IRS Guidance on Distribution Changes Effective in 2008
Lawrence Jenab, Tuesday, April 01, 2008 | Filed under: 401(k) Plans, 403(b) Plans, Legislation, Pension Plans
The IRS recently issued Notice 2008-30 (the “Notice”), which provides guidance on three distribution-related provisions of the Pension Protection Act of 2006 (“PPA”) that are first effective in 2008, as well as a distribution requirement introduced by final regulations under Section 402(g) of the Internal Revenue Code (the “Code”) that first applies to corrective distributions made during 2008.
ROTH "CONVERSION" ROLLOVERS
Beginning in 2008, qualified retirement plans must provide participants and their surviving spouses with the option of transferring eligible rollover amounts – including pre-tax deferrals – directly to a Roth IRA. This is a change from prior law, under which such a transfer could be accomplished only by rolling the distribution to a traditional IRA and then converting that IRA into a Roth IRA. The requirement also applies to eligible rollover distributions from 403(b) plans and governmental 457(b) plans.
Such a “conversion” rollover is a taxable distribution. That is, the individual’s gross income will include any amount that would have been included had the distribution been made directly to the individual, even though the amount is being rolled over. The 10% tax on distributions before age 59½ does not apply, however, unless the amount rolled to the Roth IRA is distributed before the expiration of the five-year “waiting period” applicable to Roth contributions.
Before 2010, individuals are not permitted to make a conversion rollover if they have modified adjusted gross income of more than $100,000, or they are married and file a separate return. Fortunately, plan administrators and recordkeepers are not responsible for determining a participant’s eligibility for a conversion rollover. Nor do they have any withholding obligations, even though the rollover is a taxable distribution.
Because the conversion rollover option is now a mandatory feature of most retirement plans, sponsors will need to update their benefit election forms, special tax notices, summary plan descriptions (“SPDs”), and other plan communication materials to include this option. They will in most cases also need to amend the direct rollover provisions of their plan documents. Although such amendments need not be formally adopted until the end of the 2009 plan year, plans must be in operational compliance now.
NEW "QUALIFIED OPTIONAL SURVIVOR ANNUITY" REQUIREMENT
The PPA added a new, mandatory distribution option for retirement plans that are subject to the qualified joint and survivor annuity (“QJSA”) requirements of the Code. Effective for plan years beginning in 2008, such plans must also offer a qualified optional survivor annuity (“QOSA”).
The QOSA is a joint and survivor annuity with a survivor percentage that depends on the percentage under the plan’s QJSA provision. The QOSA survivor percentage is 75% if the plan’s QJSA option has a lower survivor percentage; it is 50% if the plan’s QJSA survivor percentage is 75% or more. The value of the QOSA must be at least the actuarial equivalent of a single life annuity payable at the same time; i.e., it need not be actuarially equivalent to the QJSA.
The extent to which plan sponsors will need to amend their plans to conform to the QOSA requirement depends on their existing distribution options. In many cases, optional survivor annuities already available under the plan will satisfy the QOSA requirement. Whether spousal consent is necessary for a participant to elect a QOSA will also depend on existing plan provisions – such consent is necessary only if the QJSA is more valuable than the QOSA.
Thus, for example, a plan that already has a 50% QJSA and a 75% optional joint and survivor annuity will not need to be amended. If such a plan provides (as many do) that all optional payment forms are actuarially equivalent in value to the single life annuity, no spousal consent will be required to elect the QOSA.
Plan sponsors should review their plan documents, SPDs, and benefit election forms to determine whether they must be updated to address the QOSA requirement. As with many other PPA-mandated requirements, the plan must be in operational compliance now, but need not be formally amended before the end of the 2009 plan year.
"BETTER OF" LUMP-SUM TRANSMISSION RELIEF PERMISSIBLE, BUT COMPLICATED
As most readers are no doubt aware, the PPA also mandated new interest and mortality assumptions for determining the amount of distributions that are subject to the present value requirements of Code Section 417(e)(3). These assumptions – generally referred to as the “applicable” interest rate and the “applicable” mortality table – must be used to calculate lump sums, installment payments, and Social Security level income payments. (For ease of reference, this article discusses only lump sums.)
Underlying the Notice’s guidance on this issue is the fact – uncomfortable to many employers – that the new assumptions can substantially reduce a participant’s lumpsum amount. The Notice clarifies two highly technical aspects of the transition to the new assumptions for employers who wish to temporarily preserve the old assumptions to provide a floor under lump sum amounts, thereby cushioning the blow to participants who expected larger lump sums.
Two thorny issues arise when trying to preserve the pre-PPA assumptions for a transition period. First, doing so puts the plan at risk of losing the “anti-cutback” relief provided by the PPA. Second, it risks violating the requirement that a plan’s QJSA be at least as valuable as any other payment option. The Notice addresses both issues.
Preserving Anti-Cutback Relief. Generally, any plan amendment that reduces a participant’s accrued benefit violates the Code’s anti-cutback rule and is therefore impermissible. The relief provided in the PPA protects sponsors by making the anti-cutback rule inapplicable to an amendment implementing the PPA interest rate and mortality assumptions. Thus, even if the new assumptions reduce participant lump sum amounts, the sponsor has not violated the anticutback rule. (Congress and the IRS have historically provided such relief when changing the Section 417(e)(3) assumptions.)
This relief is available, however, only for the first amendment implementing the new PPA assumptions. Thus, if a sponsor partially implements the new factors under a “better of” formula, that amendment will end the PPA amendment period and “use up” the available relief. When the sponsor later phases out the “better of” formula and begins using only the PPA assumptions, it will have no anti-cutback protection. If the new assumptions result in lower lump sums (which is likely), the second amendment will therefore violate the anti-cutback rule.
The Notice charts a course for sponsors wishing to provide such transition relief to participants. It first explains that sponsors will be permitted to employ a “better of” formula, but only for a limited period. This period expires on the last day of the 2009 plan year or, if earlier, the date an amendment fully implementing the new assumptions is adopted. However, for purposes of determining which is the “first” amendment (and therefore uses up the sponsor’s anti-cutback relief), the Notice provides that all amendments adopted on or before June 30, 2008, will be disregarded.
Thus, sponsors wishing to preserve the pre-PPA assumptions for a transitional period may do so, in two steps:
• First, before June 30, they must adopt an amendment under which participants will receive the greater of the lump sum calculated using the pre-PPA or post-PPA assumptions; and
• Second, before the end of the 2009 plan year, they must adopt a second amendment shifting completely to the PPA assumptions.
QJSA Must Be Most Valuable Benefit.The second pitfall for sponsors wishing to preserve the pre-PPA assumptions is the requirement, found in IRS regulations, that the QJSA for a married participant must be at least as valuable as any other optional form of payment available under a qualified plan at the same time. Under an exception to this rule, payments that are subject to the present value requirements of Code Section 417(e)(3) – and which are therefore calculated using the “applicable” interest and mortality assumptions – will not violate this requirement.
Under a “better of” formula, the pre-PPA assumptions (which are no longer “applicable”) could result in lump sums that are more valuable than the plan’s QJSA, thereby violating the IRS rule. According to the Notice, however, a lump sum calculated under a “better of” formula like the one described above will not violate the rule. This relief is available only through the end of the 2009 plan year.
Action Items. Even if sponsors don’t wish to implement lump-sum transition relief, they should review their plan documents and other plan-related communications to determine whether they have properly availed themselves of the anti-cutback protection offered by PPA. In doing so, they should identify each distribution option under which the payment amount has been calculated using the pre-PPA applicable interest rate (which was the rate on 30-year Treasury bonds) or mortality table. They should then decide how to best implement the conversion to the PPA-mandated assumptions.
Plan sponsors who have already amended their plans to implement the new assumptions should also review their documents to determine whether the amendment comprehensively addresses these issues, and to determine whether a corrective amendment is necessary before the expiration of the grace period on June 30, 2008.
DISTRIBUTION OF GAP-PERIOD INCOME
Code Section 402(g) limits the amount a participant may contribute to a qualified defined contribution plan. (For 2007 and 2008, this limit is $15,500, unless the participant is eligible to make catch-up contributions.) If a participant contributes more than the 402(g) limit, the excess amount and any earnings attributable to such excess must be distributed from the plan, usually by April 15 of the calendar year following the year of contribution. The “gap period” is the period between the end of the calendar year in which the contributions were made and the date on which the excess deferrals are distributed,and “gap period income” refers to earnings on excess deferrals during the gap period.
Under final IRS regulations issued last year under Section 402(g), all gap-period income must be included with the distribution of excess elective deferrals,to the extent the participant would be credited with allocable gain or loss on those deferrals for the gap period if the total amount were distributed. This earnings requirement applies to all excess deferrals that are either pre-tax or Roth contributions, and it applies to gap-period earnings for tax years beginning on or after January 1, 2007.
Thus, plans must be in operational compliance with this rule now. With an important exception, however, sponsors need not amend their plans until the last day of the first plan year beginning on or after January 1, 2009.
The exception applies to a restated plan submitted to the IRS during either “Cycle B” or “Cycle C” of the IRS’s determination letter program. Such plans must provide for the distribution of gap-period income. According to the Notice, plan sponsors who submitted Cycle B or C plans before March 24, 2008, without the necessary provisions will be required to amend their plans in order to receive a favorable determination letter.