Guest Article

(From the January 16, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Issues Grab-Bag Guidance on PPA Changes to Plan Distribution Rules Including Lump Sums

The IRS on January 10, 2006 issued Notice 2007-7 to provide guidance on miscellaneous provisions of the Pension Protection Act (PPA) of 2006 (P.L. 109-280) that are effective in 2007 or before. Besides effective dates, the other unifying theme is distributions: all the PPA provisions the notice addresses relate to distributions from tax-qualified retirement plans or Individual Retirement Accounts (IRAs). Significantly, the notice provides guidance on the new interest rate assumptions for applying the IRC § 415(b) limit to lump sum distributions, new hardship distribution rules, the accelerated vesting requirements for employer nonelective contributions, and the expanded notice and consent period for distributions.

Interest Rate Assumptions for Lump Sum Distributions

The PPA (§ 303) specified new interest rate assumptions for applying the IRC § 415(b) limit to lump sum distributions, effective for distributions made in plan years beginning after December 31, 2005. Specifically, when adjusting the lump sum to an actuarially equivalent straight life annuity, plans must use an interest rate that is not less than the greatest of:

Prior to the PPA, the IRC required plans to use an interest rate assumption that was not less than the greater of the IRC § 417(e)(3) applicable interest rate or the rate specified in the plan. However, for plan years beginning in 2004 and 2005, a special rule required plans to use an interest rate assumption that was not less than the greater of 5.5 percent or the rate specified in the plan.

Until the PPA was enacted on August 17, 2006, there was some question about the appropriate interest rate assumption to use for distributions in 2006 plan years. As a result, some plans may have paid lump sums in 2006 that exceeded the IRC § 415(b) limit. Notice 2007-7 provides guidance on three methods for correcting these "§ 303 excess distributions."

The first correction method is available only for § 303 excess distributions made before September 1, 2006, and only if the correction is completed by March 15, 2007. This "special correction method" is a modified version of the Employee Plans Compliance Resolution System (EPCRS) method for correcting an IRC § 415(b) excess distribution, which is described in section 2.04(1) in Appendix B in Rev. Proc. 2006-27, 2006-22 IRB 945. But the modifications are substantial.

Significantly, plans using this special correction method do not have to recover the excess amount (plus interest) from the participant, as required by EPCRS. Instead, they must issue two Forms 1099-R to the participant -- one showing the amount that would have been distributed if IRC § 415(b) had been properly applied, and the second showing the excess amount distributed. The excess amount is not an eligible rollover distribution, and must be included in the participant's gross income for the year the distribution was made. This special correction method is available even if the plan does not otherwise meet the requirements of Rev. Proc. 2006-67, including the special requirements for self-correction.

The second correction method is available for corrections completed by December 31, 2007, and can be used for § 303 excess distributions occurring before or after September 1, 2006. This second correction method is the EPCRS method for correcting an IRC § 415(b) excess distribution, without the modifications discussed above. In other words, plans using the second correction method will have to take "reasonable steps" to recover the excess amount (plus interest). As with the special correction method, plans can use the second correction method even if they do not otherwise meet the requirements of Rev. Proc. 2006-67.

The third correction method is the EPCRS method for correcting an IRC § 415(b) excess distribution. This method can be used after December 31, 2007, but only by plans that meet the requirements of Rev. Proc. 2006-67.

The notice clarifies that plans can be amended retroactively to comply with the PPA's changes to the interest rate assumptions without violating the IRC § 411(d)(6) anti-cutback rules. This relief is available only if the amendment is adopted on or before the last day of the first plan year beginning on or after January 1, 2009 (2011 in the case of a governmental plan), and the plan is operated as if such amendment were in effect as of the first date the amendment is effective.

Finally, the notice specifies that the PPA's changes to the interest rate assumptions do not apply to plans with termination dates that are on or before August 17, 2006.

Hardship Distributions

There are limits on when an employee's elective deferrals to a cash or deferred arrangement -- such as a 401(k), 403(b), or 457(b) plan -- can be distributed. For example, 401(k) plans generally may not permit distributions of elective deferrals until the occurrence of certain events, including the employee's severance from employment, disability, attainment of age 59½, or death. Another event that can trigger distributions is the employee's hardship.

Current Treasury regulations limit hardship distributions to those distributions made on account of an employee's immediate and heavy financial need, and that are necessary to satisfy that financial need. The regulations list certain expenses that are deemed to be on account of an employee's immediate and heavy financial need, including some relating to the employee's spouse and dependents. The PPA (§ 826) directs the Treasury Department to modify the rules relating to hardship distributions from 401(k), 403(b), 409A, and 457(b) plans "to permit such plans to treat a participant's beneficiary under the plan the same as the participant's spouse or dependent in determining whether the participant has incurred a hardship or unforeseeable financial emergency."

According to Notice 2007-7, beginning August 17, 2006, 401(k) and 403(b) plans that allow hardship distributions can "permit distributions for expenses described in [Treas. Reg.] § 1.401(k)-1(d)(3)(iii)(B)(1), (3), or (5) (relating to medical, tuition, and funeral expenses, respectively) for a primary beneficiary under the plan." A "primary beneficiary under the plan" is a named beneficiary who has an unconditional right to some or all of the employee's account balance when the employee dies.

In the case of 457(b) plans and 409A nonqualified deferred compensation plans, the notice provides a participant's beneficiary can be treated the same as the participant's spouse or dependent "in determining whether the participant has incurred an unforeseeable financial emergency." This change will be reflected in the upcoming final IRC § 409A regulations.

Accelerated Vesting for Employer Nonelective Contributions

The PPA (§ 904) establishes accelerated vesting requirements for employer nonelective contributions to defined contribution plans. Instead of a five-year cliff or three to seven year graded vesting schedule, defined contribution plans now must use a three-year cliff or two to six year graded vesting schedule for employer nonelective contributions.

The accelerated vesting schedule applies to employer nonelective contributions for plan years beginning after December 31, 2006. Notice 2007-7 clarifies that plans can maintain a bifurcated vesting schedule for contributions in plan years beginning before and after this date. However, plans that opt to do this will need to separately account for the nonelective contributions made under the different vesting schedules. According to the notice, a contribution is for a plan year beginning before January 1, 2007 "if it is allocated under the terms of the plan as of a date in that plan year and is not subject to any conditions that have not been satisfied by the end of that plan year." This rule applies even if the actual contribution is not made until the next plan year. The notice illustrates this rule with the following example:

Additionally, the notice confirms that amendments designed to bring plans into compliance with the accelerated vesting schedule must satisfy the requirements of IRC § 411(a)(10). Basically, IRC § 411(a)(10) provides, in the case of amendments changing a plan's vesting schedule, a participant's nonforfeitable benefit derived from employer contributions after the amendment cannot be less than before the amendment. This requirement should not pose a problem in this situation because plans generally will be adopting more aggressive vesting schedules.

Additionally, IRC § 411(a)(10) requires plans to give all participants with three or more years of service the option to elect to continue using the pre-amendment vesting schedule. The notice specifies a plan does not need to offer this election to "any participant whose nonforfeitable percentage under the plan, as amended, at any time cannot be less than such percentage determined without regard to such amendment."

Notice and Consent Period for Distributions

The PPA (§ 1102) permits plans to provide the IRC § 402(f) pre-distribution notice to a participant as many as 180 days -- instead of 90 days -- before the participant's annuity starting date. Additionally, the PPA directs the Treasury Department to change its regulations to require a description of a participant's right to defer a distribution to include a description of the consequences of failing to do so.

These provisions apply to plan years beginning after December 31, 2006. According to Notice 2007-7, the new rules relating to the content of pre-distribution notices apply only to notices issued in plan years beginning after December 31, 2006, regardless of the annuity starting date for the distribution. Likewise, the 180-day rule for furnishing pre-distribution notices applies only to pre-distribution notices furnished in a plan year beginning after December 31, 2006.

Obviously, plan administrators will need to modify their pre-distribution notices to add a description of the consequences of failing to defer a distribution, if applicable. Although these new content requirements apply to pre-distribution notices furnished in plan years beginning after December 31, 2006, the PPA specifically provides a plan will not be treated as failing this requirement if the administrator makes a reasonable attempt to comply in the case of any notice provided within 90 days after the IRS issues regulations on this requirement.

Until then, Notice 2007-7 provides a safe harbor that plan administrators can use to satisfy this "reasonable attempt" standard. Pursuant to the safe harbor, the description must be written in a manner calculated to be understood by the average plan participant, and include the following information:

Other Guidance

Notice 2007-7 addresses a number of other issues, as follows:

These issues will be discussed in next week's Washington Bulletin.

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 any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.