(b)lines Ask the Experts – Defining ‘Severance From Employment’ for 403(b) Plan Distributions

“Can the Experts define what is meant by that term? And is the answer different for a 403(b) plan than for a 401(a) plan? We sponsor both types of plans.”

Stacey Bradford, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, vice president, Retirement Plan Services, Cammack Retirement Group, answer:

Generally, section 1.403(b)-2(b)(19) of the Treasury Regulations defines “severance from employment” for 403(b) plan purposes to mean “that the employee ceases to be employed by the employer maintaining the plan.”  For this purpose, “employer” includes any “related employers” eligible to maintain a 403(b) plan.

While tax-exempt entities and churches (including qualified church-controlled organizations (QCCOs) and non-QCCOs) are subject to special rules under Code section 414(c) for determining related employers under a controlled group, such determination for public schools is made under the reasonable, good faith standard of IRS Notice 89-23. The regulation cross-references section 1.401(k)-1(d), subsection (2) of which tracks the 403(b) plan definition for severance from employment. Therefore, other than the requirement that, for 403(b) plans, a related employer is limited to those employers in the controlled group who are eligible to sponsor a 403(b) plan, the general rule for severance is the same for 403(b) and 401(a) plans. 

However, the fundamentals of 403(b) plans cause some differences in the application of the definition.  Specifically, a severance from employment can occur for 403(b) plan purposes without a termination of employment, where an employee merely ceases to be an employee of an employer who is eligible to sponsor a 403(b) plan. Treasury Regulation section 1.403(b)-6(h) provides this rule—a severance occurs even if the employee continues “to be employed either by another entity that is treated as the same employer where either that other entity is not an entity that can be an eligible employer (such as transferring from a section 501(c)(3) organization to a for-profit subsidiary of the section 501(c)(3) organization) or in a capacity that is not employment with an eligible employer (for example, ceasing to be an employee performing services for a public school but continuing to work for the same State employer).” You do not find these exceptions in the 401(a) plan context, as you do not have the same limitations on eligible plan sponsors.

Further, a 403(b) plan may define severance from employment more narrowly than is required under the regulations.  For example, the plan could provide for a rule that more closely tracks the rule for 401(a) plans—an employee does not have a severance from employment, and therefore is not eligible for a distribution, if the employee continues to be employed by a related employer, even if that related employer is not eligible to sponsor a 403(b) plan (e.g., the employee transfers to another unit of a State that is not a public school).

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.