In Revenue Ruling 2011-7, the IRS recently clarified how a 403(b) plan may be terminated in compliance with applicable regulations and whether distributions upon termination are included in participant's gross income.

Applicable regulations provide that a 403(b) plan may be frozen or terminated. If a 403(b) plan is terminated, accumulated benefits may be distributed. However, benefits attributable to employees' elective deferrals and/or investment in custodial accounts generally may not be distributed unless neither the employer nor any member of its controlled group contributes to a 403(b) plan during the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan. All accumulated benefits must be fully vested at plan termination and must be distributed as soon as administratively practicable after plan termination. For this purpose, distribution of a fully paid individual annuity contract is treated as a distribution.

Rev. Rul. 2011-7 provides that a 403(b) plan will be considered terminated, and distributions may be made, if the following conditions are met:

• On or before the termination date, the employer adopts a binding resolution to cease future contributions, terminate the plan, fully vest all benefits, and distribute all accumulated accounts as soon as practicable. 
• Participants (and beneficiaries) are notified of the plan termination, including notice of their rollover rights.
• Distributions are made by distribution of fully paid individual annuity contracts, or in the case of a group annuity contract, by issuing individual certificates to each participant.  Single sums may be paid if permitted by a contract.
• Where accounts are invested in custodial accounts, distribution may be made in cash or in kind either to the participant or as a direct rollover to an IRA or another employer's retirement plan.

Satisfying the above requirements results in a plan termination within the meaning of the applicable regulations. In this case, delivery of a fully paid individual annuity contract or an individual certificate does not result in gross income until amounts under the contract actually are paid to the participant as long as the contract retains its status as a 403(b) contract. Any other distributions are included in a participant's gross income except to the extent rolled over to an IRA or other eligible retirement plan directly or within 60 days after the distribution.

Employers that want to terminate their 403(b) plans and distribute accumulated accounts should take particular care that all of the above requirements are satisfied.