumptions, including assumptions regarding interest and mortality, and that the plan sponsor guarantee benefits in the event that a payment is due that exceeds the participant’s or beneficiary’s accumulated benefit.

Under these proposed regulations, both custodial accounts and retirement income accounts would be subject to an exclusive benefit requirement similar to the exclusive benefit requirement applicable to qualified plans. Section 403(b)(7)(B) provides for a custodial account to be treated as a tax exempt organization.

When these regulations are issued as final regulations, to the extent permitted by the Commissioner in future guidance, assets held under a custodial account or a retirement income account may be pooled with trust assets held under qualified plans.

The proposed regulations include controlled group rules under section 414(c) for entities that are tax-exempt under section 501(a). Under these rules, the employer for a plan maintained by a section 501(c)(3) organization (or any other tax-exempt organization under section 501(a)) includes not only the organization whose employees participate in the plan, but also any other exempt organization that is under common control with such organization, based on 80 percent of the directors or trustees being either representatives of or directly or indirectly controlled by an exempt organization. The proposed regulations include an anti-abuse rule and would also allow tax exempt organizations to choose to be aggregated if they maintain a single plan covering one or more employees from each organization and the organizations regularly coordinate their day to day exempt activities. For a section 501(c)(3) organization that makes contributions to a section 403(b) contract, these rules would be generally relevant for purposes of the nondiscrimination requirements, as well as the section 415 contribution limitations, the special section 403(b) catch-up contributions, and the section 401(a)(9) minimum distribution rules.

These controlled group rules for tax-exempt entities generally do not apply to certain church entities. Comments are requested below under the heading Comment and Public Hearing on whether these rules should be extended to such church entities.

The proposed regulations do not include controlled group rules for public schools. As noted above (under the heading Overview), it is anticipated that, when these regulations are issued as final regulations, guidance may be issued providing controlled group safe harbors for public schools taking into account the existing safe harbors in Notice 89-23.

The proposed regulations include a number of rules that address the circumstances under which a section 403(b) plan may be terminated or assets may be exchanged or transferred.

The proposed regulations, if adopted as final regulations, would not only permit an employer to amend its section 403(b) plan to eliminate future contributions for existing participants, but would allow plan provisions that permit plan termination with a resulting distribution of accumulated benefits. In general, the distribution of accumulated benefits would be permitted only if the employer (taking into account all entities that are treated as the employer under section 414 on the date of the termination) does not make contributions to another section 403(b) contract that is not part of the plan (based generally on contributions made to a section 403(b) contract during the 12 months before and after the date of plan termination). In order for a section 403(b) plan to be considered terminated, all accumulated benefits under the plan must be distributed to all participants and beneficiaries as soon as administratively practicable after termination of the plan. A distribution includes delivery of a fully paid individual insurance annuity contract. Eligible rollover distributions would not be subject to current income inclusion if rolled over to an eligible retirement plan.

The proposed regulations prohibit an employer that ceases to be an eligible employer from making any further contributions to the section 403(b) contract for subsequent periods. In this event, the contract can be held under a frozen plan or the plan could be terminated in accordance with the rules regarding plan termination.

Under certain conditions, the proposed regulations permit the following exchanges or transfers:

However, neither a qualified plan nor an eligible plan under section 457 may transfer assets to a section 403(b) plan, and a section 403(b) plan may not accept such a transfer. In addition, a section 403(b) contract may not be exchanged for an annuity contract that is not a section 403(b) contract. Neither a plan-to-plan transfer nor a contract exchange permitted under the proposed regulations is treated as a distribution for purposes of the section 403(b) distribution restrictions (so that such a transfer or exchange may be made before severance from employment or another distribution event).

Additional plan-to-plan transfer rules may apply in the event that a plan-to-plan transfer is made to or from a section 403(b) arrangement that is subject to Title I of ERISA. See section 208 of ERISA and regulations under section 414(l) of the Internal Revenue Code (which are the regulations interpreting section 208 of ERISA).

These proposed regulations generally require a section 403(b) plan to be a defined contribution plan. This requirement would not apply to certain church plans. Specifically, section 251(e)(5) of TEFRA permits a church arrangement in effect on September 3, 1982 (the date TEFRA was enacted) to not be treated as failing to satisfy the exclusion allowance limitations of section 403(b)(2) merely because it is a defined benefit plan and these regulations would allow such a plan to be continued. Any other defined benefit plan in existence on the effective date of these regulations that has taken the position, based on a reasonable interpretation of the statute, that it satisfies section 403(b) would not be subject to the requirement in these regulations that the plan be a defined contribution plan for pre-effective date accruals, and such a plan might seek to take the position that it satisfies the section 401 qualified plan rules for subsequent accruals (assuming it satisfies those rules with respect to those accruals).

These proposed regulations also include proposed amendments to regulations under section 3121(a)(5)(D), defining salary reduction agreement for purposes of the Federal Insurance Contributions Act (FICA). The text of the proposed amendments is the same as that of temporary regulations being issued under section 3121(a)(5)(D) in this same issue of the Bulletin. The proposed regulations under section 3121(a)(5)(D) would be applicable on November 16, 2004.