A Brave New World…

1. A Brave New World… How Proposed 403(b) Regulations May Affect Public Schools in Pennsylvania By Kades-Margolis Corporation Kades Margolis Corporation

2. 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” Kades Margolis Corporation

3. 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 Kades Margolis Corporation

4. 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 Kades Margolis Corporation

5. 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 Kades Margolis Corporation

6. 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 Kades Margolis Corporation

7. 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 Kades Margolis Corporation

8. 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 Kades Margolis Corporation

9. 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 Kades Margolis Corporation

10. 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 Kades Margolis Corporation

11. 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 Kades Margolis Corporation

12. 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 Kades Margolis Corporation

13. 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 Kades Margolis Corporation

14. 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 Kades Margolis Corporation

15. 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! Kades Margolis Corporation

16. 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 Kades Margolis Corporation

17. 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 Kades Margolis Corporation

18. 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? Kades Margolis Corporation

19. 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 Kades Margolis Corporation

20. 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 Kades Margolis Corporation

21. 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 Kades Margolis Corporation

22. 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 Kades Margolis Corporation

23. 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 Kades Margolis Corporation

24. 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 Kades Margolis Corporation

25. 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 Kades Margolis Corporation

26. 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 Kades Margolis Corporation

27. 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 Kades Margolis Corporation

28. 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 Kades Margolis Corporation

29. 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 Kades Margolis Corporation

30. 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” Kades Margolis Corporation

31. Thank You Questions….if time permits? Kades Margolis Corporation

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