TRANSFERS FROM ANNUITY CONTRACTS OR CUSTODIAL ACCOUNTS TO OTHER ANNUITY CONTRACTS ARE NONTAXABLE TRANSFERS.

Rev. Rul. 90-24

ISSUE

Does a transfer of all or part of the holder's interest in a section 403(b)(1) annuity contract or a section 403(b)(7) custodial account ("section 403(b) investments") to another section 403(b)(1) annuity contract or section 403(b)(7) custodial account constitute an actual distribution to the holder within the meaning of section 403(b)(1)?

FACTS

Individuals A and B are employed by Organization M, a tax-exempt entity described in section 501(c)(3) of the Code. Neither A nor B has reached age 59-1/2. Organization M purchased Contract 1, a section 403(b)(1) annuity contract, for A and Account 1, a section 403(b)(7) custodial account, for B. These purchases were made entirely with nonelective contributions made by Organization M.

A directed the transfer of one half of A's interest in Contract 1 to Contract 2, a section 403(b)(1) annuity contract, by requesting the issuer of Contract 1 to transfer an amount representing one half of A's interest in Contract 1 as calculated under the terms of Contract 1 to the issuer of Contract 2.

B directed the transfer of B's interest in Account 1 to Contract 3, a section 403(b)(1) annuity contract, by requesting the custodian of Account 1 to transfer an amount representing B's interest in Account 1 to the issuer of Contract 3. Contract 3 provides that amounts (including any earnings allocable to such amounts) transferred to Contract 3 from any section 403(b) investment that are subject to the early distribution restrictions of section 403(b)(7)(A)(ii) or section 403(b)(11) will be accounted for separately and will continue to be subject to identical early distribution restrictions.

LAW

Section 403(b)(1) of the Code provides that if an annuity contract is purchased for an employee by an employer within certain categories, including an employer described in section 501(c)(3), and if the annuity contract meets certain specified criteria, then amounts contributed by the employer for the annuity contract on or after the employee's rights under the contract become nonforfeitable are excluded from the gross income of the employee for the taxable year within certain limitations. Section 403(b)(1) provides that the amount actually distributed to any distributee under the annuity contract is taxable to the distributee (in the year so distributed) under section 72 (relating to annuities).

Section 403(b)(7) of the Code provides that amounts paid by a qualifying employer to a custodial account that satisfies the requirements of section 401(f)(2) are treated as amounts contributed by the employer to an annuity contract for an employee, provided that the amounts are to be invested in regulated investment company stock to be held in that custodial account. Section 403(b)(7)(A)(ii) provides that amounts paid by an employer to a custodial account are treated as amounts contributed by the employer to an annuity contract for an employee only if no amounts may be paid or made available to any distributee before the employee dies, attains age 59-1/2, separates from service, becomes disabled, or, in the case of contributions made pursuant to a salary reduction agreement, encounters financial hardship. Similarly, section 403(b)(11) provides that a distribution from a section 403(b) investment attributable to salary reduction contributions may be paid only when the employee attains age 59-1/2, separates from service, dies, or becomes disabled. Distributions attributable to those contributions may also be paid in the case of hardship, but the distributions may not include income attributable to those contributions. Section 403(b)(11) is effective for years beginning after December 31, 1988, but only with respect to distributions attributable to assets other than assets held as of the close of the last year beginning before January 1, 1989.

Section 401(g) of the Code provides that, for purposes of section 403, the term "annuity" does not include any contract or certificate issued after December 31, 1962, that is transferable.

Rev. Rul. 73-124, 1973-1 C.B. 200, holds that, where an employee received a complete distribution from one section 403(b) annuity contract and immediately surrendered the proceeds to the employer who purchased a new section 403(b) annuity contract from a different insurer pursuant to a preexisting binding agreement, the transaction was a nontaxable exchange under section 1035(a)(3) of the Code. The revenue ruling states that the employee was required to surrender the original annuity contract because of the restrictions imposed by section 401(g).

ANALYSIS

There is no actual distribution within the meaning of section 403(b)(1) of the Code where funds are transferred from one section 403(b) investment to another section 403(b) investment if the transferred funds continue after the transfer to be subject to any distribution restrictions imposed on them prior to the transfer by section 403(b)(11) or section 403(b)(7)(A)(ii). A has transferred one half of A's interest in a section 403(b)(1) annuity contract that does not contain funds subject to early distribution restrictions (because the section 403(b)(1) annuity contract was purchased entirely with nonelective contributions made by Organization M) to another section 403(b)(1) annuity contract. Because A has merely transferred an interest in one section 403(b)(1) annuity contract to another section 403(b)(1) annuity contract where the first contract is not subject to early distribution restrictions, A has not received an actual distribution within the meaning of section 403(b)(1) of the Code, and the transfer is not taxable. Because A retains A's annuity interest throughout this transaction, the direct transfer between section 403(b) investments is a mere change in issuers that does not violate the nontransferability requirement of section 401(g). Cf. section 1.401-9(b)(3) of the Income Tax Regulations. Thus, the underlying premise in Rev. Rul. 73-124 that section 401(g) precludes such transfers is incorrect.

Section 403(b)(7) of the Code provides that amounts paid by a qualifying employer to a section 403(b)(7) custodial account are treated as amounts contributed to an annuity contract under section 403(b)(1). Therefore, a section 403(b)(7) custodial account is treated as equivalent to a section 403(b)(1) annuity contract in determining whether transfers among section 403(b)(1) annuity contracts and section 403(b)(7) custodial accounts are actual distributions within the meaning of section 403(b)(1) of the Code. However, a section 403(b) investment that is subject to early distribution restrictions may not, consistent with these restrictions, permit a transfer to a section 403(b) investment that contains less stringent distribution restrictions.

B has transferred B's interest in Account 1, a section 403(b)(7) custodial account containing the early distribution restrictions of section 403(b)(7)(A)(ii), to Contract 3, a section 403(b)(1) annuity contract that provides that the amounts transferred to Contract 3 from section 403(b) investments, and earnings allocable to those amounts, that are subject to the early distribution restrictions of section 403(b)(7)(A)(ii) or section 403(b)(11) will continue to be subject to identical early distribution restrictions. This transfer is a transfer from one section 403(b) investment to a section 403(b) investment that is subject to identical distribution restrictions. Therefore, the transfer is not an actual distribution within the meaning of section 403(b)(1), and is not taxable.

Similarly, if B had instead transferred B's interest in a section 403(b)(1) annuity contract that contained funds subject to the early distribution restrictions of section 403(b)(11) to another section 403(b)(1) contract, the transfer would not be an actual distribution within the meaning of section 403(b)(1) and would not be taxable if the transferred funds were subject to the same or more stringent restrictions.

The above results are not dependent on A's or B's continued employment with Organization M and the results would be the same if A or B were former employees of Organization M or beneficiaries of former employees of Organization M.

If A's or B's interests in Contract 1 or Account 1, respectively, had been purchased partially with after-tax employee contributions, a pro rata portion of their investments would be considered transferred to either Contract 2 or Contract 3, respectively. For example, if A transferred one half of A's interest in Contract 1 to Contract 2, and if the total amount that would have been transferred in a transfer of A's complete interest in Contract 1 was 10x, 4x of which was after-tax employee contributions, then A's investment in Contract 2 would be 2x.

HOLDING

If an individual transfers an interest in a section 403(b)(1) annuity contract not subject to early distribution restrictions to another section 403(b)(1) annuity contract, or to a section 403(b)(7) custodial account, the transfer is not an actual distribution within the meaning of section 403(b)(1) of the Code, and consequently is not a taxable transfer. If an individual transfers funds from a section 403(b)(7) custodial account to a section 403(b)(1) annuity contract, or to another section 403(b)(7) custodial account, and the transferred funds continue to be subject to the early distribution restrictions set forth in section 403(b)(7)(A)(ii), the transfer is not an actual distribution under section 403(b)(1) and consequently is not a taxable transfer. If an individual transfers funds from a section 403(b)(1) annuity contract containing funds subject to the early distribution restrictions of section 403(b)(11) to another 403(b)(1) annuity contract, or to a section 403(b)(7) custodial account, and the transferred funds continue to be subject to the same or more stringent distribution restrictions, the transfer is not an actual distribution section 403(b)(1) and consequently is not a taxable transfer.

In determining whether any of the above transfers constitutes an actual distribution, it is irrelevant whether a complete interest or a partial interest is transferred, and whether the transferring individual is a current employee, a former employee or a beneficiary of a former employee.

This revenue ruling does not address the consequences of a transfer that violates the early distribution restrictions of section 403(b)(7)(A)(ii) or section 403(b)(11).

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 73-124 is revoked.

PROSPECTIVE APPLICATION

Pursuant to the authority contained in section 7805(b) of the Code, the revocation of Rev. Rul. 73-124 will not be effective for any transaction described in Rev. Rul. 73-124 executed on or before December 31, 1991.

DRAFTING INFORMATION

The principal author of this revenue ruling is Linda S. F. Marshall of the Office of Assistant Chief Counsel (Employee Benefits and Exempt Organizations). For further information regarding this revenue ruling contact Linda S. F. Marshall on (202) 566-3050 (not a toll-free call).