The Internal Revenue Service (the “Service”) released Notice 2007–7 (the “Notice”) on January 10, 2007, providing guidance on several provisions of the Pension Protection Act of 2006 (the “PPA”) affecting distributions from qualified plans. The Notice addresses the following:
- Interest rate assumptions for lump sum distributions from defined benefit plans
- Hardship distributions for medical, tuition, or funeral expenses of beneficiaries
- Direct rollovers for non-spouse beneficiaries
- Early distributions for public safety employees
- Distributions to pay for accident or health insurance for public safety officers
- Vesting of nonelective contributions to defined contribution plans
- Notice and consent period for distribution
Interest Rate Assumptions for Lump Sum Distributions from Defined Benefit Plans
When a defined benefit plan pays benefits in a lump sum distribution, the amount of the distribution is limited by Section 415(b) of the Internal Revenue Code (the “Code”). Section 303 of the PPA changed the rules for determining the interest rate used to calculate the maximum amount of a lump sum distribution. Under the PPA, the interest rate for valuing distributions subject to the minimum present value requirements of Code section 417(e)(3) for plan years beginning after December 31, 2005 must not be less than the greatest of:
- the rate that provides a benefit of not more than 105% of the benefit that would be provided if the applicable interest rate (as defined in Code section 417(e)(3)) were the interest rate assumption; or
- the rate specified under the plan.
Correcting Section 303 Excess Distributions
Because the above change is retroactive, it may cause some distributions made during the 2006 plan year to exceed the new Code section 415(b) limitations. These distributions (referred to in the Notice as “Section 303 excess distributions”) may be corrected using one of the methods described in the Notice. The applicable method depends on when the distribution was made and whether the plan meets the requirements for self-correction under Revenue Procedure 2006–27 (the Employee Plans Compliance Resolution System, or “EPCRS”).
- Distributions made prior to September 1, 2006 may be corrected by issuing two Forms 1099-R to the participant. The first should include the amount that would have been distributed using the new Code section 415(b) interest rate assumptions. The second should include only the Section 303 excess distribution, and should reflect code “E” in box 7 (indicating that that the excess amount does not qualify as an eligible rollover distribution, but will not be subject to the 10% additional tax on early distributions imposed by Code section 72). This correction must be completed before March 15, 2007. Speaking at the Los Angeles Benefits Conference, W. Thomas Reeder, Deputy Benefits Tax Counsel for the U.S. Treasury Department’s Office of Tax Policy added that any Section 303 excess distribution that has been rolled over into an IRA must be withdrawn from the IRA.
- Plans eligible for EPCRS self-correction may correct Section 303 excess distributions in the same manner that other Code section 415(b) excess distributions are corrected: either the plan must require the participant to return the overpayment or, if benefits are being distributed in periodic payments, future periodic payments may be reduced to correct the excess Section 303 distribution. Plans that would not otherwise be eligible for EPCRS self-correction may also use this method if the correction is completed by December 31, 2007.
The Notice confirms that a plan may be amended retroactively to comply with the new requirements without running afoul of the anti-cutback rules if the plan is in operational compliance as of the effective date of the amendment and the amendment is adopted by the end of the 2009 plan year (for governmental plans, the 2011 plan year).
Hardship Distributions for Medical, Tuition, or Funeral Expenses of Beneficiaries
PPA section 826 allows, but does not require, plans to treat a participant’s non-spouse beneficiary the same as the participant’s spouse or dependents in determining whether the participant has incurred a hardship or unforeseeable financial emergency.
Beginning August 17, 2006, Section 401(k) and Section 403(b) plans may permit hardship distributions for medical, tuition, and funeral expenses for a “primary beneficiary under the plan,” which is defined as an individual who is named as a beneficiary and has an unconditional right to all or a portion of the participant’s account balance upon the participant’s death.
Section 457(b) and Section 409A plans may treat a participant’s beneficiary under the plan the same as the participant’s spouse or dependent in determining whether the participant has incurred an unforeseeable financial emergency.
Direct Rollovers for Nonspouse Beneficiaries
Qualified plans are required, under Code section 401(a)(31), to allow participants to elect to have an eligible rollover distribution transferred to another qualified plan through a direct trustee-to-trustee transfer. If death benefits are payable to the participant’s spouse, the plan must offer the spouse the same option.
PPA section 829 added Code section 402(c)(11), which permits plans to allow a participant’s nonspouse beneficiary to elect a direct rollover of a distribution to an IRA, which will be treated as his or her inherited IRA. The Notice provides that plans are not required under Code section 401(a)(31) to offer this option and that distributions to non-spouse beneficiaries are not subject to the notice requirements of Code section 402(f) or the mandatory withholding requirements of Code section 3405(c).
If a plan offers direct rollovers to some, but not all, nonspouse beneficiaries, such rollovers must be offered on a nondiscriminatory basis. If a nonspouse beneficiary actually receives a distribution, the distribution is not eligible for rollover (i.e., the 60 day rule does not apply with respect to distributions to non-spouse beneficiaries).
The inherited IRA receiving the distribution must be titled as an IRA with respect to a deceased individual and must identify both the beneficiary and the deceased individual: for example, “Tom Smith as beneficiary of John Smith.” If the non-spouse beneficiary is a trust, the IRA must identify the trust as the beneficiary. If the trust meets the requirements of Treasury Regulations section 1.401(a)(9)–4, Q&A–5, the trust’s beneficiaries are treated as the participant’s designated beneficiaries, which means that payments from the IRA may be distributed using the life expectancy of the oldest beneficiary.
If the participant should have taken a required minimum distribution but did not, the amount of the required minimum distribution cannot be rolled over into the inherited IRA. Q&A 17 and 18 of the Notice specify how to determine the amount not eligible for rollover.
Following the rollover, the inherited IRA becomes subject to the distributing plan’s minimum distribution rules. Thus, distributions from the inherited IRA are made as if the rollover had not occurred.
Early Distributions for Public Safety Employees
PPA section 828 allows a “qualified public safety employee” who separates from service after attaining age 50 to receive a distribution from a governmental defined benefit plan without having to pay the 10% additional tax on early distributions imposed by Code section 72(t)(1).
The Notice defines the term “qualified public safety employee” as an employee of a State or political subdivision of a State whose principal duties include services requiring specialized training in the area of police protection, firefighting services, or emergency medical services for any area within the jurisdiction of the State or the political subdivision of the State.
The separation from service must occur during or after the calendar year in which the employee attains age 50. For example, an employee who separated from service on June 30, 2006, and attained age 50 on December 12, 2006, is eligible for the exception with respect to distributions made on or after August 18, 2006 (the effective date of PPA section 828).
The Notice also clarifies how this exception affects the recapture tax imposed by Code section 72(t)(4). The 10% additional tax does not apply if an early distribution is made in a series of substantially equal periodic payments (regardless of the employee’s age). However, if the payments are modified, a recapture tax is imposed on payments that would have been subject to the 10% additional tax (i.e., payments made before age 591/2 that do not qualify for another exception). If such a modification is made on or after August 18, 2006, payments made prior to this date are subject to the recapture tax unless another exception applies.
The Notice takes the position that the exception will not apply to early distributions from an IRA or defined contribution plan that were rolled over from a governmental defined benefit plan.
Distributions that qualify for the exception should be reported on Form 1099-R, with distribution code “1” or “2” in box 7 of Form 1099-R. (Code “1” should only be used if it is unclear whether the exception applies.)
Distributions to Pay for Accident or Health Insurance for Public Safety Officers
PPA section 845 excludes from gross income distributions made after December 31, 2006 from an “eligible government plan,” to the extent the distribution is used to pay “qualified health insurance premiums” of an “eligible retired public safety officer.” The annual exclusion is limited to $3,000 (in the aggregate). Such distributions must be paid by the plan directly to the insurer. Plans are not required to offer this election.
- “Qualified health insurance premiums” include premiums for accident and health insurance or qualified long-term care insurance contracts for the officer and his or her spouse and dependents. According to the Notice, the plan must be providing insurance issued by an insurance company regulated by the state; the exclusion does not cover payments to a self-insured plan. However, speaking at the Los Angeles Benefits Conference, W. Thomas Reeder stated that the Treasury Department may expand the definition of qualified health insurance premiums to include payments to self insured plans.
- An “eligible government plan” is a Section 457(b) plan or a Section 414(d) plan that is qualified under Code section 401(a), Code section 403(a), or Code section 403(b).
- A “public safety officer” is an individual serving 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.
- An “eligible retired public safety officer” is an individual who separated from service, either by reason of disability or after attainment of normal retirement age, as a public safety officer with the employer who maintains the eligible government plan from which the distributions to pay qualified health insurance premiums are made.
Benefits attributable to service other than as a public safety officer are eligible for the exclusion as long as the individual separates from service as a public safety officer.
The exclusion is only available to the officer, and cannot be used for payments made out of any death benefits payable to his surviving spouse or dependents. Amounts used to pay qualified health insurance premiums are disregarded for purposes of the itemized deduction for medical care expenses under Code section 213.
Vesting of Nonelective Contributions to Defined Contribution Plans
PPA section 904 amends Code section 411(a)(2)(B) to require faster vesting of employer nonelective contributions to a defined contribution plan. For plan years beginning prior to January 1, 2007, plans may satisfy the minimum vesting requirements by using a 5-year cliff or a 3 to 7 year graded vesting schedule. Effective for plan years beginning on or after January 1, 2007, plans may satisfy the minimum vesting requirements by using a 3-year cliff or a 2 to 6 year graded vesting schedule for employer nonelective contributions.
Plans that wish to change from a 5-year cliff to a 2 to 6 year graded schedule will run into difficulties in complying with Code section 411(a)(10). Generally, under Code section 411(a)(10), when a plan changes its vesting schedule, it must allow participants with at least 3 years of service to elect the old vesting schedule unless it is impossible for any participant’s vested percentage to be lower under the new vesting schedule than under the old vesting schedule. Plans that amend their vesting schedule to comply with the changes made by the PPA, however, must simultaneously satisfy both Code sections 411(a)(2)(B) and 411(a)(10): no election may be made by a participant that would cause the participant’s vested percentage, in any year, to be less than the minimum vested percentage either under PPA section 904 or under the plan’s prior vesting schedule. For instance, we believe that in a plan that changes from a 5-year cliff vesting schedule to a 2 to 6 year graded vesting schedule, participants with at least 3 years of service at the time of amendment must be 100% vested after completing 5 years of service. During their 2nd, 3rd and 4th years of service, however, they must vest in accordance with the 2 to 6 year graded schedule.
The Notice confirms that plans may continue to apply the old vesting schedule to contributions for plan years beginning before 2007 if it separately accounts for contributions made under the old and new vesting schedules. If a plan uses a bifurcated vesting schedule, contributions for the 2006 plan year will vest under the old vesting schedule even if the contribution is not made until the 2007 plan year.
Notice and Consent Period for Distributions
PPA section 1102 makes changes to the distribution notice requirements for notices provided after December 31, 2006. Notices required under Code sections 402(f), 411(a)(11), and 417 must be provided no more than 180 days before the annuity starting date, and must describe a participant’s right to defer a distribution and the consequences of failing to defer a distribution. Until regulations are issued, a description that is written in a manner reasonably calculated to be understood by the average participant and that includes the following information is a reasonable attempt to comply with these requirements:
- For defined benefit plans, a description of how much larger benefits will be if the distribution is deferred
- For defined contribution plans, a description of the investment options (including fees) available if distributions are deferred
- For all plans, the portion of the plan’s SPD containing special rules that might materially affect a participant’s decision to defer