February 19, 2007
Earlier this month, the Internal Revenue Service issued Notice 2007-7 (the “Notice”) to provide guidance on a number of provisions in the Pension Protection Act of 2006 (the “PPA”). The following is a summary of certain aspects of the Notice which are important to sponsors and administrators of employee retirement plans.
Minimum Interest-Rate Assumption for Defined Benefit Plans
Benefits payable under a defined benefit plan may not exceed the limits in Section 415(b) of the Internal Revenue Code of 1986, as amended (the “Code”). For 2006, these limits were the lesser of 100% of compensation or $175,000, as applicable to a benefit payable in the form of a single-life annuity at age 62. Other forms of benefit, including lump-sum distributions, must be adjusted to an equivalent single-life annuity for purposes of determining whether the Section 415(b) benefit limitation is met.
Under prior law, the interest-rate assumption used for purposes of testing non-single-life annuity distributions for Section 415(b) compliance had to be not less than the greater of (i) 5.5% or (ii) the interest rate specified in the plan. Section 303 of the PPA changes the minimum interest rate by requiring that such rate not be less than the greater of: (i) 5.5%; (ii) the rate that provides a benefit of not more than 105% of the benefit that would be provided if the rate (or rates) applicable in determining minimum lump sums were used; or (iii) the interest rate specified in the plan. This provision of the PPA is retroactively effective for years beginning after 2005, even though the PPA did not become law until August 17, 2006.
In view of this retroactivity, it was hoped by many that Congress would enact a technical correction to the PPA to grandfather distributions that were made after 2005 and before August 17, 2006 and that exceeded the Section 415(b) limits as amended by the PPA. No technical correction has been enacted, however. Therefore, the Notice makes it clear that a distribution made in a plan year beginning in 2006 that satisfied the pre-PPA limits in Section 415(b) but not the PPA limits does violate Section 415(b). The IRS provides one exception, however: the PPA changes do not apply to a plan with a termination date that is on or before the PPA enactment date.
The Notice uses the term “excess 303 distribution” to refer to the amount by which a distribution in a plan year beginning in 2006 exceeds the Section 415(b) limits as amended by the PPA. The Notice provides the following three methods for correcting an excess 303 distribution:
- Excess 303 distributions made before September 1, 2006 which are corrected by March 15, 2007. The excess amount is not required to be returned to the plan. Instead, a plan must issue two Forms 1099-R to a participant who has received an excess distribution. The first form must include only the amount that would have been distributed had the benefit payable been adjusted using the new interest assumptions required by the PPA. The second form must include the excess amount that was distributed, and should be coded to identify the amount as an excess distribution. The excess amount is not eligible for rollover treatment and must be included in the participant’s gross income in the year the distribution from the plan occurs.
- Excess 303 distributions occurring after September 1, 2006 which are corrected by December 31, 2007. The plan may use the correction method in the IRS’s Employee Plans Compliance Resolution System (“EPCRS”), currently found in Revenue Procedure 2006-27, for distributions in excess of the Section 415(b) limits. Plans may use this correction method even if the plan does not meet the requirements specified in EPCRS, including the requirements for using EPCRS’ self-correction procedures.
- Other excess 303 distributions. Plans which meet the requirements of EPCRS can use EPCRS to correct excess 303 distributions even after December 31, 2007.
The PPA provides that a plan will not violate the “anti-cutback” requirements of Code Section 411(d)(6) if the plan is amended retroactively to comply with the new interest rate assumptions. The Notice indicates that such amendment must be adopted on or before the last day of the first plan year beginning on or after January 1, 2009 (2011 in the case of a governmental plan), and the plan must be operated as if such amendment were in effect as of the first date the amendment is effective.
Expansion of Hardship Withdrawal/ Unforeseeable Financial Emergency Rules to Include Beneficiaries
The PPA directs the issuance of regulations allowing plans operating under Code Sections 401(k), 403(b), 409A or 457(b) to treat a participant’s beneficiary the same as the participant’s spouse or dependent for the purpose of determining whether the participant may receive an early distribution on account of having incurred a hardship or unforeseeable financial emergency. The Notice clarifies that these rule changes are permissive, not mandatory.
The Notice states that beginning August 17, 2006, Section 401(k) plans and Section 403(b) plans may permit a hardship distribution for medical, tuition and funeral expenses incurred with respect to a primary beneficiary under the plan. A “primary beneficiary” is defined as “an individual who is named as a beneficiary under the plan and has an unconditional right to all or a portion of the participant’s account balance under the plan upon the death of the participant.” A hardship withdrawal as to a primary beneficiary must satisfy all other conditions of a hardship withdrawal.
The Notice also provides that plans described in Sections 409A and 457(b) may treat a participant’s beneficiary under the plan the same as the participant’s spouse or dependent in determining whether the participant has incurred an unforeseeable financial emergency. For plans subject to Section 409A, this change will be reflected in the upcoming final regulations under that section.
New Minimum Vesting Requirements
Before the changes enacted by the PPA, employer nonelective (non-matching) contributions to defined contribution plans were required to vest 100% no later than after the completion of five years of service, or 20% per year from the completion of the third through the seventh year of service. The PPA shortens this schedule to 100% within three years, or 20% per year from the second through the sixth years. The new minimum vesting requirements are effective for nonelective contributions for plan years beginning after 2006.
The Notice confirms that plans may use one vesting schedule for nonelective contributions made for plan years beginning after December 31, 2006 and another vesting schedule for earlier contributions. According to the Notice, a contribution is made for a plan year beginning before January 1, 2007, if it is allocated under the terms of the plan as of a date in 2006 and is not subject to any conditions that have not been satisfied by the end of 2006. For example, a contribution is not subject to the new vesting requirements if a calendar-year plan makes a contribution on December 31, 2006, based on compensation and service in 2006 and the contribution is not contingent upon any events occurring after 2006.
Some plans may choose to have a single vesting schedule applicable to active employees as to all nonelective contributions on their behalf, regardless of when allocated. Although this may simplify plan administration, it may also reduce the amount of forfeitures, and this can have a financial impact on the employer when the plan provides for forfeitures to reduce employer contributions.
The Notice explains that a plan amendment that alters the plan’s vesting schedule to comply with the PPA must also satisfy Code Section 411(a)(10), which provides that no change to a plan’s vesting schedule may result in a lower vested percentage for any participant, and that any participant with at least three years of service must be permitted to elect to use the plan’s pre-amendment vesting schedule. Under current regulations, no election needs to be provided for any participant whose nonforfeitable percentage under the plan, as amended, at any time cannot be less than such percentage determined without regard to such amendment.
Rollovers of Distributions Payable to Non-Spouse Beneficiaries
Under current law, a participant’s surviving spouse who receives a distribution from an “eligible retirement plan” [which includes Code Section 401(a) qualified plans, Section 403(a) or (b) annuity plans and governmental Section 457(b) plans] upon the death of the participant may roll over the distribution to his or her individual retirement account (“IRA”) or to another eligible retirement plan. Thus, the surviving spouse may delay taxation until the amounts are ultimately distributed from the IRA or other plan that accepts the rollover.
In contrast, prior to the PPA, a distribution to a participant’s non-spouse designated beneficiary was not eligible for rollover treatment. This meant that children, parents, siblings, domestic partners and other individuals designated as beneficiaries by the participant were subject to immediate taxation of amounts distributed from the plan upon the participant’s death.
The PPA has relieved some of the tax burden on non-spouse beneficiaries by permitting tax-free rollover treatment similar in some (but not all) respects to that currently available to surviving spouses. Under the PPA, as to a distribution payable to a non-spouse beneficiary after December 31, 2006 from an eligible retirement plan upon the death of a participant, such beneficiary may direct a rollover of the payment, but only in a direct trustee-to-trustee transfer to an IRA established by the beneficiary to receive the rollover distribution.
An IRA established by a beneficiary is treated as an “inherited IRA,” which means, for example, that the IRA is subject to the required minimum distribution (“RMD”) requirements under Code Section 401(a)(9) that otherwise apply to non-spouse beneficiaries.
The Notice provides the following guidance for plan administrators as to rollovers by non-spouse beneficiaries:
- An eligible retirement plan is permitted, but not required, to offer a direct rollover option for non-spouse beneficiaries. This differs from the requirement as to spousal beneficiaries, where such a plan must offer a direct rollover option.
- The rollover IRA must be specifically identified as an IRA with respect to a deceased individual (e.g., “Tom Smith as beneficiary of John Smith”).
- If a trust is the participant’s designated beneficiary, a rollover IRA may be established on behalf of the trust to accept the rollover distribution. If the trust meets certain requirements in the RMD regulations, the beneficiaries of the trust will be treated as having been designated as beneficiaries of the decedent for purposes of determining the RMD period.
- A direct rollover by a non-spouse beneficiary is an “eligible rollover distribution” only for purposes of determining the tax treatment of the distribution and not for other purposes under the Code. For example, a distribution to a non-spouse beneficiary is not subject to mandatory 20% tax withholding and the beneficiary is not required to be provided a “special tax notice” [also referred to as a “402(f) notice”] regarding the distribution. In fact, giving a standard form of such a notice to a non-spouse beneficiary would be problematic, as some of its provisions apply only to participants and to spousal beneficiaries.
- Under Code Section 402(c), an eligible rollover distribution does not include any amount that is an RMD for the year. The Notice explains how the RMD requirements applicable to a non-spouse beneficiary affect how much of the decedent’s benefit payable to such a beneficiary can be rolled over. For example, if the decedent dies before his or her “required beginning date” under Section 401(a)(9), and the so-called “five-year rule” as to post-death RMDs is applied, a rollover of the full benefit payable to the non-spouse beneficiary can be made until the end of the fourth year following the year of the decedent’s death. After that period, no rollover is possible because in the fifth year after the year of death under the five-year rule, the entire benefit payable to the non-spouse beneficiary becomes an RMD.
Changes in Notice Requirements Applicable to Certain Distributions From Qualified Retirement Plans
Various notice requirements are mandated for recipients of distributions eligible for rollover treatment under Code Section 402(f), recipients of distributions of plan benefits in excess of $5,000 under Code Section 411(a)(11), and married participants subject to qualified joint and survivor annuities under Code Section 417. The PPA has changed the required content of such notices and the time frame by which they must be issued.
Effective for plan years beginning after 2006, notices issued pursuant to Code Section 411 must explain a participant’s right to defer receipt of a distribution as well as the consequences of failing to do so. Moreover, notices required under Code Sections 402(f), 411(a)(11) and 417 may be provided to participants no more than 180 days prior to the distribution date or annuity starting date, as applicable. Prior to the PPA, such notices were required to be provided to participants within 90 days of the applicable distribution date.
The Notice clarifies that the new PPA notice requirements apply to plan years that begin after 2006, meaning that the new rules regarding the timing and content of the notices apply only to notices issued in those plan years, regardless of the date of the distributions.
The Notice also clarifies that plan administrators must revise notices issued pursuant to Section 411 before the regulations are amended to reflect the new law. Therefore, all such notices issued in plan years beginning after 2006 must be updated to reflect the new PPA content requirements.
Finally, the Notice addresses several concerns of plan administrators faced with complying with the PPA requirements before regulations are amended:
- Plan administrators who make good-faith efforts to comply with the new requirements will not be treated as failing to meet those requirements for all notices issued within 90 days after the publication of amended regulations.
- Under a safe harbor, plan administrators will be deemed to have made good-faith efforts to comply with PPA requirements if notices are written in a manner reasonably calculated to be understood by the average participant and provide the following information:
- In the case of a defined benefit plan, a description of how much larger benefits will be if the commencement of distributions is deferred. This can be a description that includes the financial effect of deferring distributions based solely on the normal form of benefit under the plan.
- In the case of a defined contribution plan, a description indicating the investment options available under the plan (including fees) that will be available if distributions are deferred.
- As to both types of plans, the portion of the summary plan description that contains any special rules that might materially affect a participant’s decision to defer.