DROP 415 Limits

[BTG]

Opinions seem to vary widely on how to properly apply Section 415 to DROP accounts. However, according to my research it appears to be generally accepted that, where the DROP accounts are credited with actual earnings, the DROP account is treated as a separate defined contribution plan for 415 purposes under Section 414(k), and is therefore subject to the annual addition limits in 415©. My question is: Would both the monthly employer contributions and the earnings credits be subject to the 415© limitations? Or would the monthly employer contributions be treated along the lines of plan-to-plan transfers, and not counted as annual additions for purposes of 415©?

Alternatively, would anyone care to challenge the premise on which the question is based (i.e. that this would be treated as a separate DC plan)? Would your opinion change if earnings were credited at the entire plan's actual earnings rate? What if there was also a minimum guaranteed rate of return?

Any and all thoughts are appreciated!

[Guest Luke Bailey]

Opinions seem to vary widely on how to properly apply Section 415 to DROP accounts. However, according to my research it appears to be generally accepted that, where the DROP accounts are credited with actual earnings, the DROP account is treated as a separate defined contribution plan for 415 purposes under Section 414(k), and is therefore subject to the annual addition limits in 415©. My question is: Would both the monthly employer contributions and the earnings credits be subject to the 415© limitations? Or would the monthly employer contributions be treated along the lines of plan-to-plan transfers, and not counted as annual additions for purposes of 415©?

Alternatively, would anyone care to challenge the premise on which the question is based (i.e. that this would be treated as a separate DC plan)? Would your opinion change if earnings were credited at the entire plan's actual earnings rate? What if there was also a minimum guaranteed rate of return?

Any and all thoughts are appreciated!

In order to be able to use 415© the plan would have to actually create an account for the member, allocate actual assets to it, and thereafter the participant's benefit would have to depend entirely on the value of the account. It's not clear to me how even a governmental plan could do that without having the conversion of the unpaid annuity to actual assets in an account be treated as a distribution folloed immediately by a rollover back into the plan. In that case, 415 wouldn't apply at all, of course, although if the participant had not yet reached normal retirement age you might have a violation of the prohibition against in-service distributions. Plan provisions would need to support the in-serviced distribution in any event, and the rollover.

In my experience, most DROPs (in fact, all that I have worked with) are not structured in the way I have described in the preceding paragraph. Rather, as in the case of a cash balance plan, after the member's DROP election the unpaid annuity amount that the participant could have taken if he or she had retired, plus, potentially, other amounts such as employee contributions, are credited by the plan to a NOTIONAL account for the member and thereafter credited with an earnings factor that will typically be based on the plan's actual rate of return (although typically averaged over a moving several year period, and perhaps with a cap and floor), but will not be the actual return of any assets allocated to the member's account. In this case, I think it's clear that (a) there is no distribution to the member, actual or deemed, and (b) only 415(b) applies, and it will apply to the sum of the annuity and the DROP balance. The way you apply it is to add the projected annuity that can be paid from the DROP balance at any point in time, using the actuarial factors prescribed in the final 415 regs, to the member's actual annuity amount.

Thus, if a member retired and commenced an annual annuity of $100,000 and the projected annuity payable from the member's $1 million DROP balance over the rest of his or her life was also $100,000, you would test an annual benefit of $200,000 against the 415 limit to determine compliance. Depending on indexing of the 415 dollar limit, the member's actual age, whether a public safety worker, etc., you might or might not have a 415 violation. In any event, if as in my example the member took a lump sum distribution of his or her DROP account at retirement and upon commencing his/her annuity, you'd be done. However, if the member is permitted to leave his or her DROP balance with the plan to accumulate further "interest," then you have to retest periodically in retirement. If the plan's rarte of return really went through the roof, any calculated excess over the 415(b) limit might grow larger. If the plan allows ad hoc distributions from DROP, then you have to actuarially adjust and then add back those distributions to the remaining balance for future testing. It can get complicated.