PENSION FUNDamentals BREAKING THE CODE TAX ISSUES AFFECTING GOVERNMENTAL RETIREMENT PLANS SPRING 2007 MAPERS CONFERENCE

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1 VANOVERBEKE MICHAUD & TIMMONY, P.C MICHAEL J. VANOVERBEKE ATTORNEYS AND COUNSELORS 79 ALFRED STREET THOMAS C. MICHAUD DETR OIT, M ICHIGAN JACK TIMMONY TEL: MICHAEL E. MOCO FAX: FRANCIS E. JUDD PENSION FUNDamentals BREAKING THE CODE TAX ISSUES AFFECTING GOVERNMENTAL RETIREMENT PLANS SPRING 2007 MAPERS CONFERENCE TRUSTEE DEVELOPMENT SEMINAR # 5 Presented By: Michael J. VanOverbeke OBJECTIVE To provide Retirement System Trustees and Plan Administrators with a general introduction to the Internal Revenue Code ( IRC ) and related rules and regulations which apply to governmental retirement systems. Important Note: Trustees, administrators and staff of governmental retirement systems should give special attention to Proposed Treasury Regulation B4UR6 which provides in pertinent part that the consumption of more than three IRC sections may cause drowsiness, impair your ability to drive a car, operate machinery and may cause health problems.

2 INTRODUCTION QUESTION 1. WHAT IS TAX LAW? Code and Statutes: The basic source of the law of federal taxation is the revenue legislation passed by Congress and signed into law by the President. This legislation has been organized into the Internal Revenue Code ( IRC or Code ). The Internal Revenue Code of 1986 was enacted October 22, 1986 and supersedes the Internal Revenue Code of NOTE: IN 1986, TAX REFORM CUT THE INTERNAL REVENUE CODE IN HALF. HOWEVER, TODAY THERE ARE MORE THAN 3.4 MILLION WORDS IN THE INTERNAL REVENUE CODE AND OVER 9 MILLION WORDS WHEN YOU INCLUDE THE REGULATIONS IMPLEMENTING THE CODE. Legislative History: Legislative history, made up of reports from the House Ways and Means Committee, the Senate Finance Committee, and the conference committee for each bill, is important because it indicates the intent of Congress in enacting a tax bill. Cases: Judicial decisions on matters affecting the interpretation of the tax law include decisions of the Tax Court, the United States Claims Court and its predecessor, the Court of Claims, and the federal district courts, circuit courts, and Supreme Court. The Internal Revenue Service does not consider itself bound by decisions of the Tax Court, but it is bound by decisions of the circuit courts in cases arising within the circuit issuing the decision, and by Supreme Court decisions. Regulations: Treasury regulations implement and interpret the Internal Revenue Code. Final regulations and temporary regulations have current authority. Proposed regulations generally have no current authority but provide an indication of the Internal Revenue Service s latest position on issues. The Internal Revenue Service states taxpayers may rely on certain proposed regulations. Revenue Rulings and Revenue Procedures: Revenue rulings are the Internal Revenue Service s view of the law, based on a particular fact pattern. Revenue procedures are similar, but their emphasis is on procedure rather than on substantive law. Revenue rulings and revenue procedures are published in the Internal Revenue Bulletin and are compiled, twice yearly, into the Cumulative Bulletin. 2

3 Letter Rulings: Letter rulings are advance rulings on specific issues rendered by the Internal Revenue Service to specific taxpayers. They are limited to the facts of the specific transaction and have no precedential value. Conclusion: Judge Learned Hand summed up the unbearable complexity of the Internal Revenue Code when he admitted that: THE WORDS OF SUCH AN ACT AS THE INCOME TAX DANCE BEFORE MY EYES IN A MEANINGLESS PROCESSION: CROSS-REFERENCE TO CROSS- REFERENCE, EXCEPTION UPON EXCEPTION-COUCHED IN ABSTRACT TERMS THAT OFFER NO HANDLE TO SEIZE HOLD OF AND LEAVE IN MY MIND ONLY A CONFUSED SENSE OF SOME VITALLY IMPORTANT, BUT SUCCESSFULLY CONCEALED, PURPORT, WHICH IT IS MY DUTY TO EXTRACT, BUT WHICH IS WITHIN MY POWER, IF AT ALL, ONLY AFTER THE MOST INORDINATE EXPENDITURE OF TIME. GRATUITOUS DISCLAIMER: In light of the foregoing, please note that this session is intended to provide a general overview of the subject matter covered. The applicable laws and regulations continue to evolve with amendments to the Internal Revenue Code, new tax regulations, other actions and interpretations by the Internal Revenue Service, and court decisions relating to the law. This information should not be considered the rendering of legal, accounting, or other professional services and should not be used as a substitute for consultation with professional tax advisers. QUESTION 2. WHAT IS A QUALIFIED PLAN? QUALIFICATION RULES FOR GOVERNMENTAL RETIREMENT PLANS This outline briefly summarizes the basic qualification rules applicable to governmental retirement plans that are intended to qualify for preferential tax treatment under the Code. The Internal Revenue Code provides substantial tax advantages to a wide variety of retirement savings devises. The most important of these devises is the Qualified Plan. The term Qualified Plan is not actually used in the Internal Revenue Code, but refers to a retirement plan that satisfies the numerous and complex IRC requirements for the tax advantages provided by the Code. The primary advantages of obtaining and retaining qualified status include:! the member does not pay tax on employer contributions to the plan until the member receives a distribution from the plan, even if the member is vested ;! the member does not pay tax on earnings and income generated by employer and member contributions until the member receives a distribution from the plan, even if the member is vested ;! certain favorable tax treatment may be available when benefits are actually distributed to members (e.g., in certain cases the member may be able to execute a tax-free rollover to an IRA or another qualified plan); 3

4 ! employers may pick-up and pay the member s required contribution (i.e., contributions are treated as employer contributions and are not included in the member s taxable income until the member receives a distribution from the plan; and! employers and members do not pay employment taxes when contributions are made or when benefits are paid. A pension plan qualified under IRC 401(a) is tax exempt under IRC 501(a). QUESTION 3. WHAT HAPPENS IF A PLAN IS NOT QUALIFIED? The above tax advantages are not available (Most significantly, benefits are subject to immediate taxation). QUESTION 4. WHAT HAPPENS IF A PLAN BECOMES DISQUALIFIED? In addition to losing the above tax advantages, certain penalties may apply (excise tax). QUESTION 5. DOES A PLAN NEED IRS APPROVAL TO BE QUALIFIED? The Internal Revenue Service has a procedure whereby it will determine whether a Plan satisfies the requirements of the IRC. While an IRS determination letter is not a requirement of being a qualified plan, it is valuable certification of proper plan administration and is recommended. QUESTION 6. WHAT CONSTITUTES A PENSION PLAN? IRC 401(a)! Held in Trust. To qualify for the favorable tax treatment, the plan must be governed by a written document that requires all contributions to be held in trust for the sole purpose of distributing benefits to members and their beneficiaries (IRC 401(f)) permits a custodial account or an annuity account to be used as a funding vehicle in lieu of a trust so long as the requirements of IRC 401 are otherwise satisfied).! Determinable Benefits. A plan that is established and maintained by an employer to provide systematically for the payment of definitely determinable benefits to employees over a period of years after retirement. Requires that benefits for each participant can be computed in accordance with an express formula contained in the plan. Rev. Rul , C.B. 130; Treas. Reg (b)(1)(i). Requires that whenever the amount of any benefit is to be determined on the basis of actuarial assumptions, such actuarial assumptions are specified in the plan. IRC 401(a)(25); Rev. Rul , C.B NOTE: Both requirements ensure that there is always a known formula whereby the member's benefits may be calculated at any given time, free from any discretion by the employer or plan administrator. 4

5 ! Exclusive Benefit. IRC 401(a)(2) requires that the plan be "for the exclusive benefit of the employees or their beneficiaries...." Therefore: Plan may not benefit a person other than the employee or their beneficiaries. Rev. Rul , C.B Investments made on behalf of the employees must be for the exclusive benefit of employees and their beneficiaries. No funds may revert back to the employer until the trust is terminated and all liabilities are paid [IRC 401(a)(2)]. Note that if the surplus is a result of a change in the benefit provisions or in the eligibility requirements of the plan, the surplus may not be transferred back to the employer. Treas. Reg (b)(1). QUESTION 7. WHAT IS A GOVERNMENTAL PENSION PLAN? A governmental plan is a plan which is established and maintained for its employees by the Government of the United States, by the government of any State or political subdivision thereof, or by any agency or instrumentality of any of the foregoing. IRC 414(d) Note that whether the plan is maintained for its employees by the government entity may become a factor if the plan covers some non-governmental employees. The PBGC has ruled a plan was not governmental if it covered both government and private employees, where contributions and assets were commingled. The result was that all participants were counted for PBGC premiums, including those employed by governmental employers. See PBGC Op. Ltr However, the DOL has opined that the participation of a de minimis number of non-governmental employees will not affect the exempt status of a governmental plan under ERISA. Important: Recognition as a governmental plan under IRC Section 414(d) exempts the plan from certain IRC requirements and ERISA. QUESTION 8. WHAT TYPES OF PLANS EXIST? Qualified plans are typically classified as either defined contribution plans, which include profit sharing, stock bonus, and money purchase plans, or defined benefit plans, which include annuity plans. The distinguishing factors between defined contribution and defined benefit plans are in the nature of the employers obligation with respect to the plan, as well as the employees ability to direct the investment of his or her account. Defined Contribution Plans For purposes of the Internal Revenue Code, a defined contribution plan is defined as a plan which provides for an individual account for each participant and for benefits based solely on the amount contributed to the participant s account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant s account. [IRC 414(i)]. 5

6 Defined contribution plans require the employer to provide plan contributions that are either discretionary in amount or based on a specified formula. In contrast to a defined benefit plan, no specific benefits are promised to a participant under a DC plan. The amount of benefits received under a defined contribution plan is determined by the amount of contributions, earnings and forfeitures that are allocated to the participant s account under the plan. In the event the participant terminates employment before becoming fully vested in the plan, the participant is entitled to a benefit equal to the vested account balance. The nonvested portion is forfeited and may be applied in several ways, including to increase the accounts of remaining participants. Defined Benefit Plans The Code defines a defined benefit plan as any plan other than a defined contribution plan. [IRC 414(j)]. Generally, defined benefit plans require the employer to provide benefits to plan participants according to a pre-determined formula established in the plan. The benefit formula provides for the payment of definitely determinable benefits to participants over a period of years. The amount of contributions to the plan depends on actuarial calculations of the amounts necessary to fund the benefits promised under the plan. As with defined contribution plans, a participant in a defined benefit plan is entitled to a benefit equal to the vested amount of his or her employee contributions, provided the particular defined benefit plan provides for such employee contributions. However, forfeitures arising under a defined benefit plan may not be allocated to other participants. Hybrid Plans Over the past decade, new types of plans have emerged in the State of Michigan which are a hybrid of both the traditional defined benefit and defined contribution plans. For example: Defined benefit plans with lump-sum options (i.e., withdrawal of employee contributions plus interest with an actuarial reduction in monthly benefits). Defined benefit plans with fixed or capped employer contributions and employees bearing the risk of plan performance. Cash balance plans- A defined benefit plan in which each member has a hypothetical account to which fixed contributions and interest payments are credited. While it resembles a defined contribution plan, the employer bears the risk and the benefits of investment performance. Deferred Retirement Option Plan (DROP) - A plan in which the member begins to receive his/her monthly retirement benefit which is deposited into a DROP Account while the member continues with full employment status. Upon the member s termination of employment, the monthly benefit becomes payable to the member and the member can receive the monies collected in the DROP Account. Deferred Compensation Plans Generally, an IRC 401(a) plan may not include "cash or deferred arrangements" ("CODAs") unless the plan meets the requirements of IRC 401(k). A CODA is any plan which allows a participant an election between receiving cash and having an amount contributed on his or her behalf to a qualified plan. If the plan is not permitted to maintain a qualified CODA, the entire plan is disqualified by the existence of a CODA. In 1986, Congress amended IRC 401(k) to prohibit state and local governments from maintaining a 401(K) plan (unless eligible under the grandfather rule). 6

7 Notwithstanding, a governmental employer has the ability to establish an eligible deferred compensation plan under IRC 457 (commonly referred to as a 457 Plan ) which permits an employee to annually defer taxes on the lesser of 100 % of includible compensation or $15,500 (in 2007) in contributions made to a 457 Plan. (Due to the provisions of EGTRRA, limits for 457 Plans are now the same as those for 401(k) plans). Deferred compensation plans are not qualified plans under IRC 401(a), but are eligible for favorable tax treatment on the basis of meeting the requirements of IRC 457. Welfare Benefits It is noted that a pension plan must exist primarily to provide retirement benefits. However, a pension plan may provide disability pensions [Treas. Reg (b)(1)(I)], incidental benefits, through life insurance or otherwise [IRC 401(a)(9)(G); Prop. Treas. Reg (a)(9)-1 Q&A F- 4A] and medical benefits for retired employees [IRC 401(h)].! IRC 401(h) permits qualified retirement plans to provide retiree medical benefits for retired members and their spouses and dependents.! However, any retiree medical benefits must be subordinate to the retirement benefits provided by the plan.! All contributions for retiree medical benefits must be kept separate, for accounting purposes, and may only be used to provide retiree medical benefits. Transfers of existing plan assets to a retiree medical account are extremely limited, and are generally not viable.! Forfeitures must reduce additional employer contributions to pay for retiree medical benefits if they do not revert to the sponsor. QUESTION 9. WHO MUST THE PLAN COVER? The Taxpayer Relief Act of 1997 ("TRA '97") exempted governmental plans from the required minimum participation standards and coverage requirement tests of IRC 401(a)(3) and the non-discrimination rules of IRC 401(a)(4) which previously prohibited contributions, benefits, optional forms of benefits and other plan features from discriminating in favor of highly compensated employees. Governmental plans are treated as satisfying Code 401(a)(3) [minimum participation rules of IRC 410(b)], 401(a)(4) [general nondiscrimination rules], 401(a)(26) [minimum participation rule], 401(k) [salary reduction nondiscrimination rules], 401(m) [matching employer contribution nondiscrimination rules], 403(b)(1)(D) and 403(b)(12) [403(b) nondiscrimination rules], and 410 [minimum participation rules] for all taxable years beginning before enactment of TRA '97. QUESTION 10. WHEN MUST PENSION BENEFITS VEST? VESTING commonly refers to the period of time after which a participant is entitled to a benefit (i.e., accrued benefits become nonforfeitable). The vesting requirements are established in the Plan. However, government plans must at a minimum satisfy the vesting requirements resulting from the application of Sections 401(a)(4) and 401(a)(7) as in effect on September 1, 1974." IRC 411(e). This requires that a governmental plan provide for: 7

8 ! 100% vesting of accrued benefits when a member reaches the plan s normal retirement age. Rev. Rul , C.B. 71.! 100% vesting if there is a partial or complete termination of the plan, or complete discontinuation of contributions, but in either situation, vesting is required only to the extent the benefits are funded. IRC 401(a)(7) (1974). QUESTION 11. WHO CONTRIBUTES TO THE PLAN? Contributions may only be made by (I) the employer, (ii) the members, or (iii) both the employer and the members. IRC 401(a)(1). In general, employee contributions will be included in gross income of the employee in the year the contributions are made. However, an exception exists whereby a governmental entity may treat certain employee contributions to a qualified pension plan as employer contributions. IRC 414(h)(2). This option is commonly referred to as EMPLOYER PICK-UP. As a result, the contributions picked up by the employer will no longer be included in the employee s gross income nor will it be subject to income tax withholdings. Treas. Reg (a)-1; Rev. Rul , C.B Note however, that employer pick-ups will be treated as employee contributions for all other purposes including calculating benefits, state taxes, cost of living increases, salary increases, bonuses, FICA, etc. Certain requirements must be met in order for contributions to constitute valid pick-ups. Specifically: 1. The employer must have specified that the contributions which would otherwise be employee contributions are being paid in lieu of contributions by the employee. 2. The employee on whose behalf the pick-up contribution is being made by the employer must not have been given the option to receive the amounts picked up directly instead of having them paid to the pension plan. 3. Employer pick-ups will not apply retroactively to compensation earned for services prior to the date of the last governmental action necessary to effect the employer pick-up. Rev. Rul , C.B. 255; Rev. Rul , C.B. 255; Rev. Rul , C.B.136. The issue of whether contributions have been picked-up by an employer within the meaning of IRC 414(h)(2) is addressed in Revenue Rulings 81-35, C.B. 255 and 81-36, C.B The common practice is to file a letter ruling request with the IRS and obtain an approval letter regarding the 414(h) pick-up arrangement. This ensures that the requirements of the Internal Revenue Code have been met and insulates the plan against potential adverse tax consequences. QUESTION 12. ARE THERE LIMITATIONS ON COMPENSATION FOR PENSION PURPOSES? IRC 401(a)(17) limits the maximum amount of annual compensation that may be taken into account for a participant in a qualified retirement plan. 8

9 For the year 2007, this limit is $225,000. The prohibition on taking more than $225,000 into account means that:! Compensation in excess of $225,000 may not be used when computing a pension benefit.! Employee contributions may not be computed on more than $225,000. The limit may be adjusted for inflation, based in part on the adjustment made under IRC 415(d). Treas. Reg (a)(17)-1(a)(3)(ii). Annual adjustments to the revised limit under IRC 401(a)(17) are made in increments of $5,000 and are rounded down to the next lowest multiple of $5,000. Treas. Reg (a)(17)-1(a)(3)(iii). QUESTION 13. ARE THERE LIMITATIONS ON CONTRIBUTIONS OR BENEFITS? IRC 401(a)(16) requires a qualified plan to abide by IRC 415, which imposes annual limits on the amount of contributions and benefits. IRC 415 limits must be met by all plan members. If even one member accrues an annual benefit greater than IRC 415 allows, or contributes more than IRC 415 allows, the penalty provided is that the entire plan will be disqualified. Definition of Compensation. "Compensation" for IRC 415 purposes includes the compensation actually paid to the employee during the limitation year. Treas. Reg (d) and (a)(3). Treas. Reg (d)(2)(I) contains the basic definition of compensation for IRC 415 purposes: The employee's wages, salaries, fees for professional services, and other amounts received (without regard to whether or not an amount is paid in cash) for personal services actually rendered in the course of employment with the employer maintaining the plan to the extent that the amounts are includible in gross income (including, but not limited to, commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, bonuses, fringe benefits, and reimbursements or other expense allowances under a nonaccountable plan (as described in (c)). Effective for years beginning after December 31, 2001, Section 616(b) of the EGTRRA amended the definition of compensation for purposes of applying the IRC 415 percentage of compensation limits on contributions to, and benefits from, qualified plans to include: (I) (ii) (iii) any elective deferral (as defined in section 402(g)(3)), and any amount which is contributed or deferred by the employer at the election of the employee and which is not includible in the gross income of the employee by reason of section 125 (including those amounts not available to a member in cash in lieu of group health coverage because the member is unable to certify that he or she has other health coverage) or 457 (i.e., 457 Plan contributions). the rate of compensation that a participant would have received for the year if he were paid at the rate of compensation paid immediately before becoming permanently and totally disabled as provided in 415(c)(3)(C). 9

10 Contributions picked-up by the employer are not included as compensation for purposes of IRC 415 testing. Treas. Reg (d)(2)(I). To the extent that an employer has picked-up mandatory or voluntary contributions, the member s compensation for purposes of IRC 415(c) testing must be reduced. Please note that there is no requirement that the definition of compensation used for IRC 415 purposes be the same definition as is used for benefit or contribution calculations, so long as both definitions independently satisfy IRC 414(s), and the eventual benefit satisfies IRC 415. Limits for Defined Benefit Plans. One of the requirements for a defined benefit plan to remain qualified is that the total amount of annual pension benefits provided to each member cannot exceed the amount specified in IRC 415(b). The Dollar Limit in the year 2007 is $180,000. Historical note: The SBJPA repealed the 100% salary limitation for governmental plans. Adjustments to the Dollar Limit. Certain adjustments must be made to the Dollar Limit. 1. The Dollar Limit is indexed for inflation. (Adjusted in increments of $5,000). 2. The Dollar Limit is raised if an individual retires later than the Social Security retirement age, and lowered if an individual retires before the Social Security retirement age or retires with fewer than ten years of participation in the plan. Code 415(b)(2)(D); 415(b)(5). The reductions for fewer than ten years of service or participation (as applicable) are made on a pro rata basis (i.e., reductions for fewer than ten years of service are reduced in proportion to ten years) whereas reductions and increases from the Social Security age are determined based on the actuarial differences of the ages indicated. See also Treas. Reg (g)(1). These rules do not apply to (a) income received as a pension, annuity, or similar allowance as a result of personal injuries or sickness, or (b) amounts received as a result of an employee's death by the employee's beneficiaries, survivors, or estate. Section 1444(c) of the SBJPA. 4. Special Limits for Governmental Plans. Certain adjustments are made to the Dollar Limit only for governmental pension plans, so in cases of early retirement, members of governmental plans are subject to a Dollar Limit that is more generous than for members of private plans. 1. No reduction of the Dollar Limit is made unless the individual retires before age 62 rather than the Social Security age. 2.. TRA '97 allows early retirement for police and fire personnel without a reduction in the Dollar Limit. IRC 415(b)(2)(G) provides that reductions for early retirement under IRC 415(b)(2)(C) do not apply to police and fire personnel (including emergency medical services) who retire before the Social Security retirement age, so long as at least 15 years of service is required to receive a full benefit under the plan. 10

11 Defined Contribution Limits. If a member participates in a defined contribution plan, the annual amount that may be added to the member's account is limited to the lesser of $45,000 or 100% of the member's compensation for the year. IRC 415(c). The IRC 415(c) limit for year 2007 is $45,000 and shall be indexed for inflation in increments of $1,000. Compensation to which the 100% limit is applied includes wages received, as well as any amount which are contributed or deferred by the employer at the election of the employee and which is not includible in the gross income of the employee by reason of IRC 457. This test is applied on an annual basis. "Annual Addition" is defined by Treas. Reg (b)(1) as the sum, credited to a participant's account for any limitation year, of: 1. Employer contributions; 2. Employee contributions; and 3. Forfeitures. Nondeductible employee contributions (both mandatory and voluntary) to a defined benefit plan are treated as a separate defined contribution plan of the employer and must be taken into consideration in computing the annual additions defined contributions plans of the employer. Rev. Rul ; 1978-CB 128. "Annual Additions" do not include: 1. The restoration of an employee's accrued benefit by the employer in accordance with section 411(a)(3)(D) or section 411(a)(7)(C) will not be considered an annual addition for the limitation year in which the restoration occurs. (See 1.411(a)-7(d)(6)(iii)(B). 2. The transfer of funds from one qualified plan to another will not be considered an annual addition for the limitation year in which the transfer occurs. 3. Rollover contributions. 4. Repayments of loans made to a participant from the plan. 5. Repayments of amounts described in section 411(a)(7)(B) (in accordance with section 411(a)(7)(C)) and section 411(a)(3)(D) (see 1.411(a)- 7(d)(6)(iii)(B)), and 6. The direct transfer of employee contributions from one qualified plan to another. 7. Employee contributions picked-up pursuant to IRC Section 414(h)(2) are not considered employee contributions to a separate defined contribution plan. IRS Letter Section 1 Q&A-8. However, the current IRS position is that the resulting benefit must be tested under IRC 415(b). 11

12 Note that there is no longer a combined test of both defined benefit and defined contribution amounts pursuant to IRC 415(e). Deferred compensation limits Generally, an IRC 401(a) plan may not include "cash or deferred arrangements" ("CODAs") unless the plan meets the requirements of IRC 401(k). Notwithstanding, a governmental employer has the ability to establish an eligible deferred compensation plan under IRC 457 (commonly referred to as a 457 Plan ) which permits an employee to annually defer taxes on the lesser of 100% of includible compensation or $15,5000 (in 2007) in contributions made to a 457 Plan. (Due to the provisions of EGTRRA, limits for 457 Plans are now the same as those for 401(k) plans). Deferred compensation plans are not qualified plans under IRC 401(a), but are eligible for favorable tax treatment on the basis of meeting the requirements of IRC 457. EGTRRA repealed the coordination requirements for 457 plans. Individuals are no longer required to coordinate the maximum annual deferral amount for 457 plans with contributions made to other types of retirement plans. Catch-up contributions. For tax years beginning after 2001, the otherwise applicable dollar limit on elective deferrals under a 457 governmental plan increased for individuals who have attained age 50 by the end of the year. The additional amount of contributions that may be made is the lesser of: 1. A specified dollar amount. (The dollar amount is $5,000 for 2007); or 2. The participant s compensation for the year reduced by his or her other elective deferrals for the year. Under the Job Creation and Worker Assistance Act of 2002, IRC 414(v) catch-up contributions do not apply to a participant for any year for which a higher limitation applies under the IRC 457 plan catch-up provisions, under IRC 457(c). [IRC 414(v)(6)(C) as amended by 2002 Act 411(o)(8)]. The limits on elective deferrals during one or more of the participant s last three years before reaching normal retirement age is the greater of: (1) the sum of: (a) (b) the plan ceiling established for purposes of the elective deferral limit under IRC 457 without regard to 457(b)(3) catch-up rules, plus the applicable dollar amount (catch-up contribution limit) for the tax year under IRC 414(v)(2)(B)(I); or For example: (2) the amount determined under the IRC 457(b)(3) or IRC 457(c) without regard to IRC 457(e)(18). [IRC 457(e)(18) as amended by 2002 Act 411(o)(9)] In 2007, P is a participant in a governmental 457 plan in which the ceiling on deferrals is $15,500 (or 100% of compensation, if less). P is 64 years old in Normal retirement age under the plan is 65. The plan contains a limited catch-up provision. In the ten years of his participation in the plan, P has deferred a total of $500 less than the aggregate annual maximums allowed. P elects to defer up to the maximum amount permitted for 2007 under the limited catch-up provision. For 2007, P had includible compensation of $60,000. P is also an eligible participant for purposes of the IRC 414(v) catch-up contribution rules. Thus, under IRC 457(e)(18), P would be able to elected deferrals of the greater of: 12

13 (1) $20,500 (the sum of $15,500 plan ceiling without regard to the catch-up rules) and $5,000 P s applicable dollar amount under IRC 414(v); or (2) $16,000, which is the amount that P could defer under IRC 457(b)(3) and (c) (the sum of $15,500 plan ceiling without regard to the catch-up rules and $500 of P s unused deferrals. Thus under IRC 414(v)(6)(C), P can elect to defer $20,500 in For 457 plans, this catch-up rule does not apply during the participant s last 3 years before retirement. In those years, the regularly applicable dollar limit is doubled as provided in IRC 457(b)(3). [IRC 414(v)(6)(C) as amended by EGTRRA] Deemed IRAs - Under EGTRRA, a qualified employer plan may provide for voluntary employee contributions to a separate account that is deemed to be an IRA. Qualified employer plans include the following plans maintained by a governmental employer: a qualified retirement plan under IRC 401(a) and an eligible deferred compensation plan under IRC 457(b). QUESTION 14. MAY A PARTICIPANT PURCHASE SERVICE CREDIT? One common method of enhancing an employee's benefit under a governmental defined benefit plan is to allow the employee to purchase additional years of service credit for certain years of service he or she might have with the current employer or with a previous government employer. TRA '97 added a new IRC 415(n). This establishes a new limitation structure for "permissive service credit" purchases, instead of the prior defined contribution limitations. This Section allows IRC 415 to be satisfied if:! The defined benefit limit in IRC 415(b) is met, treating the accrued benefit derived from all permissive service credits as part of the member s annual benefit. -or-! The $45,000 (2007) defined contribution limit in IRC 415(c) is met, treating all permissive service credit as an annual addition. These limits can be applied on a participant-by-participant basis rather than choosing to apply the limits plan-wide. For transfers after December 31, 2001, a participant in a State or local governmental plan is not required to include in gross income a direct trustee-to-trustee- transfer to a governmental defined benefit plan from a 403(b) annuity [IRC 403(b)(13)] or a 457 plan [IRC 457(e)(17)] if the transferred amount is used (1) to purchase permissive service credits under the plan, or (2) to repay contributions and earnings with respect to an amount previously refunded under a forfeiture of service credit under the plan or another plan maintained by a State or local government employer within the same State. "Permissive service" credit is any service credit:! Recognized by the governmental plan for calculating a member's benefit.! Which the member does not already have credited under the plan.! That the member can receive only by an additional voluntary contribution, in an amount determined by the governmental plan, which does not exceed the amount necessary to fund the benefit attributable to this service credit. 13

14 ! However, service under the first three points above will be nonqualified service if recognition of the service would cause the member to receive a retirement benefit for the same service under more than one plan. A plan will not meet this new IRC Code 415(n) if:! More than five years of nonqualified service are taken into account. -or-! Any nonqualified service is taken into account before the employee has at least five years of participation under the governmental plan. "Nonqualified service" is all permissive service except for:! Service (including parental, medical, sabbatical, and similar leave) for the US government, or any state or political subdivision thereof, or any agency or instrumentality of any of the foregoing.! Service (including parental, medical, sabbatical, and similar leave) for an educational organization which is a public, private, or sectarian school which provides elementary or secondary education (through grade 12) as determined under state laws.! Service for an association representing employees of the US, state or political subdivision.! Military service (non-userra covered) recognized by the governmental plan. This rule was effective for years beginning after December 31, Repayments of Cash-outs/Restorations of Service TRA '97 provides that any repayment of contributions (including interest) will not be taken into account for IRC 415 purposes if the repayment is to a governmental plan with respect to an amount previously refunded on a forfeiture of service credit under that plan or any other governmental plan maintained by the state or any local governmental employer within the same state. Rollovers. Governmental plans may also make use of rollovers for service purchases pursuant to Treas. Reg. Section (b)(3). Service Purchase by Employer Pick-Up. Governmental plans have sought and continue to seek private letter rulings to extend the pick-up concept to voluntary employee contributions for the purchase of service or for benefit enhancements. PLR , , 65, 66, 67, 70, 71. In private letter rulings the IRS has permitted employees to buy back prior service credit and to purchase additional serve credit. PLR ; PLR ; PLR ; PLR (Private letter rulings may not be cited as precedent or relied upon by any one other than the person to which they were issued.) In these rulings the IRS has stressed the following factors: 14

15 ! The resolution to pick up the contributions must be completed prior to the pick-up.! The salary deduction authorization for the purchase must be binding and irrevocable.! The employee may not terminate payroll contributions by making a voluntary payment. QUESTION 15: WHEN MAY A PLAN MAKE DISTRIBUTIONS? In general, a member may not withdraw contributions made by the employer, or earnings on such contributions, before normal retirement, termination of employment, or termination of the plan. Rev. Rul , C.B. 94. In addition, a member may only withdraw funds that he or she contributed and earnings on such contributions under limited circumstances. The IRS has developed certain limitations on in-service withdrawals of members' funds prior to retirement or separation of employment, arising from Treas. Reg (a)(2)(I).! Where a plan has been amended to eliminate any member contributions, the member may withdraw contributions he or she had previously made. Rev. Rul , C.B. 108.! Where a member has discontinued participation in the plan, the member may withdraw contributions he or she previously made as well as interest earned on such contributions. Rev. Rul , C.B. 146.! A member may receive a loan of plan funds as long as such loans are uniform and nondiscriminatory. In order to constitute a loan rather than a distribution, such payment must be adequately secured, bear a reasonable interest rate, and provide for repayment in a specified time. Rev. Rul , C.B. 151; see also Code 72(p). Generally, Section (b)(1)(I) of the Income Tax Regulations would not permit a distribution prior to death, disability, separation from service, or attainment of normal retirement age The IRS considers an employee separated from service only upon the employee s death, retirement, resignation or discharge, and not when the employee continues on the same job. This was called the same desk rule. As a result of the same desk rule, employers, following a merger, acquisition, or sale, were often forced to retain terminated employees in their plans who are continuing in the same job with the new employer. EGTRRA eliminated the same desk rule for distributions from 401(k), 403(b) and 457 plans. Therefore, effective with distributions after December 31, 2001, a retirement system may permit distribution on severance from employment, meaning when the participant ceases to be employed by the employer that maintains the plan. The question also arises as to whether qualification for normal retirement, without a separation from service, should be a sufficient justification for a distribution. The IRS has ruled that in the case of a pension plan in which the normal retirement age is 65, a plan could not make a distribution at age 59 ½ to an active participant. If, however, the normal retirement age were 59 ½, the plan could make such distribution even if the participant continued working. Let Rul

16 Note: The Pension Protection Act prompted the addition of IRC 401(a)(36) which provides that a trust forming part of a pension plan is not treated as failing to constitute a qualified trust under section 401(a) solely because the plan provides that a distribution may be made from such trust to an employee who has attained age 62, and who is not separated from employment. The regulations are applicable to governmental plans beginning on or after January 1, Premature Distribution. IRC 72(t) imposes a 10% excise tax on premature distributions from qualified plans. This tax generally applies to distributions paid to members before the member attains age 59 ½. However, exceptions apply to the following types of distributions:! distributions paid on or after the member s death;! distributions attributable to the member s being disabled;! distributions paid in the form of substantially equal periodic payments for life or based on life expectancy;! distributions to a member after separation from service after attainment of age 55;! distributions to a qualified public safety employee who separates from governmental service after attaining age 50 [Pension Protection Act of 2006 (effective August 17, 2006)];! distributions that do not exceed the amount allowable as a deductible medical expense for the member during the taxable year in which the distribution is paid;! distributions to unemployed persons for the payment of health insurance premiums; and! distributions paid to an alternate payee pursuant to the terms of a qualified domestic relations order. QUESTION 16. WHEN IS A PLAN REQUIRED TO MAKE DISTRIBUTIONS? IRC 401 (a)(9) includes several rules governing distributions from qualified plans.! A plan will not be qualified under 401(a) unless it provides that each employee s entire plan interest will be distributed: 1. No later than the required beginning date to the employee, or 2. Beginning no later than the required beginning date, over; a. the life of the employee; b. the lives of the employee and a designated beneficiary; c. a period not extending beyond the life expectancy of the employee, or d. a period not extending beyond the life expectancy of the employee and the designated beneficiary.! Distributions must begin to be paid by the later of April 1 of the calendar year after member attains age 70 1/2 or April 1 of the calendar year after the member actually retires. 16

17 ! Final and temporary regulations were issued in These regulations adopted, with numerous modifications, the 2001 proposed regulations under section 401(a)(9). The 2002 regulations apply to account balances and benefits for calendar years beginning on or after January 1, 2003, even if the employee died before January 1, Thus, for an employee who died prior to January 1, 2003, the designated beneficiary must be redetermined in accordance with the new rules and the applicable distribution period must be reconstructed for purposes of determining the amount required to be distributed for calendar years on or after January 1, 2003.! Uniform Lifetime Table The 2002 Final Regulations provide a simple table, the Uniform Lifetime Table, that most employees can use to determine minimum distributions during their life. If an employee's sole beneficiary is the employee's spouse and the spouse is more than 10 years younger than the employee, the employee can use the longer distribution period of the joint life and last survivor life expectancy of the employee and spouse.! Death after required beginning date When the employee dies after the required beginning date with a designated beneficiary, the distribution period is the beneficiary's life expectancy for the year after death reduced by one for each subsequent year. When an employee dies after the required beginning date without a designated beneficiary, the distribution period is the employee's life expectancy for the year of death reduced by one for each subsequent year. In order to be named a designated beneficiary, an individual must generally be a beneficiary as of the date of the employee's death, and remain a beneficiary as of Sept. 30 of the year following the year of the employee's death.! Death before required beginning date The 2002 Final Regulations allow the choice for the default rule in the case of death before the employee's required beginning date. Distribution may now be made under either the five-year rule or under the life expectancy of the designated beneficiary rule.! Incidental Benefit Requirements In addition to meeting the minimum distribution requirements, all distributions to beneficiaries or survivors must meet the incidental benefit requirements. The minimum distribution incidental benefit (MDIB) requirement provides that, where the spouse is not the designated beneficiary, the amount of the payments to be made to the employee (or IRA owner) before death must be determined under the principles of the RMD rules, using a hypothetical individual not more than ten years younger than the employee as the employee's designated beneficiary. If the spouse is the designated beneficiary, the MDIB requirements are met if distributions satisfy the minimum required distribution rules, without any additional MDIB requirement. By limiting the amount of annuity payments to an employee's survivor, the MDIB rules ensure that plan benefits are paid primarily to the employee as retirement benefits. This restricts the availability of plans to defer the payment of taxable plan benefits beyond the employee's life.! The general incidental death benefit tests for pre-retirement death benefits require that the cost of providing such a death benefit cannot exceed 25% of the cost of all of the member s benefits or that the death benefit not exceed 100 times the expected monthly amount that would have been paid to the member. This rule applies only to benefits paid from qualified trusts. Distributions from federally or state funded line of duty death benefit programs can be set up separately to avoid a problem in this regard. 17

18 ! The plan must be operated in a manner that complies with each of the rules under IRC 401(a)(9) and the plan document must specifically include a statement that distributions will be made in accordance with these rules and that any contradictory provisions in the plan are expressly overridden.! For distributions after December 31, 2001, amounts deferred under a 457 plan of a State or local government are includible in income only when paid. The special minimum distribution rules for 457 plans are repealed and those plans are subject to the minimum distribution rules that apply to qualified plans. [IRC 457(d), as amended by EGTRRA 649]! In addition to the qualification issue, a nondeductible excise tax may apply if the amount actually distributed to a recipient is less than the required minimum amount. IRC The excise tax is equal to fifty percent (50%) of the difference between the required minimum distribution amount and the actual amount distributed during the calendar year. IRC 4974(a); Prop. Treas. Reg Q&A-1. The recipient of the distribution is liable for this tax. QUESTION 17. HOW ARE DISTRIBUTIONS TAXED? Basis Recovery Rules IRC 72 is the governing provision for the taxation of qualified annuity distributions, such as the annuity withdrawal provisions. Generally, IRC 72 requires any amount received as an annuity to be included in gross income. Certain exceptions apply to qualified annuities which allow post-tax employee contributions to be excluded from gross income. These post-tax employee contributions represent the participant s basis or investment in the contract and are recoverable over the life of the annuity. Once the employee s entire amount of employee contributions has been recovered, all subsequent amounts received under the annuity are included in the employee s gross income. Unfortunately, the Internal Revenue Service (IRS) does not separate post-tax contributions from pre-tax contributions when dealing with pre-annuity distributions. Instead, the IRS considers all amounts the individual is to receive over the entire life of the annuity to be commingled. To the extent an individual receives a distribution of employee contributions under the annuity withdrawal option, the IRS considers such distribution to consist of both pre-tax and post-tax dollars (not a straight return of the individual s post-tax employee contributions, as one would think). The portion of the distribution the IRS considers to be a return of post-tax employee contributions is permitted to be put in the individual s pocket (i.e., immediately excluded from gross income). The portion of the distribution the IRS considers to be a payment of pre-tax dollars is subject to federal income taxation. Thus, the return of the employee s post-tax contributions is considered to be on a pro rata basis. Although the employee may withdraw the amount of annuity contract that represents post-tax employee contributions and interest, the IRS considers the amount withdrawn to consist of both pretax and post-tax dollars. 18

19 The bottom line regarding the taxation of annuity withdrawals is that recovery of after-tax employee contributions distributed before the annuity starting date will be on a pro rata basis throughout the life of the annuity. Note: Amounts distributed from a 457 plan are subject to the early withdrawal tax to the extent the distribution consists of amounts attributable to rollovers from another type of plan(i.e., DB or DC 401(a) plan). [IRC 72(t)(9), as added by EGTRRA 641(a)] It is important to note that the Internal Revenue Code does provide for the eventual recovery of all post-tax employee contributions. However, instead of such post-tax dollars being immediately excluded from a member s gross income, the IRS requires those dollars to be excluded in small increments throughout the life of the annuity. The following formula is used for determining the excludable portion of each annuity payment: The balance of after-tax contributions to be recovered over the life of the annuity Expected number of payments The non-taxable portion of a member s annuity payment is determined by dividing the investment in the contract by the number of anticipated payments based on the primary recipient s age at the annuity starting date. The member s investment in the contract is the total of all after-tax employee contributions as of the annuity starting date. The following table contains the expected number of payments under the annuity as determined by the Internal Revenue Service. Age 55 & Under # of Payments & Over 160 The attached example illustrates the method by which the excludable portion of a single-life annuity payment may be calculated when a member elects to withdraw employee contributions under the annuity withdrawal option. In 1997, the Taxpayer Relief Act made a slight alteration in the way the non-taxable portion of a joint annuity is calculated. Prior to the Taxpayer Relief Act of 1997, the number of anticipated payments was based on the age of the primary recipient of the annuity irrespective of whether the annuity was a single life annuity or a joint and survivor annuity. Beginning in 1998, the Internal Revenue Code make a distinction between single life annuities and annuities paid over multiple lifetimes. The Code now requires a different table be used to determine the number of payments when joint and survivor annuities are involved. The table listed above continues to be used for single life annuities; however, for joint annuity starting dates beginning on or after January 1, 1998, the following table will be used: Combined Ages of Annuitants on Annuity Starting Date # of Payments 110 & Under & Over