IRS Issues Final Regulations on Limitations on Benefits and Contributions under Qualified Plans

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1 IRS Issues Final Regulations on Limitations on Benefits and Contributions under Qualified Plans The IRS has released comprehensive final regulations under Internal Revenue Code Section 415, which consolidate more than 25 years of guidance on statutory changes to the limitations on benefits and contributions under qualified plans. The regulations generally follow the proposed regulations issued in 2005, but include some important changes. They also include guidance on changes made by the Pension Protection Act of In particular, the regulations do not include some contentious proposed rules on multiple annuity starting dates (which will be addressed separately in future proposed regulations). The final regulations are effective April 5, 2007, but generally apply to limitation years beginning on or after July 1, Background Section 415(b) limits the amount of a plan participant s annual benefit that can be paid from a qualified defined benefit plan. This amount for benefits starting at ages 62 to 65 is the lesser of a dollar limit ($180,000 in 2007) or a compensation-based limit (100% of the participant s average Section 415 compensation for his or her high three consecutive years). The compensation-based limit does not apply to governmental and multiemployer plans. Section 415(c) provides that annual additions to an employee s account in a defined contribution plan cannot exceed the lesser of a dollar amount ($45,000 in 2007) or 100% of the participant s Section 415 compensation for the year. The IRS issued proposed regulations under Section 415 in 2005, which consolidated guidance on all laws enacted since 1981 (the last time regulations were issued), including TEFRA, DEFRA, TRA 86, GATT, EGTRRA, and PFEA. (See our July 1, 2005 For Your Information.) Since then, Congress enacted the Pension Protection Act of 2006 (PPA), which made further changes to Section 415. Now the IRS has issued final regulations under Section 415, incorporating the changes made by all of these laws. Final Regulations The final regulations are substantially similar to the 2005 proposed regulations, but contain several significant changes. In what follows, we discuss some of the major highlights of the final regulations.

2 Multiple Annuity Starting Dates The Section 415 limits for defined benefit plans are expressed in terms of an annual benefit (i.e., a benefit payable annually as a single life annuity). The proposed regulations provided complex rules for calculating the annual benefit limit under one or more defined benefit plans for participants with multiple annuity starting dates. The IRS received so many comments expressing concern about these rules that it decided to withdraw them completely from the final regulations and plans to issue them separately as proposed regulations at a later date. However, the regulations include an interim rule i.e., if a participant has distributions from one or more defined benefit plans commencing at more than one annuity starting date, the Section 415 limitations must be satisfied as of each of the annuity starting dates, taking into account the benefits that have been or will be provided at all of the annuity starting dates. Compensation Post-Severance Compensation Amounts received following severance from employment are generally not treated as compensation for Section 415 purposes. Thus, former employees may generally not make contributions to Sections 401(k), 403(b) and 457 plans from post-severance pay. However, the proposed regulations allowed specified payments to be considered compensation for Section 415 purposes if they were made within 2½ months of severance and met certain other conditions. The final regulations expand this exception by allowing these payments to be considered Section 415 compensation if they are made within the later of 2½ months following severance from employment or the end of the limitation year that includes the date of severance. (Governmental plans may substitute the end of the calendar year that includes the date of severance for the end of the limitation year that includes the date of severance.) They also include a new exception for post-severance compensation paid to a permanently and totally disabled individual. The final regulations also provide that post-severance payments of accrued sick, vacation and other leave are not included in Section 415 compensation unless the plan specifically provides otherwise. In addition, the regulations clarify that taxable amounts payable after severance of employment from nonqualified deferred compensation plans are includible as Section 415 compensation only if the payment is made before the later of 2½ months after severance from employment or the end of the limitation year that includes the date of severance, and such payment would have been made at the same time if the employee continued to be employed. Payments to Nonresident Aliens The final regulations adopt the most common interpretation of the 1981 regulations regarding the treatment of compensation for nonresident aliens i.e., that amounts paid to such individuals may be treated as compensation [ 2 ]

3 regardless of whether they are excluded from U.S. gross income because of where the services are performed or because all of the compensation provided by the employer would otherwise be excludible from U.S. gross income. Under these rules, the Section 415 limitations on compensation will not prevent nonresident aliens with no U.S. source income from participating in U.S. employer qualified plans. However, the preamble to the regulations notes that other rules relating to the permissibility of nonresident aliens participation in qualified plans are not modified and still apply. Payments for those on Military Leave As under the proposed regulations, the final regulations provide that payments to individuals on a military leave of absence are included in Section 415 compensation to the extent they do not exceed the amount that the individuals would have received if they were working. This provision went into effect for limitation years that began on or after January 1, High Three-Year Average Compensation As noted earlier, Section 415(b) generally limits the annual benefit that may be paid from a qualified defined benefit plan for benefits commencing at ages 62 through 65 to the lesser of a dollar limit or 100% of a participant s average compensation earned during his or her high three consecutive calendar years. The proposed regulations provided that compensation used for this purpose would be restricted to compensation earned while an active plan participant, but PPA eliminated this active participant requirement for years beginning after December 31, Thus, this provision does not appear in the final regulations. However, the final regulations do retain the provision in the proposed regulations that the compensation in each of the three years may not exceed the annual compensation limit under Section 401(a)(17) for that year. As a result of comments from Buck and others, the final regulations now grandfather certain compensation for purposes of this rule. That is, Section 415 compensation can include amounts in excess of the Section 401(a)(17) limit for benefits accrued or payable under the plan as of the end of the limitation year that is immediately prior to April 5, 2007 (the effective date of the regulations) as long as the plan provision and limitation year were adopted and effective before April 5, For a rehired participant, the three-year average is the greater of the three-year average prior to termination or the three-year average taking into account service both before and after rehire (i.e., treating the years prior to and immediately following termination as consecutive). There are also rules for determining the high three-year average compensation for participants with less than three consecutive calendar years of service. Nonqualified Deferred Compensation The regulations clarify that Section 415 compensation includes amounts that are includible in gross income under the rules of Section 409A or Section 457(f)(1)(A) or because the amounts are constructively received by the employee. They also clarify that a plan is permitted to include as Section 415 compensation amounts received [ 3 ]

4 pursuant to a nonqualified deferred compensation plan only to the extent the amounts are includible in gross income. Age Adjustments to Dollar Limitation Mortality Adjustments The regulations adopt previous guidance on mortality adjustments in computing the dollar limitation for benefits commencing before age 62 or after age 65 that is, no mortality adjustment is made for the period before age 62 or after age 65 to the extent that a forfeiture does not occur upon the participant's death before the annuity commencement date. If a forfeiture does occur upon the participant's death before the annuity commencement date, a mortality adjustment must be made for the period before age 62 or after age 65. The regulations provide a simplified method for applying the mortality adjustment rules. If a plan does not charge participants for providing a qualified preretirement survivor annuity, then a forfeiture may be deemed not to occur upon a participant's death and no mortality adjustment is needed as long as this treatment applies to the age adjustments for periods both before age 62 and after age 65. No Adjustment for Police and Fire Employees The regulations provide that no adjustment is made to the dollar limitation for early commencement (i.e., before age 62) for any participant in a plan maintained by a state, Indian tribal government, or any political subdivision thereof, who has at least 15 years of benefit service as either a full-time employee of a police or fire department, or as a member of the U.S. Armed Forces. Incorporation By Reference of Increases in Dollar Limitation Many defined benefit plan documents incorporate the defined benefit dollar limitation and any annual cost-of-living increases on the dollar limitation by reference. The final regulations provide that annual increases in the limitation apply to a participant who separated from service (or whose benefit has commenced) only if the plan specifies that the increases apply. This follows the prior regulations but reflects a change from the proposed regulations, which had the same provision based on the participant's annuity starting date instead of on the participant's separation from service. The regulations also include two safe harbors for plan amendments that increase benefits to reflect cost-of-living adjustments to the Section 415 dollar limit. Converting Benefit Forms to Straight Life Annuities The final regulations reflect prior statutory changes and other prior guidance to the rules for converting benefit forms to a straight life annuity to demonstrate compliance with Section 415, including changes to the interest rate [ 4 ]

5 assumptions made by PPA for benefits subject to the Section 417(e)(3) minimum present value rules (e.g., lump sums). The regulations provide a simplified method for converting benefits to straight life annuities, but only for benefits not subject to the Section 417(e)(3) minimum present value rules. Questions were raised about the need to make certain adjustments for annuities that have automatic cost-of-living adjustments. The final regulations provide that if the form of benefit is not subject to Section 417(e)(3), no adjustments need be made as long as the form of benefit without the cost-of-living adjustment satisfies the requirements of Section 415(b) and the plan provides that the amount payable will never exceed the Section 415(b) limit applicable at the annuity starting date (and as indexed in subsequent years). 10-Year Phase-In of Limitations The final regulations follow previous guidance for applying the 10-year phase-in of the dollar limitation (based on years of participation) and modify the guidance in the 1981 regulations on applying the 10-year phase-in of the compensation limit (based on years of service) to make it consistent. Terminating Defined Contribution Plans The final regulations provide a new rule for terminating defined contribution plans. If a defined contribution plan is terminated effective as of a date other than the last day of the plan s limitation year, the plan will be considered to have been amended to change its limitation year and the defined contribution plan dollar limit will be prorated under the short limitation year rules. Rollover Contributions Excluded from Annual Benefit Limitation The final regulations clarify that in determining the annual benefit for Section 415 purposes, the benefit attributable to rollover contributions from an eligible retirement plan made to a defined benefit plan is excluded. In this case, the annual benefit attributable to such contributions is determined by applying the rules of Section 411(c). Benefits Paid Partially in the Form of a QJSA Under Section 415, the survivor portion of a qualified joint and survivor annuity (QJSA) is not taken into account in determining the annual benefit for Section 415 purposes. The final regulations retain the clarification in the proposed regulations that this rule applies to the survivor annuity payments under the portion of a benefit that is paid in the form of a QJSA, even if another portion of the benefit is paid in some other form. [ 5 ]

6 Aggregation Rules The regulations make several changes to the rules under which all defined benefit or defined contribution plans ever maintained by an employer in a controlled group must be aggregated. For example, the rules clarify that an employer s plan must be aggregated with all plans maintained by a predecessor employer, regardless of whether assumed by the successor employer. The regulations contain special rules regarding the extent to which a plan must aggregate benefits accrued under plans formerly maintained by the employer or maintained by an entity that was formerly affiliated with the employer, as well as benefits accrued under plans maintained by a predecessor employer that are not assumed by the successor employer. The regulations provide a rule preventing the double counting of a participant's benefit when applying the aggregation rules. They also clarify that a Section 403(b) annuity contract is not aggregated with plans maintained by a participant s employer, unless the individual on whose behalf the annuity contract is purchased is in control of the employer. Effective Dates The final regulations are effective as of April 5, 2007, but generally apply to limitation years beginning on or after July 1, Thus, for calendar year plans they apply on January 1, Timing of Plan Amendments The failure of a plan provision to satisfy these regulations could result in plan disqualification. Thus, amendments necessary to comply with the final regulations must be adopted by the filing date applicable to the plan s remedial amendment period. Under PPA, an extended remedial amendment period (generally ending at the end of the 2009 plan year) applies for amendments required by these regulations that relate to specific PPA changes. Conclusion Now that the IRS has issued these final regulations, plan sponsors need to ensure that their plans are in compliance. Buck s consultants would be pleased to discuss the final regulations with you. This FYI is intended to provide general information. It does not offer legal advice or purport to treat all the issues surrounding any one topic. [ 6 ]