DUFF , WHITE & TURNER, L.L.C.

Attorneys And Counselors At Law

SCHOOL LAW
"ISSUE OF THE MONTH"
February 2008

New IRS Rules for 403(b) Investment Accounts: The Next Steps

In July 2007, the Internal Revenue Service (IRS) promulgated new rules affecting tax-deferred investment accounts held by many public school district employees under Section 403(b) of the Internal Revenue Code. In the past, districts were responsible only for directing employee 403(b) plan contributions to the correct vendor. The new IRS rules, however, allocate several new responsibilities to districts as 403(b) plan "sponsors." Because these rules are, for the most part, effective January 1, 2009, districts have some time to determine how best to implement these new responsibilities.

It should first be noted that the new rules allow districts to terminate their 403(b) plans altogether after January 1, 2009. In practice, however, plan termination is almost impossible to accomplish. First, a district must insure that all 403(b) funds have been distributed to every account holder or rolled over into a non 403(b). Since account holders may include retired and former employees, some account holders could be difficult to locate. Additionally, some participants may object to the distribution or rollover, in some cases because a penalty may be incurred.

Districts that choose not to terminate their plans will be required to develop a written 403(b) plan document identifying authorized account vendors. Under the plan, the district and any authorized vendor must agree to share certain employee information pertinent to the 403(b) administration process, to include an employee's salary information and information related to an employee's separation from service. Because of the personal nature of the shared information, and because of the importance of plan compliance, districts must carefully consider whether to select a single provider or multiple providers, and which particular provider or providers to use.

The benefits of using a single vendor include a likely reduction in district administrative responsibilities and fewer potential 403(b) plan violations. In exchange for the district's restriction to a single vendor, the vendor likely will agree to handle the required administrative responsibilities for the district. A single vendor also may be willing to lower or waive certain fees or offer a greater level of customer service. Additionally, the single vendor approach eliminates the risk of unauthorized exchanges, since there would be no exchanges between vendors. On the other hand, the single vendor approach may require districts to reduce employee investment choices and sever certain existing vendor relationships.

Alternatively, a district may choose to adopt a multiple vendor approach, particularly where the district and its employees currently have good relationships with several vendors. Although vendors often offer similar investment vehicles with only slight differences in fees, using multiple vendors may allow a district to provide a diverse range of investment options for its employees. With multiple vendors, however, the district's administrative responsibilities may increase, as well as the risk of plan violations that are inherent with exchanges between vendors. Districts also would be solely responsible for developing and maintaining the plan document and for coordinating information sharing between vendors.

Districts that choose the multiple vendor approach have the option of hiring a "third party plan administrator" to take on many of the administrative duties otherwise performed by the district. A third party plan administrator would ensure compliance with the plan, keep the plan up to date, and act as an intermediary between the 403(b) players. However, districts may find that hiring a third party administrator is costly.

No matter which approach districts choose, the new rules require the assurance of "universal availability" of the plan to its employees. This means that all district employees who are eligible to participate in the plan must receive annual notice of the plan's availability. The yearly notice requirement can be satisfied by placing a reference to the plan in an employee's annual employment renewal notice, or by some other verifiable notice method. Although the rules allow districts to exclude certain hourly employees who work less than 20 hours per week, it is recommended that districts make the plan available to all employees. If a district is found to have improperly excluded an employee, the district would be in violation of this universal availability requirement and the district's entire 403(b) plan could fail, subjecting every employees' 403(b) funds to taxation.

Lastly, it should be noted that one aspect of the new rules has already gone into effect. Beginning September 25, 2007, exchanges between funds are subject to taxation, unless by January 1, 2009, the district and the vendor who receives the funds enter into an information sharing agreement and the vendor is included in the district's written plan document. This requirement has spurred a flurry of vendor requests to districts to enter into information sharing agreements and to allow employee exchanges. Districts should be careful, however, not to sign agreements with current or potential vendors, or allow any 403(b) exchanges to those vendors, without being prepared to include those vendors in their written plan document.

In anticipation of the approaching January 1, 2009, effective date, each district should begin analyzing its options for moving forward in light of these new rules, partuclarly as to choice of vendors and the development of a district plan. The IRS recently issued a model plan document that districts may wish to review and/or adopt. It can be found at http://www.irs.gov/irb/2007-51_IRB/ar09.html.

If you would like more information about these new requirements, please feel free to contact us.