Guest Article

(From the April 22, 2002 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Issues Final (and Temporary) Required Minimum Distribution Regulations

The IRS published final and temporary section 401(a)(9) minimum distribution regulations in the April 17 edition of the Federal Register (67 FR 18988). The final regulations must be used to determine required minimum distributions for calendar years beginning on or after January 1, 2003. However, plans may use the final regulations, or either of two sets of proposed regulations-- one issued in 2001 and the other in 1987-- to determine required minimum distributions for the remainder of 2002.

The final regulations are substantially similar to the 2001 proposed regulations, although several important changes have been made. For example, the final regulations include updated mortality tables that Congress mandated as part of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), make a series of changes designed to simplify required minimum distribution calculations, and provide anticutback relief for plan amendments that eliminate optional forms of benefit that do not satisfy the minimum distribution requirements, et al.

IRS also made significant changes to the minimum distribution rules relating to defined benefit plans and annuity contracts. In order to accommodate suggestions on these changes, IRS released these provisions [Reg. Sec. 1.401(a)(9)-6T] in the form of proposed and temporary regulations. 67 FR 18834 (April 17, 2002).

In addition to the final regulations, IRS also issued Notice 2002-27 to specify IRA trustee reporting requirements relating to the required minimum distribution rules. Notice 2002-27 will be published in Internal Revenue Bulletin 2002-18, dated May 6, 2002.

Impact on Plan Sponsors

As noted above, retirement plan sponsors have to start using the final minimum distribution rules next January 1. Most probably will want to start using them before that time, if possible, because the final rules generally are easier to apply than the 1987 proposed rules and, in many cases, should produce a smaller minimum distribution than either the 1987 or 2001 proposed rules. According to the preamble to the final regulations, IRS plans to publish guidance on amending qualified plans to reflect these final 401(a)(9) regulations in the near future. The following summary of the final rule is for general information only. If you have specific questions, or if you need a copy of the final regulations, please contact your Deloitte advisor.

Summary of IRC Sec. 401(a)(9) and the Final and Temporary Regulations

All tax-qualified retirement plans must provide that each employee's interest in the plan will be distributed (and thus generally subjected to taxation) at least as quickly as specified in IRC section 401(a)(9). In addition to tax-qualified stock bonus, pension and profit-sharing plans, these minimum distribution rules apply to section 403(a) annuities, section 403(b) annuity contracts or custodial accounts, and certain section 457 deferred compensation plans. Individual Retirement Accounts (IRAs) and, for some purposes, Roth IRAs, also are subject to these rules. [Note that 403(b) contracts are treated as individual retirement annuities for purposes of the 401(a)(9) rules. However, according to Notice 2002-27, the reporting requirements applicable to trustees of individual retirement annuities do not apply to section 403(b) contracts at this time.]

Plans subject to the minimum distribution rules must operate in accordance with those rules, and also must include certain provisions. According to the regulations, plans must--

In addition to these mandatory provisions, plans also may include optional distribution provisions that do not conflict with the minimum distribution rules.

General Rule

The general rule is that each employee's entire interest in a plan must be distributed on or before the employee's "required beginning date" ("RBD"), or distributions must begin on or before the employee's required beginning date and extend over the course of the employee's life, the lives of the employee and a designated beneficiary, or over the employee's life expectancy or the life expectancy of the employee and his or her designated beneficiary.

For most employees, the required beginning date is April 1 of the calendar year that follows the year in which the employee attains age 70-1/2 or in which the employee retires, whichever is later. However, the required beginning date for employees who are 5-percent owners is April 1 of the calendar year that follows the year in which the employee attains age 70-1/2, even if the employee has not yet retired. The 5-percent owner rule does not apply to governmental plans or to church plans.

According to the regulations, a plan may provide that the RBD for all employees-- including those who are not 5-percent owners-- is April 1 of the calendar year that follows the year in which the employee attains age 70-1/2. Defined benefit plan sponsors, in particular, may want to take advantage of this because IRC sec. 401(a)(9)(C)(iii) requires that employees' benefits be actuarially adjusted to reflect any period beyond age 70-1/2 that they don't receive a benefit because they continue working.

Pre-RBD Distributions

Of course, distributions to an employee may begin before his RBD. In general, the regulations specify these pre-RBD distributions do not have to satisfy the minimum distribution requirements. However, if post-RBD distributions under a particular distribution option-- such as an annuity, for example-- will not satisfy the minimum distribution requirements, then the distribution option violates IRC sec. 401(a)(9) as of the time the distribution begins.

What if Employee Dies After Distributions Begin, But Before Entire Interest Is Distributed?

What happens if employees die after required minimum distributions begin, but before their entire interest has been distributed? The rule is that the remaining portion of the deceased employee's interest must be distributed at least as rapidly as under the distribution method being used at the time of the employee's death. IRC sec. 401(a)(9)(B)(i). According to the regulations, this rule applies only with respect to employees who die on or after their RBDs, regardless of whether any payments are actually made before that date.

What if Employee Dies Before RBD?

Different rules apply with respect to employees who die before their RBDs. In general, their interests must be distributed within 5 years after they die (the "5-year rule"). However, to the extent the deceased employee's interest is payable to a "designated beneficiary," that interest can be paid over the designated beneficiary's life expectancy, but payments must begin no more than 1 year after the employee's death (the "life expectancy rule"). If the sole designated beneficiary is the employee's surviving spouse, the distributions do not have to begin until the employee would have attained age 70-1/2 (or, if later, the end of the calendar year after the year of the employee's death).

According to the regulations, a "designated beneficiary" is an individual who is entitled to a portion of an employee's benefit, contingent on the employee's death or another specified event. Only persons can be designated beneficiaries. If an employee attempts to identify an entity (such as the employee's estate) as a beneficiary, the employee will be treated as having no designated beneficiaries even if the employee also identifies persons as beneficiaries. An exception may apply if a trust is identified as a beneficiary.

The regulations provide plans may specify either that the 5-year rule will apply to certain distributions even if the deceased employee has a designated beneficiary, or that the 5-year rule will apply in all cases where employees die before their RBDs. In addition, plans may allow employees or beneficiaries to elect either the 5-year or life expectancy rule in circumstances where either would be appropriate. The election must be made by the end of the calendar year in which distributions must begin under the life expectancy rule or the end of the calendar year that includes the fifth anniversary of the employee's death, whichever is earlier. As of the applicable deadline, the election must be irrevocable. The plan may designate default rules for situations where elections are not made.

What if Employee and Surviving Spouse Die Before Distributions Begin?

Finally, what if the employee's surviving spouse who is the sole designated beneficiary dies before distributions begin? In that case, the 5-year and life expectancy rules are to be applied as if the surviving spouse were the employee. IRC sec. 401(a)(9)(B)(iv)(II). Thus, the surviving spouse's designated beneficiary may be able to take advantage of the life expectancy rule. However, according to the regulations, the special life expectancy rule for surviving spouses will not be available to the surviving spouse of the employee's surviving spouse.

How Much Must be Distributed? (Defined Contribution Plans)

An employee's required minimum distribution (RMD) from a defined contribution plan for a distribution calendar year is determined by dividing her account by the "applicable distribution period" ("ADP"). A distribution calendar year is any year for which an employee must take a RMD, including the year she attains age 70-1/2 or retires, whichever is applicable. In general, the RMD for an employee's first distribution calendar year must be made by her RBD, and by the last day of each distribution calendar year thereafter.

For purposes of calculating an employee's RMD for a distribution calendar year, her account is valued as of the last valuation date of the previous calendar year (valuation calendar year). This amount is increased by any contributions or forfeitures allocated to the account during the valuation calendar year (but after the valuation date), and decreased by any distributions made during this same period.

The valuation rules are the same regardless of whether any portion of the employee's account is not yet vested. However, RMDs will be made only from the vested portion of the account. If the RMD for a distribution calendar year is greater than the employee's vested benefit, then the RMD for the next year must be increased accordingly.

An employee's ADP for a distribution calendar year depends on whether the employee is dead or alive, among other things. In general, if the employee is alive during any part of the distribution calendar year, then the "Uniform Lifetime Table" [which is set out in the final regulation section 1.401(a)(9)-9, A-2] is used to determine the ADP based on the employee's age at the end of the year. However, if the employee's sole designated beneficiary is her spouse, then the ADP for the distribution calendar year is the longer of the distribution period determined using the Uniform Lifetime Table or the joint life expectancy of the employee and her spouse. [The joint life expectancy table is set out in the final regulation section 1.401(a)(9)-9, A-3.]

If the employee is dead for the entire distribution calendar year, the appropriate ADP depends on when he died in relation to his RBD. If the employee died on or after his RBD and has a designated beneficiary, then the ADP is the designated beneficiary's life expectancy or the employee's life expectancy, whichever is longer. If there is no designated beneficiary, the employee's life expectancy is used. Finally, if the employee died before his RBD, then the ADP is either the designated beneficiary's life expectancy or, if there is none, the employee's life expectancy. The method for determining the designated beneficiary's life expectancy is different for spouses who are sole beneficiaries than for others. [The life expectancy table is set out in the final regulation section 1.401(a)(9)-9, A-1.]

What if the employee has more than one designated beneficiary? In general, for purposes of determining the ADP, the designated beneficiary with the shortest life expectancy will be used.

In general, all amounts distributed from an employee's account during a distribution calendar year count towards the section 401(a)(9) requirements, even if all or part of the distribution is not included in the employee's income. Thus, for example, a RMD can include after tax contribution amounts. Exceptions to this general rule include corrective distributions [i.e., distributions required to comply with 402(g), 415(c), and nondiscrimination testing (ADP/ACP) limits], loans treated as deemed distributions under IRC sec. 72(p), ESOP dividends (except for reinvested dividends), and the costs of life insurance coverage.

How Much Must be Distributed? (Defined Benefit Plans)

In the case of a defined benefit plan, section 401(a)(9) generally requires distributions in the form of periodic annuity payments be paid over the employee's life (or the joint lives of the employee and beneficiary), or over a fixed period certain. In general, life annuities also may include a period certain feature.

Annuity payments must be made in uniform intervals of no more than one year, and payments may not increase from year to year (the "nonincreasing payment rule") unless the increase--

• is based on a Bureau of Labor Statistics cost-of-living index;

• represents an adjustment to a joint and survivor annuity payment because the beneficiary dies or ceases to be the employee's beneficiary as a result of a qualified domestic relations order;

• represents a cash refund of employee contributions upon the employee's death; or

• results from a plan amendment that raised benefits.

There are limits on how long a period certain can last. If payments begin while the employee is alive and on or after his RBD, then the period certain may not exceed the employee's ADP (determined using the Uniform Lifetime Table) for the calendar year in which payments begin. If the employee's spouse is his sole beneficiary and payments will extend only for a period certain (i.e., there is no life annuity component), the period certain can be as long as the joint life and last survivor expectancy of the employee and his spouse. Special rules apply for determining the employee's maximum period certain if payments begin before the employee's RBD and before his 70th birthday.

If annuity payments begin under the life expectancy rule after the employee's death, the maximum period certain depends on whether there is a designated beneficiary and, if so, whether the sole beneficiary is the employee's spouse.

Life annuity payments (whether over a single life or joint lives) also must satisfy the "minimum distribution incidental benefit" ("MDIB") requirements. In most cases, if the other sec. 401(a)(9) requirements are satisfied, the MDIB requirement will be deemed satisfied. Thus, for example, if an employee's benefit is being distributed as a joint and survivor annuity for the lives of the employee and his spouse (and the employee's sole beneficiary is his spouse), then the periodic payment to the surviving spouse may be 100 percent of payment to the employee regardless of their age difference.

However, in the case of a joint and survivor annuity for the life of the employee and the employee's non-spouse beneficiary, the MDIB rule requires that payments to the surviving beneficiary be less than payments to the employee if the surviving beneficiary is more than 10 years younger than the employee. In this case, the maximum periodic payment to the survivor must be calculated according to the table set out in the regulations [sec. 1.401(a)(9)-6T, A-2(c)(2)].

What if the employee continues accruing benefits after his first distribution calendar year? In the case of annuity distributions under a defined benefit plan, distributions of the additional accruals generally must begin with the next payment interval that ends in the year after the year the additional accruals occur, but in no event later than the last day of that calendar year. This rule also applies to benefits that vest during a distribution calendar year.

Using Annuity Contracts to Satisfy 401(a)(9)

Both defined benefit and defined contribution plans may annuitize employees' benefits. In general, as long as the payments from these annuity contracts satisfy the minimum distribution rules, the plan will be in compliance with those rules.

Special rules apply when defined contribution plans or section 403(a) annuity plans annuitize benefits for employees. In particular, the annuity payments will not violate the nonincreasing payment requirement simply because payments increase--

• by a constant percentage, applied at least annually;

• to provide a payment at the employee's death equal to the difference between total pre-death payments and the account value that was annuitized;

• as a result of dividend payments or other payments that result from actuarial gains (measured at least annually);

• to make a final payment under the annuity contract, but only if the payment does not exceed the total future expected payments as of that date; or

• to make a partial distribution under the annuity contract, but only if certain requirements are satisfied.

Miscellaneous Rules

Following is a quick summary of some of the other aspects of the final rules that may be of interest to plan sponsors.

• Amounts distributed by one plan and then rolled over to another plan still count towards the distributing plan's minimum distribution requirements (if any) with respect to the employee. However, the required minimum distribution amount included in the distribution is not an "eligible rollover distribution."

• In the case of a direct plan-to-plan transfer of an employee's benefit, the transfer is not treated as a distribution by the transferor plan for purposes of sec. 401(a)(9), but the employee's benefit in the transferor plan is decreased by the amount transferred. If the transfer occurs during a distribution calendar year, the transferor plan must determine the required minimum distribution amount for that year and distribute that amount to the employee. The employee's benefit in the transferee plan is increased by the transferred amount.

• The rules that apply to direct plan-to-plan transfers also apply in the event of corporate spinoffs, mergers, or consolidations.

• If an employee is a participant in more than one plan, the 401(a)(9) distribution requirements must be satisfied by each plan (i.e., the plans cannot be aggregated).

• Required minimum distributions must be made in accordance with sec. 401(a)(9) and the regulations even if the employee (and, if applicable, the employee's spouse) does not consent to the distribution.

• A distribution of an annuity contract is not a distribution for purposes of sec. 401(a)(9).

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have questions or need additional information about this article, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Copyright 2002, Deloitte.