Do the required distribution regulations allow a defined benefit plan to pay part of the benefit in an annuity and part in a lump sum?

[Everett Moreland]

Does IRC Section 401(a)(9) allow a governmental defined benefit plan to add, as a new benefit, a lump sum payment of the value of a participant's accrued sick leave at termination of employment, with the option to receive the value as a life annuity? The terminated employee would also receive a life annuity starting at the same time, based on years of service and final average compensation. This appears to have been allowed under the 1987 and 2001 proposed regulations, but not under the 2002 temporary or 2004 final regulations. The 2002 temporary and 2004 final regulations appear to require that a participant's entire benefit be paid in either an annuity or a lump sum, and not to allow payment of part in annuity and part in a lump sum. Any thoughts?

[Ron Snyder]

My thoughts: this appears to be a "gimmick" to avoid FICA and Medicare taxes on the accumulated sick leave. Because it doesn't pass the smell test, I would be very careful.

IRS has issued letter rulings approving involuntary conversion of accumulated sick leave (and vacation, etc.) at retirement into retirement plan contributions. However, adding this as a defined contribution plan benefit (within a DB plan) in the manner you describe doesn't square with the facts ruled on by IRS previously.

I would consider: (1) doing the sick leave conversion in a separate plan; (2) submitting the arrangement to IRS for a private letter ruling before implementation.

[Everett Moreland]

vebaguru:

Some governmental defined benefit plans with a current IRS determination letter have provided such a benefit for many years.

[mbozek]

I am assuming that the employer will permit a transfer of sick pay to a qualfied plan. Offering the employee a choice between cash for the accumulated sick leave and the annuity is constructive receipt. IRS has approved Qual plan where employee could transfer excess sick leave or vacation pay to qualified plan provided employee did not have option to receive cash payment for excess, e.g., options are limited to forfeiture, transfer to q plan or taking the benefits as vacation.

[Everett Moreland]

mbozek:

The personnel policies and labor agreements of the local governments I am familiar with that provide this sick leave benefit through their defined benefit plan do not provide for cashing out the sick leave outside the plan. The plan is the only source of payment for unused sick leave. The particular local government I am dealing with that wants to add this sick leave benefit has provided this benefit through a defined contribution plan. The provider of that defined contribution plan is discontinuing the local government's participation, because the IRS has taken the position that, where the employer's only contribution to the defined contribution plan is for unused sick leave, the plan fails the requirement in 1.401-1(b)(2) that the employer make recurring and substantial contributions.

[Ron Snyder]

Any IRS regs applicable to DC plans would likely also be applied to DC benefits within DB plans.

I would love to see where IRS ruled on those "governmental defined benefit plans with a current IRS determination letter" that "have provided such a benefit for many years." My guess is that the d-letter didn't specifically approve the language, and the filing did not ask for a ruling on the feature.

I reiterate my recommendation to file for a PLR, especially with all the red flags you are pointing out. Are you trying to justify a decision or to assure that your client (and yourself) don't get into trouble?

[Everett Moreland]

vebaguru:

The accrued sick leave benefit is not a defined contribution benefit. There is no contribution and no account. It is a defined benefit, defined as a function of salary and accrued sick leave hours.