(b)lines Ask the Experts – Can a 403(b) Plan be Disqualified?

Michael A. Webb, Vice President, Retirement Services, Cammack LaRhette Consulting, answers:  

If you mean “disqualified” in the traditional sense that a 401(k) or other qualified plan is disqualified, the answer is no.

The final 403(b) regulations do not state conditions under which an entire 403(b) plan would lose its tax-qualified status and thus fail to be a 403(b) plan. However, the final regulations do list  three situations where all of the contracts in a 403(b) plan would not be section 403(b) contracts, as follows: 

a)      If the employer fails to have a written plan which, in form, satisfies 403(b) (plan document requirement); 

b)      If the employer is not an employer eligible to sponsor a 403(b) plan; and
c)      If a plan fails to satisfy the nondiscrimination rules (including the universal availability requirement for elective deferrals).

Well, if they are not section 403(b) contracts, what are they? They become nonqualified annuity contracts under Section 403(c), where the contributions (but interestingly, not the earnings), would become taxable to employees. Note that, though it is not entirely clear, it is presumed that custodial accounts would be treated the same as annuity contracts for this purpose, since 403(b)(7)(A) of the Code treats contributions to a custodial account as amounts contributed to an annuity contract.

Regardless, this is clearly not a desirable effect for employees, so plan sponsors should make certain that they treat these specific areas of compliance extremely seriously. It should be noted that other failures identified in the 403(b) regulations, such as operational failures to follow plan terms, excess contributions, or failure to have required provisions in the contract or account, do NOT affect all contracts in a plan; only the contracts to which the failure relates (though that can wind up being a lot of contracts or even all of them if the error is widespread). 

The interesting aspect of these rules is that unlike with a qualified plan of a for-profit employer where the employer loses a sizable tax deduction (and can be subject to significant tax penalties) in the event of disqualification, employees, rather than the employer, bear the brunt of an employer’s failure to comply with 403(b). The IRS acknowledges this fact in the preamble to the final 403(b) regulations: “… while there are various factors that will often cause an employer or issuer to have an interest in procedures that ensure that the requirements of section 403(b) are satisfied (including income tax withholding requirements), an employee generally bears the income tax exposure and other risks of failing to comply with rules set forth in the plan.”

Thus, it will be interesting to see how enforcement of the final regulations will ultimately play out in a situation where employees could be punished more harshly for the actions of an employer than the employer itself. When the corrective procedures under EPCRS are updated to reflect the final 403(b) regulations, perhaps we will see some insight from the IRS as to their approach and flexibility in this area. Stay tuned!  

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.