Section 403(b) of the Internal Revenue Code of 1986, as amended (the "Code") authorizes a type of retirement plan that can be sponsored by certain tax exempt organizations (e.g., a Code Section 501(c)(3) organization, including a church), certain educational organizations (as described in Code Section 170(b)(1)(a)(ii), including colleges), and certain state or local governmental organizations. In many cases, a 403(b) plan's assets are held in either annuity contracts or custodial accounts (with participant direction of the investments) which may limit the plan sponsor's involvement.
The major Code provisions applicable to 403(b) plans include: (1) subject to certain limited exceptions, a requirement that the right to make employee salary reduction deferrals be available to all employees who are willing to defer at least $200 per year; (2) a limitation in the annual amount of employee salary reduction deferrals ($18,500 in 2018 plus a $6,000 catch-up contribution for participants age 50 and above); (3) a nondiscrimination rule for contributions other than employee salary reductions; and (4) a requirement that distributions under the 403(b) plan must commence by the later of the participant attaining the age of 70 1/2 or the participant's retirement (i.e., the Required Minimum Distributions or "RMDs").
In many cases, the organization sponsoring the 403(b) plan has a small human resources department (if at all) and the 403(b) plan is the favored retirement arrangement because of the plan sponsor's perception that a 403(b) plan is easier to administer. In some cases, substantial administrative responsibilities are allocated to the vendors who provide the plan's funding vehicles (either the insurance company providing the annuity or the custodial account provider) and the sponsoring organization's activities focus primarily on making the arrangement universally available to its employees and making contributions to the plan's funding vehicles.
A recent Internal Revenue Service ("IRS") memorandum highlights an administrative issue that 403(b) plan sponsors may be overlooking. As described above, 403(b) plans are required to make RMDs. While the IRS memorandum provides relief for the failure to make RMDs with respect to certain missing participants and beneficiaries, the memorandum is a reminder that 403(b) plans must make RMDs to all participants.
When 403(b) plan participants quit or retire, most participants either begin to take periodic distributions, take a lump sum distribution, or rollover their benefits to an arrangement that accepts rollover distributions. Thus, 403(b) plans rarely hold benefits attributable to former employees and RMDs are typically not an issue for 403(b) plans. Given that former employees rarely leave their benefits in the 403(b) plan, plan sponsors may not have procedures in place to (1) maintain former participant contact information; and (2) ensure that the RMDs requirements are satisfied.
In the IRS memorandum, the acting director of Employee Plans' Examinations noted that 403(b) plans are required to make RMDs, but advised that the examiners should not challenge a 403(b) plan for violations of the RMD standards for failure to commence distributions with respect to certain "missing" participants and beneficiaries. However, this relief is conditioned on the plan taking the following steps:
(1) Searching plan (and related plan) records, plan sponsor records, and publicly-available records or directories for alternative contact information;
(2) Using any of the search methods listed below:
(a) a commercial locater service;
(b) a credit reporting agency; or
(c) a proprietary internet search tool for locating individuals; and
(3) Attempting contact via United States Postal Service (USPS) certified mail to the last known mailing address and through appropriate means for any address or contact information (including email addresses and telephone numbers).
In order to obtain relief, a plan must complete all three of the above-enumerated steps. Further, the plan sponsor should document that all of the steps have been completed.
Significantly, the memorandum states "[i]f a 403(b) plan has not completed the steps above, [Employee Plan] examiners may challenge a 403(b) plan for violation of the RMD standard for failure to commence or make a distribution to a participant or a beneficiary to whom payment is due."
Generally, when a plan's failure to comply with a Code requirement is discovered during an IRS examination, the plan sponsor enters into a closing agreement whereby the plan sponsor corrects the failure and makes a payment to IRS (commonly referred to as the "sanction amount"). The sanction amount is subject to negotiation and is based on the facts and circumstances giving rise to the failure. In the case of a RMD failure, the sanction amount will likely be a percentage of tax the IRS could collect as a result of the failure (i.e., the income tax on the undistributed RMDs plus the 50% excise tax on undistributed RMDs under Code Section 4974). As such, a plan's failure to comply with the RMD standard could result in a significant plan sponsor liability.
In summary, 403(b) plans are subject to the Required Minimum Distribution standard (RMDs). While RMDs do not appear to be a major issue for 403(b) plans, plan sponsors may not have procedures in place to: (1) maintain former participant contact information; and (2) ensure that RMDs are being made (to both known and missing participants). While the recently issued IRS memorandum provides limited relief from the RMD standards for missing participants and beneficiaries (when certain steps are taken), this memorandum is a reminder to plan sponsors that procedures should be established to ensure that RMDs are made to all 403(b) plan participants/beneficiaries.