On June 15, 2004, the Internal Revenue Service issued final regulations under Section 401(a)(9) of the Internal Revenue Code (the “Code”). Treasury Regulations section 1.401(a)(9)–6 provides guidance on the minimum distribution requirements for defined benefit plans, for annuity contracts purchased with account balances under defined contribution and individual retirement plans, and for annuity contracts which provide benefits under 403(b) arrangements. The final regulations generally follow the proposed regulations published in April 2002, with some important modifications. An amendment to Treasury Regulations section 1.401(a)(9)-8 contains a change to the separate account rules concerning required minimum distributions from defined contribution plans. Following is a summary of key provisions.
Distributions from Defined Benefit Plans
In general, distributions of an employee’s entire interest under a defined benefit plan must be paid in the form of periodic annuity payments for the employee’s or beneficiary’s life (or their joint lives), or over a comparable period certain. Such distributions can be made from an annuity contract which is purchased by the plan from an insurance company, as long as the payments satisfy the Code section 401(a)(9) requirements. Payments must either be nonincreasing, or only increase as described later in this article.
Incidental Death Benefit Requirement
The minimum distribution incidental benefit (“MDIB”) rules require that death and other nonretirement benefits paid from a retirement plan must be “incidental” to the primary purpose of the plan, which is to provide retirement benefits for the employee. If the employee’s spouse is his or her sole beneficiary, and the minimum distribution requirements are met without regard to the MDIB rules, then the MDIB requirement is deemed satisfied.
However, if distributions commence under a joint and survivor annuity distribution option where the beneficiary is not the employee’s spouse, the MDIB requirement is not satisfied unless the payments to the beneficiary do not exceed the percentage provided in the table under Q&A-2(c)(2) of the regulations. The percentage is based on the number of years that the employee’s age exceeds the beneficiary’s age, and the percentage decreases as the difference between the ages increases.
In the Preamble to the regulations, the IRS notes that a number of commentators suggested that an adjustment to the table would be appropriate for distributions commencing before age 701/2, since in that event more payments would likely be made during the employee’s lifetime. In response, the regulations provide that if an employee’s annuity starting date is at an age younger than 70, an adjustment is made to the employee/beneficiary age difference to permit a higher percentage survivor annuity after an employee’s death. Specifically, the age difference is reduced by the number of years that the employee is younger than 70. So, for example, prior to this change, for an employee who was age 55 on his or her annuity starting date, a 66% survivor annuity would have been the largest survivor annuity that could be provided if the survivor were 25 years younger than the employee. Under the new rule, the age difference in this example is reduced to 10 (age 70 minus age 55 = 15; 25 years age difference minus 15 = 10), and based on the table, if the age difference is 10 years or less, a 100% survivor annuity can be provided.
As noted above, in general, annuity payments must be nonincreasing. Permitted exceptions include:
- increases in benefits due to a plan amendment;
- the return of an employee’s contributions upon the employee’s death; or
- a “pop up” in payment in the event of the beneficiary’s death or the divorce of the employee and spouse.
In addition, both for annuity contracts purchased from insurance companies and annuities paid from 401(a) qualified trusts, the regulations permit variable annuities and certain other regular increases, as long as certain conditions are satisfied.
Cost of living increases are also permitted; however the annual increase must not exceed the increase in an eligible cost-of-living index for a 12-month period ending in the year during which the increase occurs, or in the prior year. An “eligible cost-of-living index” is a consumer price index issued by the Bureau of Labor Statistics and based on prices of all items (or all items excluding food and energy). For plans that provide a ceiling on annual increases that does not allow for a full cost-of-living increase in some years, the plan may allow the unused portion of the cost-of-living increase to be provided in a subsequent year.
In addition, a governmental plan may provide for annuity payments that are adjusted by a certain percentage based on the increase in compensation for the position the employee held at the time of retirement. A nongovernmental plan may provide for this increase only if such a provision was included in the plan as in effect on April 17, 2002.
Finally, as did the temporary regulations, the final regulations permit an annuity contract purchased from an insurance company with an employee’s defined contribution plan account balance to provide for variable and increasing payments, and the regulations clarify that the same rules apply when a qualified trust purchases an annuity from an insurance company for a defined benefit plan.
The final regulations replace the rule permitting partial and complete withdrawals with a broader rule that permits all types of acceleration. Any method is allowed, so long as it retains the same rate of increase in future payments but results in the total future expected payments under the annuity being decreased, thereby allowing acceleration in the form of a shorter payment period as well as through withdrawals. This broader rule is not extended to annuity payments from a qualified trust.
Changing the Form of Payment
The final regulations now allow an employee or beneficiary to change the form of future distributions under the following circumstances:
- The employee or beneficiary may change the form of distribution prospectively when the employee actually retires, or if the plan terminates, regardless of the form of annuity payments before termination or retirement;
- If the distribution is a period-certain only annuity, the individual may change the form of distribution prospectively at any time; or
- The employee may change to a qualified joint and survivor annuity in connection with marriage.
In any of the above circumstances, the resulting modification is treated as a new annuity starting date, and the future payments must satisfy the requirements of Code sections 401(a)(9), 415, and 417.
Determining Account Value Prior to Annuitization
The final regulations retain the basic rule in the temporary regulations that before annuitization, the defined contribution plan rules apply. Thus, an employee’s entire interest under an annuity contract is the dollar amount credited to the employee (or beneficiary) under the contract, plus the actuarial value of any contractually provided additional benefits (such as survivor benefits in excess of the account balance). However, these additional benefits may be disregarded when there is a pro-rata reduction in the additional benefits for any withdrawal, provided that the actuarial present value of the additional benefits is not more than 20 percent of the account balance. An exception also applies when the additional benefit is in the form of a guaranteed return of premiums upon death.
Additional Benefits that Accrue after the Employee’s First Distribution
In the case of annuity distributions under a defined benefit plan, if any additional benefits accrue in a calendar year after the employee’s first distribution calendar year, distribution of such additional benefits must commence no later than the calendar year following the year in which such additional benefits were accrued.
Payments to Children
Any amount paid to a child will be treated as if it had been paid to the surviving spouse if such amount will become payable to the surviving spouse when the child reaches the age of majority (or dies, if earlier). For this purpose, a child is not considered to have reached the age of majority if the child has not completed a specified course of education and is under the age of 26, or so long as the child is disabled.
The final regulations provide a grandfather rule under which annuity distribution options under a governmental plan, as in effect on April 17, 2002, will not fail to satisfy Section 401(a)(9) merely because the annuity payments do not satisfy the requirements set forth in the regulations. The annuity distribution option must, however, satisfy a reasonable and good faith interpretation of Section 401(a)(9) (see “Effective Date,” below), and any new distribution option or change in a distribution option must comply with the rules governing nongovernmental plans under the final regulations.
Separate Accounts Under Defined Contribution Plans
The final regulations provide that if separate accounts (determined as of an employee’s date of death) are actually established by the end of the calendar year following the year of an employee’s death, the separate accounts can be used to determine required minimum distributions for the year following the year of the employee’s death. Post-death investment experience must be shared on a pro-rata basis until the date on which the separate accounts are actually established.
The regulations apply to required minimum distribution determinations for calendar years beginning on or after January 1, 2003. For distributions from a defined benefit plan, annuity contract, or governmental plan, a reasonable and good faith interpretation of these regulations will suffice through calendar year 2005. A distribution that satisfies the parallel provisions of the 1987 or 2001 proposed regulations, the 2002 temporary and proposed regulations, or the 2004 final regulations will be deemed to satisfy a reasonable and good faith interpretation of Section 401(a)(9). For governmental plans, the reasonable good faith standard continues through the end of the calendar year containing the 90th day after the opening of the first legislative session of the legislative body authorized to amend the plan that begins on or after June 15, 2004, if such 90th day is later than December 31, 2005.