In Internal Revenue Service Notice 2007-7 (the "Notice"), the Internal Revenue Service recently provided guidance on several provisions of the Pension Protection Act of 2006 ("PPA") affecting distributions from tax-qualified retirement plans. The Notice addresses the following key areas: (1) notice and consent requirements for distributions; (2) interest rates utilized in determining the maximum permissible lump sum distributions from defined benefit pension plans; (3) hardship distributions for non-spouse beneficiaries; (4) rollovers for non-spouse beneficiaries; and (5) vesting schedules for non-elective contributions to defined contribution plans.
Notice and Consent Period for Distributions
The PPA made certain changes to the notice and consent requirements relating to plan distributions. Specifically, the PPA allows plan sponsors to provide notices to plan participants advising them of their rights in connection with plan distributions as early as 180 days (up from 90 days under prior law) prior to a plan distribution. The PPA also requires that the description of a participant's right to defer a distribution must also include a description of the consequences of failing to defer receipt of a distribution.
The Notice clarifies that the new PPA provisions relating to the notice period apply only to notices distributed after December 31, 2006. With respect to the content requirements, the Notice clarifies that until regulations are issued, a description that is written in a manner reasonably calculated to be understood by the average participant, and that includes the following information, will be considered a good faith attempt to comply with the content requirements: (1) in the case of a defined benefit plan, a description of how much larger benefits will be if the commencement of distributions is deferred; (2) in the case of a defined contribution plan, a description indicating the investment options available under the plan (including fees) that will be available if distributions are deferred; and (3) in the case of all plans, the portion of the plan's summary plan description that contains any special rules that might materially affect a participant's decision to defer (e.g., provisions imposing restrictions on the timing and/or amount of future distributions).
Plan sponsors should revise their distribution forms packages to include the requisite good faith language set forth above. Notably, because most plan sponsors revised their distribution forms packages subsequent to the enactment of PPA and prior to the release of the Notice, such revised distribution forms packages do not currently contain the requisite "good faith" provisions.
Interest Rate Assumptions for Lump Sum Distributions
Section 415(b) of the Internal Revenue Code of 1986, as amended (the "Code"), provides limitations on benefits payable from a defined benefit plan. If a benefit is payable in a form other than a straight life annuity, the benefit is adjusted to an actuarially equivalent straight life annuity for purposes of determining whether such limitations have been satisfied.
Notably, the PPA, which was enacted in the summer of 2006, modified the interest rate that is applicable in determining whether the limitations under Section 415(b) of the Code are satisfied for plan years beginning in 2006, effective retroactively to January 1, 2006 (i.e., generally requiring the use of a minimum interest rate of 5.5 percent—up from a variable rate that was below five percent for most of 2006). A higher interest rate effectively lowers a plan's maximum allowable lump sum distributions and, as a result of the retroactive application of this change, many plans found that they had paid lump sum distributions in 2006 which exceeded the new modified limits. Prior to the release of the Notice, plans that paid lump sum distributions in 2006, prior to the enactment of PPA which exceeded the new modified limits were faced with the dilemma of needing to "correct" the overpayment to avoid the risk of plan disqualification, but without the benefit of any affirmative guidance on how such correction should be implemented.
The Notice provides alternative correction methods for plans to use if a distribution in excess of the 415 limits was made prior to the enactment of the PPA in the 2006 plan year. First, the Notice provides a "special correction method" for overpayments made prior to September 1, 2006. Under this method, an overpayment resulting from the PPA's interest rate assumption change does not need to be returned to the plan. Rather, the correction method requires the plan to issue an affected participant two Form 1099-Rs. The first Form 1099-R should include only the amount that would have been distributed using the PPA's new interest rate assumptions. The second Form 1099-R should include only the amount of the actual distribution that was in excess of the distribution using the PPA's new interest rate assumptions (the "excess distribution"), and should include code "E" in box 7 to identify the amount as an excess distribution. The excess distribution does not qualify as a distribution eligible for tax-free rollover into another tax-qualified retirement plan and/or an individual retirement account (an "IRA"), and thus must be included in gross income in the year distributed from the plan, but will not be subject to the ten percent additional tax on early distributions imposed by Section 72 of the Code. (Notably, to the extent that a plan participant has made a tax-free rollover of an excess distribution into an IRA, such participant will be subject to a 15 percent excise tax for making an impermissible contribution to such IRA.) In order to utilize such correction method, the correction must be completed before March 15, 2007.
Alternatively, plans eligible for so-called "self-correction" under the Internal Revenue Service's Employee Plans Compliance Resolution System ("EPCRS") may correct the excess distribution at any time by requesting that the affected participants return the overpayments to the plan and notifying them that the excess distribution is not eligible for rollover into another tax-qualified retirement plan and/or an IRA. (As with the special correction method, to the extent that a plan participant has made a tax-free rollover of an excess distribution into an IRA, such participant will be subject to a 15 percent excise tax for making an impermissible contribution to such IRA.) Plans that would not otherwise be eligible for EPCRS self-correction may also use this method so long as the correction is completed by December 31, 2007.
The Notice also confirms that defined benefit plans may be amended retroactively to comply with the new interest rate requirements without violating the so-called "anti-cutback rules" contained in Section 411(d)(6) of the Code. Notably, such relief is necessary because such amendment will result in an actual reduction of the benefits for certain participants who took lump sum distributions in 2006 prior to the enactment of the PPA.
Hardship Distributions for Non-Spouse Beneficiaries
An employee's elective contributions under a 401(k) plan can only be distributed upon the occurrence of certain events, one of which is the employee's "hardship." IRS Treasury Regulations set forth which expenses are deemed to be on account of a participant's hardship. Several of these listed expenses can be expenses of the employee's spouse or dependents. The PPA permits, but does not require, tax-qualified retirement plans to treat a participant's designated beneficiary under the plan the same as the participant's spouse or dependents in determining whether the participant has incurred a hardship.
The Notice clarifies that 401(k) plans may permit hardship distributions for a "primary beneficiary's" medical, tuition or funeral expenses. For this purpose, a "primary beneficiary" is an individual who is named as a beneficiary under the plan and has an unconditional right to all or a portion of the participant's account balance under the plan upon the death of the participant.
Notably, the Notice also provides that plans governed by Sections 457 or 409A of the Code may treat a participant's beneficiary under the plan the same as the participant's spouse or dependent in determining whether the participant has incurred an "unforeseeable financial emergency" under such sections. The Notice indicates that such provision will be reflected in the upcoming final regulations under Section 409A of the Code.
Rollovers for Non-Spouse Beneficiaries
Tax-qualified retirement plans are required to allow participants to elect to have a distribution that is eligible for rollover transferred to an IRA and/or another tax-qualified retirement plan through a direct trustee-to-trustee transfer. If death benefits are payable to the participant's spouse, the plan must offer the spouse this same option. Before the enactment of the PPA, a non-spouse beneficiary could not roll over a distribution from a tax-qualified retirement plan to an IRA or another tax-qualified retirement plan.
The PPA expressly permits a direct trustee-to-trustee transfer to be made from a tax-qualified plan to an IRA of the participant's non-spouse beneficiary, thereby permitting such non-spouse beneficiary to defer the payment of taxes on such amounts. The Notice provides that tax-qualified retirement plans are not required to offer this option. In addition, the Notice provides that distributions to non-spouse beneficiaries are not subject to the Code's notice requirements or the Code's mandatory withholding requirements. If a non-spouse beneficiary actually receives a distribution, the Notice indicates that such distribution is not eligible for rollover.
Vesting of Non-Elective Contributions
Prior to the enactment of the PPA, a defined contribution plan satisfied the Code's minimum vesting requirements if it maintained either a five-year cliff vesting schedule (i.e., 100 percent vesting after year five) or a three-to-seven year graded vesting schedule (i.e., 20 percent vesting as of year three, increasing by 20 percent per year). For plan years beginning on or after January 1, 2007, the PPA shortened the minimum vesting requirements for defined contribution plans to either a three-year cliff vesting schedule or a two-to-six year graded vesting schedule.
The Notice clarifies that defined contribution plans may maintain one vesting schedule for contributions made for plan years prior to 2007 and another for contributions made for plan years beginning on and after 2007. In addition, the Notice clarifies that contributions for the 2006 plan year may vest under the pre-2007 vesting schedule even if the actual contributions are not made to the plan until the 2007 plan year.
The Notice provides welcome clarification and amplification with respect to the PPA's newly enacted distribution provisions. In this regard, plan sponsors should take this opportunity to review their administrative practices, plan documents and distribution forms packages to ensure that they are all compliant with the newly released guidance contained in the Notice. Of course, White & Case would be pleased to assist you in this regard.