As we reported in our November issue of Benefits in Brief, many provisions of last year’s Pension Protection Act (“PPA”) became effective on January 1, 2007. The IRS has now issued a “grab bag”of guidance on certain of those provisions, primarily dealing with distribution issues. Among the topics addressed in this Notice 2007-7 are the following:
Special correction methods for “excess” lump-sum payments resulting from a retroactive change in the Code Section 415 limits;
- Expanded hardship distribution rules;
- Direct rollovers by non-spousal beneficiaries;
- Faster vesting of non-matching employer contributions to defined contribution plans; and
- Notification of the consequences of failing to defer receipt of a distribution.
Special Correction Methods
Although not enacted until August 17, 2006, the PPA modified the interest rate assumptions to be used in applying the Code Section 415 limitations to lump-sum payments from defined benefit plans as of January 1, 2006. Plans may have made lump-sum payments during the first eight months of 2006 that – although permissible under the pre-PPA rules – exceeded the limit later established by the PPA. Fortunately, Notice 2007-7 specifies three alternative methods of correcting such an “excess” lump-sum payment.
One of these three methods would require action by March 15, 2007. The advantage of this method, however, is that neither the recipient of the lump-sum payment nor the sponsoring employer would be required to restore the “excess” payment amount to the plan. Instead, the plan would simply issue two separate Forms 1099-R, with one reporting the “proper” amount of the lump-sum payment and the other reporting the amount by which the actual payment exceeded that proper amount. The excess payment is not eligible for rollover treatment, must be immediately includible in the recipient’s taxable income, and may also be subject to an excise tax on excess distributions.
Expanded Hardship Distributions
The PPA expanded the circumstances under which a participant in a 401(k) or 403(b) plan may obtain a “hardship distribution” of elective contributions. In considering whether medical expenses, tuition, or funeral expenses may give rise to a hardship distribution, the plan may now consider such expenses not only of the participant and his or her spouse or other dependents, but also the participant’s “primary beneficiary.” A similar expansion applies in determining whether expenses attributable to a participant’s primary beneficiary may constitute an “unforeseeable emergency” for purposes of obtaining a distribution from a Section 457(b) plan or of nonqualified deferred compensation under Code Section 409A.
The recent IRS Notice defines “primary beneficiary” for this purpose. This is “an individual who is named as a beneficiary under the plan and has an unconditional right to all or a portion of the participant’s account balance under the plan upon the death of the participant.” Plan sponsors may wish to begin implementing such expanded hardship distribution or unforeseeable emergency provisions.
Direct Rollovers by Non-Spousal Beneficiaries
Similarly, the PPA expanded the “direct rollover” concept to include non-spousal beneficiaries. Although the statutory language on this point is somewhat ambiguous, the Notice makes clear that this expanded rollover opportunity is entirely optional on the part of a plan sponsor. Thus, contrary to a statement made in our November issue, a sponsor may decide not to offer the direct rollover option to non-spousal beneficiaries.
The Notice also clarifies certain other aspects of this expanded rollover opportunity. For instance, the IRA to which such a direct rollover is made must be established in a manner that identifies it as an inherited IRA with respect to the deceased participant. For instance, the IRA might be titled in the name of “Tom Smith as beneficiary of John Smith.”
Moreover, even if a plan allows direct rollovers by non-spousal beneficiaries, the distribution is still not treated as an “eligible rollover distribution” for purposes of either the mandatory 20% withholding or the notification requirements of Code Section 402(f). And, contrary to a spousal beneficiary, a non-spousal beneficiary may not receive a distribution in cash and then make a rollover to an IRA within 60 days thereafter.
Faster Vesting Rules
The PPA amended both ERISA and the Tax Code to apply the same permissible vesting schedules to all types of employer contributions to defined contribution plans. All such contributions must now vest under a schedule that is at least as rapid as either a three-year cliff or a graded schedule of 20% per year from years two through six. Previously, only matching contributions were subject to these accelerated vesting schedules.
The Notice makes clear that any portion of a partici-pant’s account balance attributable to non-matching contributions made for years before 2007 may remain under a slower vesting schedule. This is true even for amounts that were not contributed until 2007, so long as those amounts are allocated under the terms of plan as of a date in the 2006 plan year. Of course, plan administrators may not wish to take on the burden of applying two different vesting schedules to a participant’s various accounts. If so, it may make sense to apply the more rapid vesting schedules even to amounts attributable to years before 2007.
Notification Concerning Distribution Deferral Rights
Recognizing that many participants may not fully understand the adverse consequences of taking an early distribution of their retirement assets, the PPA imposed an additional notification obligation on plan administrators. Effective for plan years beginning on and after January 1, 2007, administrators must not only notify participants of their right to defer receipt of a distribution, but must also describe the consequences of failing to defer receipt.
Although the IRS has not yet issued regulations under this new provision, the Notice makes clear that plan administrators must nonetheless make a reasonable attempt to comply with the new requirement. This “reasonable compliance” standard will remain in effect until 90 days after final regulations are issued.
In the interim, the Notice also provides certain “safe harbor” rules for establishing reasonable compliance with the statutory requirement. In addition to directing a participant to the portion of the plan’s summary plan description containing any special rules that might mater-ially affect his or her decision to defer a distribution, such a safe-harbor distribution notice must include the following information:
- In the case of a defined benefit plan, a description of how much larger the participant’s benefit would be (in the plan’s normal form) if a distribution were deferred; and
- In the case of a defined contribution plan, a description of the investment options that would be available under the plan if a distribution were deferred, including any fees attributable to those options.
Many of the PPA provisions discussed above will require changes to a plan’s distribution forms and procedures. Thus, although plan sponsors still have a number of years in which to adopt conforming amendments, they and their plan administrators will want to address these issues in the near term.