Guest Article

(From the June 11, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Issues Final Regulations Relating to Phased Retirement

The IRS on May 22, 2008 issued final regulations on making in-service distributions from defined benefit pension plans. 72 FR 28604 (May 22, 2007). The final regulations are part of an ongoing effort by the IRS, recently joined by Congress, to facilitate phased-retirement alternatives for workers. Basically, the idea is to permit near-retirees to reduce their hours worked and use partial distributions from their pension plans to make up for their reduced wages. The final regulations eliminate one of the primary obstacles to phased retirement arrangements by permitting in-service distributions from defined benefit plans under certain circumstances. However, the final regulations do not address many other issues raised by phased retirement arrangements.

Background

At issue is Treas. Reg. § 1.401(a)-1, which previously provided that defined benefit plans "... must be established and maintained by an employer primarily to provide systematically for the payment of definitely determinable benefits to its employees over a period of years, usually for life, after retirement" (emphasis added). As a result, the IRS's position was that defined benefit pension plans generally could not pay benefits to a participant before he or she retired. However, an example in Revenue Ruling 71-147, 1971-1 CB 114, indicated pre-retirement benefit payments could be made to participants who continued working past the plan's normal retirement age.

The IRS issued proposed regulations to facilitate phased retirement arrangements in 2004. In addition to permitting in-service distributions to participants who had reached normal retirement age, those proposed regulations would have allowed pre-retirement distributions beginning at age 59½ pursuant to a "bona fide phased retirement program." Additionally, the proposed regulations included rules for accruing benefits during the phased retirement period, adjusting phased retirement benefits in cases where the employee worked more hours than expected, and offsetting the employee's full retirement benefit by any phased retirement benefits paid. Critics have called the IRS's 2004 proposed regulations "unworkable."

While the IRS reviewed comments on the 2004 proposed regulations and considered its next move, Congress got involved by including a provision to facilitate phased retirement in the Pension Protection Act (PPA) of 2006 (P.L. 109-280). Specifically, the PPA established new IRC § 401(a)(36), which provides a pension plan does not fail to satisfy the tax-qualification rules solely because it permits distributions to employees who are at least 62 years old and still working. This provision is effective for plan years beginning after December 31, 2006.

Trying to sort everything out, the IRS earlier this year issued Notice 2007-8 to solicit comments on what guidance it should publish with respect to IRC § 401(a)(36) and on whether the 2004 proposed regulations should be finalized. Additionally, Notice 2007-8 asked for comments on the following specific issues:

The final regulations the IRS issued on May 22 mostly do not address these issues. In a nutshell, the final regulations amend Treas. Reg. § 1.401(a)-1 to incorporate the new IRC § 401(a)(36) rule permitting in-service distributions beginning at age 62 and to adopt the basic rule from the proposed regulations permitting in-service distributions upon attainment of the plan's normal retirement age. Additionally, the final regulations establish rules for setting a plan's normal retirement age. Guidance on the more complicated issues outlined in Notice 2007-8 apparently will have to wait for another day.

Summary of Final Regulations

The final regulations amend Treas. Reg. § 1.401(a)-1 to create two exceptions to the rule that defined benefit plans may not begin paying benefits until after a participant retires. The first exception simply conforms the regulations to new IRC § 401(a)(36), which was added by the PPA. According to that section, a defined benefit plan may permit distributions to employees age 62 or older even if they have not yet separated from service. The second exception permits pre-retirement distributions to any participants that have attained the plan's "normal retirement age." However, the final regulations also provide rules for setting a plan's normal retirement age. Not surprisingly, these rules strongly encourage plans to set their normal retirement ages at or above age 62.

The general rule is that a plan's normal retirement age may not be "earlier than the earliest age that is reasonably representative of the typical retirement age for the industry in which the covered workforce is employed." Because that is a somewhat ambiguous standard, the regulations also provide a safe harbor normal retirement age of 62 -- the same age plans can permit pre-retirement distributions under IRC § 401(a)(36). According to the final regulations, an age 62 normal retirement age is deemed to satisfy the general rule.

What if a plan sponsor wants to set its plan's normal retirement age below age 62? As long as the plan's normal retirement age is at least age 55, a "facts and circumstances" test will be applied to determine if the general rule is satisfied. According to the preamble to the final regulations, the IRS will give deference to the employer's "good faith determination of the typical retirement age for the industry" assuming that it is "reasonable under the facts and circumstances." But if the plan's normal retirement age is less than age 55, the final regulations establish a presumption that the general rule is not met. Only the IRS Commissioner can rebut this presumption.

The final regulations also anticipate and eliminate a possible subterfuge to the normal retirement age rules. Specifically, a plan could define "retirement" as a certain reduction in the number of hours worked so that an employee of any age could continue working and begin receiving his or her pension benefit. However, the final regulations specify that "a mere reduction in the number of hours that an employee works" does not constitute "retirement" and thus that "benefits may not be distributed prior to normal retirement age solely due to a reduction in the number of hours that an employee works."

Special Safe Harbor for Plans for Public Safety Officers

A special safe harbor applies to plans in which "substantially all of the participants" are "qualified public safety employees," as defined in IRC § 72(t)(10)(B). (This section defines "qualified public safety employees" as "any employee of a State or political subdivision of a State who provides police protection, firefighting services, or emergency medical services for any area within the jurisdiction of such State or political subdivision.") Any plan meeting this description is deemed to satisfy the general rule so long as its normal retirement age is at least age 50.

Effective Date and Limited Anti-cutback Relief

The final regulations generally are effective beginning May 22, 2007, subject to an exception for plans maintained pursuant to one or more collective bargaining agreements. Furthermore, governmental plans do not have to comply with the final regulations until plan years beginning on or after January 1, 2009.

The effective dates are especially important to those plans that currently have normal retirement ages below 62 and permit in-service distributions. These plans may need to be amended to increase the normal retirement age, and thus to eliminate the right to begin receiving in-service distributions at an earlier age. Because such an amendment would raise issues under the IRC § 411(d)(6) anti-cutback rule, the final regulations provide relief from this rule. However, the relief is available only if the plan amendment is adopted after May 22, 2007, and on or before the last day of the applicable remedial amendment period under Treas. Reg. § 1.401(b)-1.

The IRC § 411(d)(6) relief is available only to the extent the amendment is eliminating the right to an in-service distribution prior to the amended normal retirement age. Additionally, the plan amendment must comply with other applicable tax-qualification requirements. These include IRC § 411(a)(9) (requiring that the normal retirement benefit not be less than the greater of any early retirement benefit payable under the plan or the benefit commencing at normal retirement age), IRC § 411(a)(10) (relating to changes to a plan's vesting rules), and IRC § 4980F (notice requirements for amendments that reduce the rate of future benefit accruals).

The final regulations illustrate the operation and scope of the IRC § 411(d)(6) relief with the following example.

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, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879.5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.