IRS Provides Guidance on PPA Distribution Rules

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1 IRS Provides Guidance on PPA Distribution Rules The IRS has issued Notice , which provides guidance on provisions under the Pension Protection Act of 2006 relating to various qualified plan distribution rules. Background The Pension Protection Act of 2006 (PPA), which was signed into law on August 17, 2006, includes several provisions affecting distributions from qualified plans. Many of these provisions needed clarification. Notice The IRS has now issued Notice , which provides guidance relating to the following PPA provisions on distributions from qualified plans lump sum and hardship distributions, direct rollovers to nonspouse beneficiaries, expanded distribution notice requirements, elimination of the early withdrawal tax on certain distributions to eligible retired public safety officers, and pre-tax distributions to pay for public safety officers health insurance. The notice also provides guidance on the new vesting schedule for nonelective employer contributions and on the use of IRA distributions to make charitable contributions. Interest Rate Assumptions for Calculating Maximum Lump Sum Benefits PPA retroactively amended Section 415 to require plans to use new actuarial assumptions when adjusting certain forms of benefit (including lump sums) to an equivalent straight-life annuity for distributions made after December 31, As a result, certain distributions made in 2006 (both before and after the enactment of PPA) and in 2007 may exceed the Section 415 limit determined using the new assumptions. According to the IRS, these excess distributions must be corrected using one of three correction methods. The first special correction method only applies to excess distributions made prior to September 1, 2006 as long as they are corrected by March 15, Under this method, a plan uses the correction method for correcting excess distributions under the Employee Plans Compliance Resolution System (EPCRS) (see Revenue Procedure ) even if it is not otherwise eligible for EPCRS. Although EPCRS requires excess amounts to be returned to the plan, this is not required under this special method. Instead, two Forms 1099R must be

2 provided to the participant one indicating the amount that should have been distributed and the other showing the excess distribution. The excess amount is not an eligible rollover distribution and is taxable. Under the second correction method, a plan that is not otherwise eligible for EPCRS has until December 31, 2007 to use the EPCRS correction method for excess distributions (whenever made). Under the third method, a plan that is eligible for EPCRS may use that program to correct an excess distribution (whenever made). The IRS also confirms that a plan does not violate the Section 411(d)(6) anti-cutback rules if the plan is amended retroactively to comply with this PPA provision as long as the amendment is adopted by the last day of the first plan year beginning after January 1, 2009 (January 1, 2011 for governmental plans) and if the plan is operated in accordance with the amendment from its effective date. Hardship Distributions Made After August 16, 2006 PPA requires the IRS to amend its hardship distribution rules to allow distributions for certain hardships of beneficiaries other than a spouse or dependent. In the notice, the IRS clarifies that Section 401(k) plans and Section 403(b) plans that permit safe harbor hardship distributions may also allow hardship distributions to pay for medical, tuition, or funeral expenses of the participant's primary beneficiary. A primary beneficiary is defined as an individual who is a named beneficiary and who has an unconditional right to all or a portion of the participant's account balance upon the participant's death. For purposes of distributions from a Section 457 or a Section 409A plan on account of an unforeseeable financial emergency, the IRS provides that the plan may treat the beneficiary the same as the participant s spouse or dependent in determining if there was such an emergency. BUCK COMMENT. Although this provision is optional and entails additional administrative burdens, it would likely be well received by many employees (e.g., those with domestic partners). Direct Rollovers by Nonspouse Beneficiaries Under PPA, a qualified plan distribution transferred after December 31, 2006 to an IRA set up by a nonspouse beneficiary is treated as a rollover of an eligible rollover distribution under Section 402(c) and the IRA is treated as an inherited IRA. The IRS clarifies that such a distribution (or the portion that is actually rolled over) is treated as an eligible rollover distribution only for purposes of Section 402(c) it is not subject to the direct rollover requirements of Section 401(a)(31), the Section 402(f) rollover notice requirement, or the mandatory 20% withholding requirement of Section 3405(c). The IRS also clarifies that this plan feature is optional, but if offered must be provided to participants on a nondiscriminatory basis. [ 2 ]

3 The IRS provides guidance on applying the minimum required distribution rules when direct rollovers are made on behalf of nonspouse beneficiaries under this provision. BUCK COMMENT. This PPA provision gives employers an opportunity to provide a desirable option for nonspouse beneficiaries, although there are a number of issues to be considered in implementing it, particularly with regard to the minimum distribution rules. Expanded Notice Period and Content Requirement Effective for plan years beginning after December 31, 2006, the earliest time that the distribution-related notices required under Sections 402(f), 411 and 417 may be provided is changed from 90 days before benefit commencement to 180 days before benefit commencement. Significantly, PPA requires that the notices include a description informing participants of the consequences of failing to defer receipt of the distribution until the attainment of normal retirement. The IRS clarifies that the expanded notice period and the new content requirements apply only to notices provided during plan years beginning after December 31, 2006, regardless of the annuity starting date. Thus, for a calendar year plan, a notice issued in December 2006 is not required to comply with the expanded content requirements even if the annuity starting date is in The IRS also clarifies that, pending issuance of final regulations, plan sponsors must make a reasonable attempt to comply with the expanded content requirements. The notice provides a safe harbor for plan sponsors who amend their notices to include both of the following a description of how much larger the defined benefit plan benefits would be if the distribution of benefits is deferred (e.g., the financial effects of deferring distribution based on the normal form of benefit) or a description of the investment options available under the defined contribution plan (including fees) if distributions are deferred a description of how participants may access the portion of the SPD that contains any special rules that might materially affect their decision to defer receipt of the distribution. Early Distributions to Public Safety Employees PPA provides that qualified public safety employees who separate from service during or after the calendar year in which they attain age 50 are not subject to the 10% additional tax on early distributions from a qualified governmental retirement plan. This provision applies to distributions made after August 17, The IRS defines a qualified public safety employee as a state, county or city employee employed in the areas of police protection, firefighting services, or emergency medical services and clarifies that the provision applies only to defined benefit plans. The IRS also provides guidance on how these employees may qualify for the exception from the additional tax. For example, an eligible retired firefighter who separated from service on May 1, 2006 [ 3 ]

4 and attained age 50 on December 31, 2006 is eligible for the exception with respect to distributions made after August 17, The IRS provides instructions on how governmental employers should report the distribution amount. Distributions to Pay for Health Insurance Premiums of Public Safety Officers PPA provides that eligible retired public safety officers may elect to have up to $3,000 paid on a pre-tax basis from eligible governmental retirement plans for qualified health insurance premiums (e.g., premiums for accident and health insurance or qualified long-term care insurance). The IRS clarifies that this provision is optional for eligible plans, but more surprisingly, that payments may only be made to insured plans (i.e., health plans regulated by a state) and not self-funded plans. Public safety officers are defined for this purpose as individuals serving in a public agency in an official capacity, with or without compensation, as a law enforcement officer, a firefighter, a chaplain, or as a member of a rescue squad or ambulance crew. The IRS defines an eligible retired public safety officer as one who separates from service after attaining normal retirement age under the plan or becoming disabled while serving as a public safety officer with an employer who maintains an eligible governmental retirement plan. Benefits attributable to service other than as a public safety officer are eligible for the exclusion from gross income as long as the individual separates from service as an eligible public safety officer with the employer maintaining the eligible retirement plan. BUCK COMMENT. This optional provision can be very valuable to affected individuals and may be worth the additional administrative expenses to plan sponsors. A plan amendment will be necessary, as will creation of election forms and communication materials. Faster Vesting of Employer Nonelective Contributions PPA accelerated the minimum required vesting schedules for employer nonelective contributions in defined contribution plans for plan years beginning after December 31, The IRS clarifies that plans may apply the new vesting schedule prospectively only i.e., they may use a different vesting schedule for employer nonelective contributions made in plan years beginning prior to January 1, A contribution that is treated for tax purposes as having been made in 2006 is treated for vesting purposes as having been made for the 2006 plan year even if the contribution is not actually made until (This treatment also applies to forfeitures and ESOP allocations from a suspense account.) The IRS points out that under Section 411(a)(10), participants with at least 3 years of service may elect to have the nonforfeitable amount of their benefit determined under the pre-ppa vesting schedule. However, no election need be provided if a plan participant s vested percentage is at all times the greater of the minimum vested percentage under PPA and the vested percentage under the plan s prior vesting schedule. [ 4 ]

5 IRA Distributions to Charitable Organizations For 2006 and 2007 taxable years, PPA permits individuals to exclude from gross income required minimum distributions made from IRAs directly to certain charitable organizations. The IRS clarifies that qualified charitable distributions made during the entire 2006 tax year are eligible for this exclusion (e.g., it is not limited to distributions made after August 17, 2006). The notice also provides that individual IRA owners may make a maximum aggregate amount of qualified charitable distributions of $100,000 in a single tax year ($200,000 for married individuals filing a joint return). The exclusion from income for qualified charitable distributions is also available for distributions from an IRA maintained for the benefit of a beneficiary, but only if the beneficiary attained age 70½ prior to the distribution. Conclusion The IRS has provided very useful guidance on several of PPA s provisions relating to plan distributions. Nonetheless, employers that need to implement the mandatory provisions, or wish to implement the voluntary provisions, will need to consider the administrative issues involved. Plan amendments, communications and the development of other materials (e.g., election forms) may be needed. Buck s consultants would be pleased to discuss the guidance in Notice 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. [ 5 ]