403(b) Crunch Time Series #1: Avoiding Problems With 403(b) Custodial Accounts

Yesterday, I introduced our forthcoming 403(b) Crunch Time Series. It will be geared towards helping 403(b) plans get ready for the January 1, 2009 compliance deadline for the new Internal Revenue Service regulations.

During this series, I’ll be joined by Bob Toth as a guest blogger. Bob, a Partner in the Baker & Daniels law firm, has over 25 years experience advising 403(b) plans and service providers.

And since it all starts with the new plan document requirement, here’s Bob with his guest post, Avoiding Problems With 403(b) Custodial Accounts.

The 403(b) Custodial Agreement. You know, that piece of paper you use in a 403(b) implementation that no one ever reads or understands, and is just signed because the Tax Code requires it? Heck, they’ve been used for years by the 403(b) vendors, so they’ve got to be pretty standard by now. How can they cause my 403(b) plan ANY problems at all?

Well, they generally still won’t cause you any problems in plans funded individual 403(b) custodial accounts. The problems are arising when folks are trying to set up 403(b) plans on a “401(k)-like” investment platform using a “group” or “master” custodial arrangement. Here, the “forms” are anything but settled.

There are two common errors:

Using a 401(k) Trust Document. The first common error occurs when you try to take a standard 401(k) trust document, change the word “trust” to “custodian,” place some gratuitous 403(b) language in the document, and think you are done.

This is almost right. But you need to make sure that the rules under 403(b)1(B)-(E) are also included in the document and, if the custodial account is also going to hold an annuity contract, have language which defers to that group contract (including the fact that the custodian won’t control the assets in the contract).

It is probably best for the custodial account NOT to hold annuity contracts; though its OK for the employer to hold that group annuity contract outside of the custodial agreement. By the way, collective trusts (often referred to in these 401(k) trusts) can’t serve as the “cash” holding account for the plan unless its “registered” as a “registered investment company.”

Using an Individual Custodial Document as a Group Document. The second common error is the “jury-rigged” use of the individual custodial account form with some modifications to try to make it serve as a group contract. This actually can cause you serious problems. Those custodial contracts DO have the necessary language that you wont find in the 401(k) trust. The problem is that they have too much language.

The individual custodial document was designed to serve the purpose of a plan document/service agreement, so they often have much language you would never otherwise find in a group trust document. There will often be language related to loans, hardships, distributions and the like, so that they almost look like a “quasi” plan document. And that is what causes the problem.

Plans using a group custodial document almost invariably also have a separate plan document-usually from a different vendor than who wrote that custodial document. So you have dramatically increased the probability of inconsistent terms, which can disqualify the document. You no more want your custodian having to monitor plan compliance than you would want your 401(k) trustee having that monitoring duty.

Thanks, Bob. Look for #2 in our 403(b) Crunch Time Series on Thursday when I’ll be talking about Complying With Contribution Limits For 403(b) Plans.