To (b) or not to (b): is that the question? Twenty-first century Schizoid plans under section 403(b) of the Internal Revenue Code.

• Author: Pratt, David

I. INTRODUCTION II. THE EVOLUTION OF SECTION 403(B) A. Before the Fall: 1958 Through 1985 B. The Brave New World: The Tax Reform Act of 1986 C. Major Changes Enacted During the 1990s D. Major Changes Enacted by EGTRRA E. The Pension Protection Act of 2006 III. 403(8) PLANS AND 401(K) PLANS A. Eligible Employers B. Who Is Eligible to Participate? C. Compensation D. Dollar Limit on Elective Salary Reduction Contributions 1. General Rule Thus, the proposed coordination rule appears to squarely conflict with the plain meaning of section 402(g)(7) of the Code. 3. Coordination with Other Plans E. Funding F. Applicability of ERISA 1. In General 2. Consequences of ERISA Coverage If the plan is subject to ERISA, there are major consequences. First, ERISA limits the employee eligibility requirements that may be imposed and prohibits the cessation or reduction of benefit accruals because of age 3. The Impact of the New 403(b) Regulations G. The "Written Plan" Requirement H. Special Section 415 Rules for 403(b)Arrangements I. Former Employees J. Nondiscrimination 1. Elective Deferrals 2. Other Contributions K. Employer Aggregation and Controlled Group Rules L. Distributions 1. Minimum Distribution Rules 2. Salary Reduction Contributions 3. Custodial Accounts 4. Plan Termination 5. Other Amounts M. Transfers N. Defined Benefit Programs O. Insurance P. Nonforfeitability Q. Years of Service R. The Anti-Conditioning Rule S. Automatic Enrollment T. 403(b) Final Regulations: Effective Date and Transition Rules U. Effect of Failure to Satisfy the Section 403(b) Requirements V. EPCRS W. The Excise Tax IV. PROPOSED CHANGES A. Eligible Employers B. Compensation C. The Special 403(b) Catch-Up D. Funding E. Applicability of ERISA F. The Written Plan Requirement G. Section 415 H. Nondiscrimination I. Distributions J. Transfers K. Insurance L. Nonforfeitability M. The Excise Tax V. CONCLUSION I. INTRODUCTION

In 1996, I published an article in this law review (3) that discussed in detail the rules governing retirement plans described in Section 403(b) of the Internal Revenue Code ("Code"). (4) The year 2008 marked the fiftieth anniversary of the enactment of section 403(b), and so it is an appropriate time to revisit these issues and discuss developments that have occurred since 1996.

Section 403(b) provides a special type of tax-favored retirement arrangement that is available only to three types of employers: (1) organizations that are tax-exempt under Code section 501(c)(3); (2) public educational institutions; and (3) ministers of religion. (5) These arrangements are variously known as "403(b) plans," "403(b) arrangements," and "tax-sheltered annuity arrangements."

Like its younger but better-known cousin, the 401(k) plan, (6) the 403(b) plan has morphed into something very different from what was originally envisaged. From its inception, a 403(b) plan could only be made available by an "eligible employer" but, unlike "qualified plans" (7) subject to the rules of Code section 401(a), 403(b) plans were not viewed as a retirement savings vehicle for employees generally. Rather, section 403(b) was enacted to limit the extent to which highly paid employees of tax-exempt employers could defer income taxation by voluntarily deferring a portion of their compensation. (8)

Prior to 1958, employees of certain tax-exempt organizations could defer all or part of their income from the organization through the use of a tax-sheltered annuity arrangement. (9) Under the 1958 legislation, an employee's deferral for income tax purposes was limited to the "exclusion allowance," a calculation based on the employee's compensation and length of service with the employer. (10) From these modest beginnings, section 403(b) has become an integral part of the benefit packages of eligible employers. Many tax-exempt organizations (including private schools, colleges, and hospitals) use a 403(b) plan as their primary retirement plan while others (such as public school districts) maintain 403(b) arrangements, often funded exclusively by employee deferrals, to supplement their primary plans. (11) As of December 31, 2007, 403(b) plans held a total of $692 billion in assets. (12)

In 1958, and until several years after the enactment of the Employee Retirement Income Security Act of 1974 ("ERISA"), (13) the other major federal statute governing retirement plans, the dominant form of retirement plan was the traditional defined benefit plan. (14) 403(b) plans (like 401(k) plans, (15) in the years immediately following the enactment of section 401(k) in 1978) were viewed as being merely supplements to the primary plan. (16)

Since then, the landscape has changed dramatically. First, the number of traditional (defined benefit) pension plans has declined significantly. (17) As Professor Zelinsky has observed, (18) we live in a defined contribution world, and defined benefit plans are now largely limited to the public sector, very large employers, and multi-employer plans of large national unions such as the Teamsters. (19) Defined contribution plans have increasingly replaced defined benefit plans as the primary retirement savings vehicle. (20) Unlike traditional defined benefit plans, these plans generally require employees to contribute part of the cost, typically through voluntary deferrals, which are then matched by the employer. (21)

Second, 403(b) plans have gradually been subjected to many of the rules that previously applied only to qualified plans. (22) This has greatly increased the complexity of the 403(b) plan rules and has also created difficulties in determining how rules that were designed for qualified plans should be applied to 403(b) plans, which evolved for very different reasons and in very different ways. (23) As originally enacted, section 403(b) was relatively straightforward. The rules, however, have now become a complex mixture of (1) rules applicable only to 403(b) arrangements, (2) rules applicable to qualified plans under section 401(a), which have been extended to 403(b) arrangements, often with modifications, and (3) special rules applicable only to certain types of employers. (24)

Until recently, 403(b) arrangements received little attention from the IRS, and no IRS program existed for approving plan documents, comparable to the determination letter program for qualified plans. (25) The difficulty of complying with the section 403(b) rules is illustrated by the fact that, after many years of benign neglect, the IRS discovered, as part of its program of auditing tax-exempt colleges and hospitals, that there was a high level of noncompliance. (26) Substantial sanctions were imposed on certain employers: negotiated compliance settlements relating to defects in 403(b) arrangements were in the "million dollar ranges." (27) In 1995, an IRS official stated that section 403(b) noncompliance was the hottest employee benefit issue for the IRS, and that all future audits of exempt organizations would include a review of their 403(b) arrangements. (28)

The changes to section 403(b) (29) resulted in a serious disconnect between the statutory requirements and the regulations issued under section 403(b) by the Treasury Department and IRS. As a result, the Treasury and IRS have now issued new regulations, (30) the first comprehensive 403(b) regulations for forty years, (31) which reflect statutory amendments to section 403(b) up to and including the Pension Protection Act of 2006 ("PPA"). (32) These regulations are helpful in many respects. They do, however, include several controversial changes and several other changes that do not appear to be required or (in some cases) even warranted by the statute. The regulations are generally effective in 2009. (33)

Comments submitted to the Treasury and IRS in response to the proposed regulations illustrate two diametrically opposed views of the role of section 403(b) plans in today's retirement system. The first, represented by many provisions of the regulations and discussed in the preamble to the regulations, is that convergence of the 403(b) plan rules and the 401(k) plan rules is appropriate. The second is that differences between the 403(b) plan rules and the 401(k) plan rules are necessary because of fundamental differences between the tax-exempt employers to which 403(b) plans are available and the businesses who are the primary sponsors of qualified plans. Proponents of this view argue that the regulations do not sufficiently respect these differences.

Part II of this article will summarize the evolution of the 403(b) plan rules from 1958 to today. Part III will summarize the more important 403(b) plan rules and the major remaining differences between 403(b) plans and qualified plans. Part IV will discuss reform proposals, and whether retention of section 403(b) plans can be justified on policy (as opposed to historical) grounds.

II. THE EVOLUTION OF SECTION 403(13) (34)

A. Before the Fall: 1958 Through 1985

As originally enacted, section 403(b)(1) was relatively simple. (35) The amount excluded from income for any taxable year was limited to the "exclusion allowance," namely the excess (if any) of (i) 20% of the employee's "includible compensation," multiplied by the number of the employee's "years of service," over (ii) the aggregate amount contributed by the employer, and excluded from the employee's gross income, for all prior taxable years. (36) There are three notable features of the original statute. First, it was available only to private employers that were tax-exempt under Code section 501(c)(3). (37) Second, the only permissible funding vehicle was an annuity contract. (38) Third, unlike qualified plans described in section 401(a), or qualified annuity programs described in section 403(a), there was no requirement that a 403(b) plan be nondiscriminatory. (39) It could be, and often was, limited to highly paid employees. (40)

In 1961, Congress expanded the class of eligible employers...