Pension & Benefits News IRS issues guidance on distribution of individual custodial accounts in-kind by terminating 403(b) plans
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Wednesday, December 9, 2020

IRS issues guidance on distribution of individual custodial accounts in-kind by terminating 403(b) plans

By Pension and Benefits Editorial Staff

The IRS has issued guidance for employers and employees concerning terminating Code Sec. 403(b) plans that fund benefits through Code Sec. 403(b)(7) custodial accounts. The guidance reflects changes in the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act, P.L. 116-94) regarding the distribution of an individual custodial account (ICA) in-kind from a terminating Code Sec. 403(b) plan to a participant or beneficiary of the plan.

Distributions of ICAs by terminating plans and the SECURE Act. One of the requirements for terminating a Code Sec. 403(b) plan is that all accumulated benefits under the plan must be distributed to all participants and beneficiaries as soon as administratively practicable after termination of the plan. Rev. Rul. 2011-7 provides that a plan may be terminated under these rules by delivery to participants and beneficiaries of a fully paid individual annuity contract or an individual certificate evidencing fully paid benefits under a group annuity contract.

Act Sec. 110 of the SECURE Act directs that guidance be issued providing that, if an employer terminates a plan under which amounts are contributed to a custodial account under Code Sec. 403(b)(7), the plan administrator or custodian may distribute an ICA in-kind to a participant or beneficiary of the plan. It also provides that the distributed ICA should be maintained by the custodian on a tax-deferred basis as a Code Sec. 403(b)(7) custodial account, similar to the treatment of fully paid individual annuity contracts under Rev. Rul. 2011-7, until amounts are actually paid to the participant or beneficiary.

New ruling. The new ruling provides that a plan can satisfy the termination requirements in situations that involve the distribution of an ICA in-kind. A distribution of an ICA in-kind to a participant or beneficiary is not includible in gross income until amounts are actually paid to the participant or beneficiary from the ICA, so long as the ICA maintains its status as a Code Sec. 403(b)(7) custodial account.

The ruling considers separately two situations: one where the plan is funded solely through the use of Code Sec. 403(b)(7) custodial accounts maintained under individual agreements. The other funded through a group agreement where participants are provided a document that evidences the ICA, including the accumulated nonforfeitable value of the participant’s or beneficiary’s interest in the custodial accounts maintained under the group agreement, and associated rights and responsibilities of the participant or beneficiary and custodian.

Individual and group ICAs. In situation 1, distributions of accumulated benefits are made either (1) by payment to the participant or beneficiary, or to an IRA established by the participant or beneficiary or another eligible retirement plan; or (2) by distribution of an ICA in-kind to each participant or beneficiary as soon as administratively practicable after the date of plan termination. Because the plan is funded solely through custodial accounts maintained under individual agreements, no further action is required to be taken in order to distribute the ICA in-kind.

In situation 2, the same actions are taken, except that the employer distributes an ICA in-kind to a participant or beneficiary whose accumulated benefits are funded by a custodial account maintained under a group agreement by providing a document to the participant or beneficiary that evidences the ICA, including the accumulated nonforfeitable value of the participant’s or beneficiary’s interest in the custodial accounts maintained under the group agreement, and associated rights and responsibilities of the participant or beneficiary and custodian. The distribution of the ICA in-kind to the participant or beneficiary constitutes a distribution of the participant’s or beneficiary’s accumulated benefit in the custodial accounts maintained under a group agreement.

In both situations, the employer has no material retained rights under an ICA after it has been distributed (and the employer is not treated as retaining material rights merely because the ICA was originally opened under a group contract). Accordingly, the distribution of an ICA in-kind to a participant or beneficiary is not immediately includible in gross income, but rather amounts are includible in income only when actually paid to the participant or beneficiary from the custodial account, so long as the ICA maintains its status as a Code Sec. 403(b)(7) custodial account. The Code Sec. 403(b)(7) custodial account status of the ICA generally is maintained if the ICA continues to adhere to the requirements of Code Sec. 403(b) that are in effect at the time of the distribution of the ICA. Any other amount paid to a participant or beneficiary, such as a single-sum payment, is includible in the gross income of the participant or beneficiary, except to the extent the amount is rolled over to an IRA or other eligible retirement plan by a direct rollover or by a transfer made within 60 days.

Holding. In Situation 1 and Situation 2, distribution of an ICA in kind to a participant or beneficiary is not includible in gross income until amounts are actually paid to the participant or beneficiary out of the ICA, so long as the ICA maintains its status as a Code Sec. 403(b)(7) custodial account. Any other amount distributed from a custodial account to a participant or beneficiary to effectuate plan termination is includible in gross income, except to the extent the amount is rolled over to an IRA or other eligible retirement plan by a direct rollover or by a transfer made within 60 days.

Comments requested on application of ERISA annuity and spousal rights. Note, the above guidance explicitly does not address a situation involving annuity and spousal rights under ERISA §205 in connection with distributions of individual custodial accounts in kind.

Although no Code Sec. 403(b) plans are subject to the annuity and spousal rights provisions of Code Secs. 401(a)(11) and 417, some Code Sec. 403(b) plans that are subject to ERISA (such as a plan of a non-church tax-exempt employer that provides for matching contributions) are subject to the parallel annuity and spousal rights provisions of ERISA Sec. 205.

ERISA Sec. 205(a) generally, provides that a distribution must be provided either as a qualified joint and survivor annuity (QJSA) in the case of a participant who does not die before the annuity starting date, or as a qualified preretirement survivor annuity (QPSA) in the case of a participant who dies before the annuity starting date.

Issues remain regarding the application of ERISA Sec. 205 in connection with a distribution of an ICA in kind under section 110 of the SECURE Act for a Code Sec. 403(b) plan with at least one participant to whom ERISA Sec. 205 applies, including if a participant cannot be reached, a participant does not elect to waive the QJSA and QPSA form of benefit, or a married participant elects to waive the QJSA and QPSA form of benefit but the participant’s spouse does not consent to the waiver.

The IRS requests comments on the application of ERISA Sec. 205 annuity and spousal rights provisions in connection with a distribution in kind of an ICA under section 110 of the SECURE Act, including any administrative or other burdens that may arise and potential methods or rules that could minimize or eliminate those burdens. The IRS is particularly interested in information on current practices and arrangements, the administrability of alternative dates for when rights under ERISA Sec. 205 might be required to be protected, the use of the Pension Benefit Guaranty Corporation’s missing participants program for defined contribution plans, and types of transition relief.

Comments should be submitted in writing on or before February 3, 2021, and should include a reference to Notice 2020-80. The comments may be sent electronically via the Federal eRulemaking Portal at www.regulations.gov, or by mail to the Internal Revenue Service, Attn: CC:PA:LPD:PR (Notice 2020-80), Room 5203, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. The IRS strongly encourages all commenters to submit comments electronically, as access to mail may be limited.

Source: Rev. Rul. 2020-23;. IRS Notice 2020-80.

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