substantially equal installments

[Guest Mike Schwing]

In my corbel sponsored 401(k) prototype adoption agreement there exists a distribution option "substantially equal installments."

I was wondering what this meant and how it works.

How does an employer go about paying a 401(k) distribution in equal installments should a participant choose such an option?

Do they set up an annuity?

Who chooses the length of the installments, the employer or the participant?

I've never seen this chosen by a participant but it is an option and I was wondering the mechanics of who does what for whom should the participant elect such an option.

[Blinky the 3-eyed Fish]

Mike, installments are a common distribution option, but I have never seen one taken. Depending on how the document reads, it would be an equal amount taken each period (month, year, etc.) until his balance ran out. It differs from an annuity in that an annuity is tied to life expectancy, while installment payouts are not.

If a person receiving installments were to die, the beneficiary would still receive the balance on the account. If a person receiving a life annuity were to die, then payments are ceased.

[RTK]

Quite frankly this is a matter that should be addressed in the plan document. Even though the IRC addresses substantially equal installments (or its equivalent), e.g. the 72(t)(2)(A)(iv) exception to the 10% tax, the 402©(4) eligible rollover distribution definition, it is the plan document that establishes the participant's rights with respect to a distribution.

It is difficult to advise a client when a plan document does not address how "substantially equal installments" are to be calculated and paid (i.e., amount and frequency of payment). You could try asking Corbel or try reviewing summary plan description or administrative forms for a clue.

That said, there are two basic ways to provide for installments:

1. Specify the amount of each installment (usually elected by the participant) and frequency of payment (as elected by participant or specified by plan). In such case, installments would be paid in the fixed amount until the entire account is distributed (subject to 401(a)(9) required minimum distribution once age 70-1/2.)

2. Specify the number of installments and the period over which to be paid (as elected by the participant or fixed by plan terms). In such case, the installments are paid over that period, and the amount of each installment is determined by dividing the account balance by the remaining number of installments to be made. (This is the declining balance method of 401(a)(9) regs.)

The first method is often more popular, since it is more in line with what participants want to elect: give me $400 a month vs. give me $ equal to dividing account balance by 20 years. However, this does require a determination of whether payments will be made for 10 or more years for purposes of the direct rollover/payment election.

[Guest lforesz]

Hi,

Let's assume someone does say give me $400 a month, how would you determine if that is payable over more than 10 years and thus ineligible for rollover and exempt from the 20% withholding as you have no idea how the investments will perform?

If the fund tank, the distributions may only span 7 years. If they soar, they could go 11. Is there a method we are supposed to use?

Greatly appreciate the insight.

Lori

[RTK]

Lori,

This is addressed in 1.402©-2 Q&A5.

The general rule in 1.402©-2 Q&A5(a) is that it is determined using the principles of IRC 72(t)(2)(A)(iv) at the time distribution begins without regard to contingencies or modifications that have not yet occurred. Under IRS Notice 89-25, there are three methods that can be used to determine substantially equal payments made for life or life expectancy for purposes of IRC 72(t)(2)(A)(iv):

1. Any method acceptable for determining 401(a)(9) required distributions.

2. Amortizing the account balance over life expectancy determined in accordance with the 401(a)(9) regulations at an interest rate that does not exceed a reasonable rate of interest determined when distributions begin.

3. Distributing an annual amount determined by dividing the account balance by an annuity factor derived from a reasonable mortality table and an interest rate that does not exceed a reasonable rate of interest when distributions begin.

1.402©-2 Q&A5(d) sets forth two specific methods to determine this for defined contribution plans.

1. Declining balance of years. A series of installments will be considered substantially equal over a period if, for each year, the amount distributed is calculated by dividing the account balance by the number of years remaining in the period.

2. Reasonable actuarial assumptions. If an account is to be distributed in annual installments until the balance is exhausted, the period of years over which the installments are to made is determined by using reasonable actuarial (interest) assumptions.

The reasonable actuarial assumption method of 1.402©-2 Q&A5(d)(2) is the one that I typically use to determine if $400 month installments will be made for 10 or more years. The regulations give two examples for a $100,000 account balance.

1. Employee elects distribution of $12,000 per year until account is exhausted. If future rate of interest is assumed to be 8% per year, the account balance will be exhausted in 14 years.

2. Employee elects distribution of less than $10,000 per year. It is reasonable to assume that future rate of return will be greater than 0%, and account will not exhausted in less than 10 years.

Because the general rule states that this is to be determined at the time payments begin, without regard to contingencies or modifications that have not occurred, I believe that the eligible rollover distribution determination can be made only at the time payment of the installments begins and does not have to be changed for shorter or longer payment periods resulting from investment gains and losses (unless participant elects to change the amount of the installments if permitted by the plan).

I do work with one dc plan that determines the amount of monthly installments by an annuity factor developed each year by the actuary that is expected to result in distribution over the participant's lifetime based on reasonable mortaility and interest. This mirrors method 3 of IRS Notice 89-25. For that plan, the installments are always made for life expectancy, and would never be eligible rollover distributions.

I can't believe I am doing this on Friday night. I'm out of here - have games to play. Hope this helps.

[Guest lforesz]

Hi,

I didn't expect anyone to actually respond on a Friday night!!

You are truly a committed (or crazy) person.

It does help. Thanks a lot for sharing your knowledge.

Lori

[lkpittman]

RTK is right on. Also keep in mind that several letter rulings support a de minimus increase in the annual amount for cost of living purposes (usually 3%). Also, once the participant has reached age 59 1/2, the annual amount may be changed, so long as distributions have been going on for at least 5 years. Finally, you might want to check out Rev Rul 2002-62. This recent ruling modifies Notice 89-25 and provides guidance on how the method for determining the substantially equal periodic payments (and the amount of the payment) may be changed. In addition, 2002-62 prescribes a specific mortality table and puts and upper limit on the interst rate that can be used for the annuity method.