IRS Releases Grab Bag of Guidance on Pension Distributions

The IRS has released guidance on a variety of retirement plan distribution issues arising from the Pension Protection Act of 2006 (PPA). The guidance addresses both defined benefit and defined contribution plans. Because it deals with so many different issues, the IRS is calling the guidance the distribution “grab-bag.”

Right-to-Defer Disclosure in Benefit Election Notices
Among the more significant items in the grab bag is the guidance on the new rules for participant consent notices. In addition to the content already required for benefit election forms, including a description of the tax consequences of the distribution, the PPA requires sponsors to inform participants and beneficiaries of their right to defer retirement distributions and the consequences of failing to defer. The PPA also extended the maximum period for providing the tax information and for obtaining required participant and spousal consent to 180 days before the annuity starting date (it used to be 90 days).

While the PPA did not indicate whether the 180-day extension was discretionary or required, the notice clarifies that it is a discretionary maximum. As a voluntary plan change, different rules apply to the timing of amendments adopting the 180-day consent period.

The PPA and the legislative history were also unclear regarding the effective date of the new notice requirements, leading some sponsors to conclude that the new notice could wait until the IRS issued regulations. The guidance clarifies that the new right-to-defer content requirements take effect for plan years beginning after 2006, based on the notice’s issue date, not the distribution commencement date. Plan sponsors must make reasonable attempts to provide the expanded notice before the regulations are issued. Sponsors may want to revise their plans’ benefit election materials and reissue any notices already released in 2007. Alternatively, some sponsors may argue that the law does not require a reasonable attempt to satisfy the new requirements until January 29, 2007, the official publication date of the guidance.

Although all qualified plans must issue right-to-defer notices, such notices do not apply to all distributions. Notice of deferral rights is required only if the distribution is subject to participant consent, so the notice is unnecessary if total vested benefits are less than $5,000, or if participants have reached the later of age 62 or the plan’s normal retirement age. Many plan sponsors have eliminated nonconsensual distributions between $1,000 and $5,000 to avoid EGTRRA’s automatic rollover rule. Even though the plan requires participant consent for such distributions, it is reasonable to assume that right-to-defer notices are not required for vested accrued benefits of $5,000 or less. Many plans, however, would prefer having one set of notices and disclosures for benefit elections and so may prefer to provide right-to-defer notices to all participants making a benefit election.

Defined benefit plan sponsors can meet the reasonable-attempt standard by providing a clearly worded description of “how much larger the participant’s benefits will be if the commencement is deferred,” along with any portion of the plan’s summary plan description that contains “special rules that might materially affect the participant’s decision to defer.” Rather than spelling out participant-specific amounts, notices may illustrate the financial implications of deferring benefits on a generalized chart based on the plan’s normal distribution form.

Defined contribution plan sponsors can meet the reasonable-attempt standard by providing a description of the investment options available under the plan (including fees) if the participant defers his or her distribution, in addition to the relevant portion of the summary plan description containing the special rules discussed above.

Limitation on Benefits
The Internal Revenue Code limits the maximum benefit payable from a defined benefit plan, and adjusts the form of payment to a single-life annuity using either the rate specified for determining lump sum distributions or the plan rate. A specified fixed rate was used for the 2004 and 2005 plan years, but calculations in early 2006 would have reverted to using the statutory rate. Under the PPA, plans should adjust the form of payment using the greatest of (1) the specified fixed rate, (2) the rate that provides a benefit of not more than 105 percent of the benefit calculated using the statutory lump sum rate or (3) the rate specified under the plan. This change took effect for distributions made in plan years beginning after 2005, which could create complications for plans that paid benefits in 2006 before the PPA was enacted. Pre-PPA distributions could have complied with the maximum limits then in effect, but violated the post-PPA maximums.

While many employers sought relief from applying the PPA changes for distributions made in 2006 before August 17, the IRS confirms that the new provision applies to all distributions in 2006, though the IRS does provide some relief on bringing the plan into compliance. If a 2006 distribution exceeds the post-PPA limits, there are three ways to correct the excess distribution:

• In the first method, the sponsor need not return the excess distribution to the plan. Rather, the plan issues one Form 1099-R to the participant that identifies the excess distribution with a special code and another Form 1099-R that identifies the post-PPA normal distribution amount.
• The other two methods are based on the excess distribution correction procedure from the Employee Plans Compliance Resolution System (EPCRS) program. Depending on the timing of the correction, the plan may be able to use the EPCRS even if it doesn’t meet the usual criteria.

In 401(k) and 403(b) plans, a hardship distribution must both (1) be made on account of the employee’s immediate and severe financial need and (2) be necessary to satisfy the financial need. The 401(k) regulations list expenses that are deemed to meet that requirement; several of them can be expenses of the employee’s spouse or dependents.

The notice provides that for both 401(k) and 403(b) plans:

• Beginning August 17, 2006, a plan that permits hardship distributions of elective contributions only for expenses listed in the 401(k) regulations may optionally permit distributions for medical expenses; tuition, fees, and room and board expenses; and funeral or burial expenses for a primary beneficiary.
• A “primary beneficiary under the plan” must be named as a beneficiary under the plan and have an unconditional right to all or a portion of the participant’s account balance upon the participant’s death.
• A plan that adopts these expanded hardship provisions must still satisfy all the other requirements for hardship distributions.

Section 411 Vesting for Defined Contribution Plans
The PPA reduced the vesting schedule for defined contribution plans, requiring three-year cliff vesting or two-to-six-year graded vesting for nonelective employer contributions. The new vesting schedule applies to contributions for plan years beginning after 2006, and the notice clarifies that the plan may have separate vesting schedules for pre- and post-PPA contributions. The notice also clarifies how to determine the year to which a contribution applies.

Other Issues
The grab-bag guidance also addresses PPA provisions concerning benefit distributions, specifically direct rollovers to IRAs for nonspouse beneficiaries, benefits paid to public safety employees and officers, and the new income exclusions for IRS distributions to certain charitable organizations.

February 2007