A Brave New World…

March 10, 2005 Kades Margolis Corporation

A Brave New World…

How Proposed 403(b) Regulations May Affect Public Schools in

Pennsylvania

By Kades-Margolis Corporation


Proposed 403(b) Regulations

Over 200 pages of material Cannot cover everything in this presentation Highlights of changes affecting employers Not effective until later of January 1, 2006

or issuance of final regulations MAY NOT rely upon these proposed

regulations until finalized Translate that into “do not panic…yet”


Biggest Changes to 403(b) Plans

Written plan documentation requirement for all plans

Control and Responsibility shifted to Employers Changes to Rules Governing Employees’ Rights

to Move Accounts Unlikely that “severance payments” or

accumulated leave payments may be used as source of elective deferrals for employee contributions


Plan Document Requirements

What Must the Document Include? Document must contain provisions explaining:

Eligibility Benefits Contribution limits, The designation of products available in the plan, The time and form of benefit distributions, and A statement satisfying the universal eligibility requirements

Possibility: “wrap around” document incorporating underlying annuity contract/custodial accounts


At Employer’s Discretion… Plan May Include Optional Features

Hardship withdrawals Loans Acceptance of rollovers In service withdrawals Whether plan will permit “exchange” to

products approved within the plan And, whether plan to plan transfers are

permitted or accepted


Key Concepts to Understand IRS treating the §403(b) program as an employer plan

with all control at the employer level Plan document will determine all terms of the plan

NOT underlying contracts and custodial accounts Plan may prohibit loans and withdrawals even if underlying

contracts permit such transactions May restrict transfers to/from accounts

If conflicts in underlying custodial accounts and annuity contracts, the plan document must resolve inconsistencies

Will restrict access to employees Only products specifically named in plan document may contact or

service employees


Implications of Document Requirement

Each employer will be responsible for document How?

Board resolution authorizing adoption of plan– And naming of employee or “office” with authority for

support and maintenance of program

– Otherwise, have to go to board for every change and modification


Implications of Document Requirement

Employer is responsible for maintenance and support of plan Amendments for law or tax changes Adhering to terms of document

Potential CBA issues on access to employees and approved products


Possible Sources of Documents

Private vendors Like me! Other attorneys or consultants

Product providers Like Kades-Margolis Corporation Other product providers But be careful of using plan document that limits products

to one vendor Will offer “free” document for restrictions on access to employees Scheme to market other products/services to employees

– Often “noncompetitive” products or services


Reminder…Rules NOT in Effect Yet!

Time to reflect and consider options Can comment directly to IRS or through

associations (PASBO or ASBO) Address is:

CC:PA:LDP:PR (REG-155608-02)Room 5203Internal Revenue ServiceP. O. Box 7604, Ben Franklin StationWashington, D. C. 20044

Start researching options for plan document support


New Transfer Restrictions…

Repeals existing rules that permit employees to “transfer” their accounts to any provider of their choosing

Can only transfer to products “authorized” under the employer’s plan

Proposed regulations impose an “active employment” requirement on transfers

Restricts transfers to “exchanges” between approved products under the current employer’s plan, or

Plan to plan transfers from former employer’s plan to current employer’s plan

No transfers “outside” of the plan No transfers for “retirees,”however, rollovers permitted


New Transfer Rules

Employer’s plan would have to permit transfers Transfers are optional feature of plan

But plans must permit rollovers However, no rollover unless there is a

distributable event first! Employer would have to confirm “distributable

event” before rollover permitted


Implications on Employers?

New employees may not be able to continue their relationship with their vendors New superintendent? Union and negotiations on employee rights

Plan will have to be amended to add or delete vendors

Much more employer involvement Acknowledging that product is approved under the plan

or advising vendor that transfer may not be made because transferee is not authorized under the plan


Severance Pay Change

Regs appear to restrict the use of severance pay or accumulated leave payments as a source of employee deferrals Salary reduction contributions can only be made by

“former” employee if the affected payroll period begins before employment is severed

Severance pay, in general, is not based on a payroll period beginning before severance from service

Note: IRS promises separate guidance dealing with post severance elective deferrals from all types of deferral plans


Other Changes Under the Regulations

Investment Restrictions on 403(b)s Limited to Annuity Contracts and 403(b)(7)

Custodial Accounts Life Insurance contracts issued after *February

14, 2005 are not considered to be “annuity contracts”

– NOT permitted

*Effective date problematic since regulations cannot be relied upon until 2006 or finalization!


More Changes

Clarifications to “universal eligibility” requirements 20 hour per week exception has been expanded

to include 1,000 hours per year standard Employees must get written notice of eligibility

to participate at least annually and have “reasonable opportunity” to make deferral elections at least once per year

Violations result in plan failure


Frozen and Terminated Plans

Employers may “freeze” plans, not allowing future contributions

Employers may terminate §403(b) plans and make distributions from the terminated plans without violating the restrictions on early distributions If the employer follows the requirements Difficult to do unless plan uses group contracts or trust

because of mandatory distribution requirement


Impact of Plan Termination Proposals

Plan document would have to allow distributions upon plan termination.

Contracts and custodial accounts will have to be amended to permit distributions upon plan termination

Consideration will have to be given to who controls the assets of “terminated” plans

Will contracts be distributed upon request of employer? Must employees consent to distributions?

What about outstanding loans and the 10% early distribution penalty if there is a cash distribution?


Timing Requirements for Deposits of Employee Contributions

Requires that salary reduction contributions be remitted to the vendor “as soon as administratively possible” Based on facts and circumstances Suggests standard of no later than 15 business

days in the month following reduction of salary May require changes to employer’s procedures


Other Issues Related to Retirement Plans

New Cost of Living Limits for 2005 PA Dept. of Rev. PIT 04-018 Revocation of IRS Approval for 401(a)

“special pay” plans Possible PA legislation changing state

taxation of benefit programs WFTRA redefines “dependent” for tax

purposes


Cost of Living Changes for 2005

Employee deferrals - $14,000 For 403(b) and 457(b) Limits are NOT combined if employee

participates in both types of plans

Age 50+ catch up – additional $4,000 415(c) limit - $42,000

Total limit to 403(b) for employer and employee contributions during the year


PIT 04-018

PA Dept. of Revenue responded to request from school district

Employer contributions of accumulated leave were contributed into a 401(a) plan

Question was whether or not those contributions were included as taxable income for PA state purposes Facts as presented “doomed” the response


PIT 04-018 con’t…

Ruling held that such contributions were includable as income for PA income tax purposes Otherwise paid as cash (in the past) Plan not an “eligible retirement plan” under PA rules

Employees could take the contribution out immediately Not a lifetime payment

My opinion? Ruling applies to all types of “special pay”

contributions into any type of retirement program


Repeal of IRS Approval for “Special Pay” 401(a) Plans

IRS sent letter to every “known” employer using an approved “special pay” plan Said IRS approval was revoked for years after 2004

unless plan satisfied several requirements, including: Requirement that employees participate before final year of

service Requirement that plan must make regular and ongoing

contributions for participants Requirement that amending plan alone is not sufficient; such

changes must be acted upon– No form over substance


What to Do if You Have a 401(a) Special Pay Plan?

Choice of actions Amend plan to conform to all requirements

Requires ongoing contributions for all participants New IRS filing of amended plan Funding and contract issues to consider

Terminate 401(a) plan and use 403(b) plan for “special pay” contributions

IRS letter does not affect 403(b) plans Special rules in 403(b) plans designed to accommodate

“special” employer contributions


Governor’s Veto

Gov. Rendell vetoed a bill that would have followed the federal rules of constructive receipt for purposes of applying PA income tax rules to nonqualified deferred compensation

Expected to be reintroduced in 2005 Formerly House Bill 176 Cited as costing PA $220 million annually


WFTRA Changes to “Dependents”

Working Families Tax Relief Act created a “uniform” definition of “dependent” for tax purposes

Dependent is now either a “qualifying child” or a “qualifying relative”

Created unintended problems with employee benefits


Dependents…

“Qualifying Child” bears a specified relationship with taxpayer lives with taxpayer for at least ½ of the year is less than 19 years of age (or 24 if full time

student) or is permanently disabled, and provides less than ½ of own support

Prior law had no age or residence requirement for qualifying children


Dependents…

“Qualifying relative” must bear a specified relationship with the taxpayer must live with the taxpayer and be a member of the taxpayer’s

household must have gross income of less than $3,200 (in 2005) must receive over ½ of support from taxpayer, and must not be a “qualifying child” of any other taxpayer

The change precludes any person with income in excess of $3,200 from being a dependent


Problems? Heath insurance often provides coverage to persons that

will not qualify as”dependents” under new rules Students over age 23 or Domestic partners

Special exception for healthcare IRS Notice 2004-79 eliminates the income limitation on “qualifying

relative” for healthcare purposes only

Hardship withdrawals, tuition reimbursement programs, dependent care programs, etc. all affected by new definitions

Impact on Employers? Must impute income to employee for any benefit received by an individual who is not a “dependent”


Thank You

Questions….if time permits?


M Kristi Cook

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