More from the IRS on the Pension Protection Act of 2006……

Early this year the IRS issued additional guidance on several provisions of the PPA that are effective in 2007 (or earlier). Those that have broad application to qualified retirement plans are discussed below.

The PPA amended the interest rate used to determine the maximum lump sum benefit under defined benefit plans. The amended rate must not be less than the greater of 5.5%, the plan rate, or the rate that provides a benefit of not more than 105% of the benefit that would be provided using the applicable interest rate (defined in IRC §417(e)(3)). The guidance explains that this change applies to distributions made in plan years beginning after December 31, 2005 (except that they do not apply to plans with a termination date on or before August 17, 2006). Retroactive plan amendments must be adopted by the last day of the first plan year beginning on/after January 1, 2009 (2011 for governmental plans), with operational compliance required from the effective date. The practical effect of the law change is to reduce the amount of lump sum distributions. Plans sponsors are rightly concerned about lump sum distributions made during 2006 that complied with the pre-PPA 415 limit, but which exceed the PPA 415 limit. While the guidance confirms that such distributions violate 415, it also provides three methods for correcting 2006 excess distributions. First: follow the EPCRS correction procedure for an IRC §415(b) excess as described in Section 2.04(1) of Appendix B to Rev. Proc. 2006-27, except that the excess amount need not be returned to the plan. Instead, two forms 1099-R are issued to the participant. One discloses only the amount that would have been distributed using the PPA rate; the other discloses only the excess distribution amount using Code “E” in Box 7. The excess is included in income in the year distributed and is not eligible for rollover. This method may be used even if the plan does not otherwise meet the correction requirements set forth in EPCRS. Correction under this method is available only for distributions made before September 1, 2006, and the correction must be completed by March 15, 2007. Second: follow the same EPCRS correction procedure. While the excess amount (with interest) must be returned to the plan, the general requirements under EPCRS need not be met. This method is available for corrections made after March 15, 2007 that are completed by December 31, 2007. Third: follow the same EPCRS correction procedure, but all EPCRS requirements apply. This is the only method available for corrections made after 2007. Although there are three correction methods, the timing of the distribution and/or the correction will determine which one to use.

The PPA amended the minimum vesting requirements for non-elective employer contributions in defined contribution plans by imposing a minimum vesting schedule of a three year cliff or a 2-to-6 year graded schedule. The new vesting schedule applies to contributions made for plan years beginning after December 31, 2006. The guidance explains that the required election available to participants with at least three years of service must, at all times, provide the participant with a vested percentage that is no less than the minimum vesting under one of the new schedules and that determined under the pre-amendment plan schedule. The guidance also confirms that a plan may maintain dual vesting schedules: one for contributions made for plan years beginning after December 31, 2006 (i.e. one of the new PPA schedules) and one for pre-2007 plan years (i.e. the old schedule), provided that separate accounts are maintained. Otherwise, the PPA schedule will apply to all such contributions.

The PPA changed the notice requirements for distributions. First, the maximum time period for providing certain notices (the rollover notice, the notice related to consent to distributions in excess of the cash-out limit, and the joint & survivor annuity notice) is changed from 90 to 180 days for notices distributed in plan years beginning after December 31, 2006. Second, new content is required for the general distribution consent notice. In addition to including a description of the participant’s right to defer a distribution (if any), the notice must also include a description of the consequences of failing to defer the distribution. Until regulations are issued, the guidance provides that a plan will not be treated as failing to comply if a reasonable attempt to comply is made with respect to notices issued up to 90 days after the issuance of regulations. A description written in a manner reasonably calculated to be understood by the average participant that includes the following information is deemed a reasonable attempt to comply (a "safe harbor"):

(a)        For defined benefit plans, a description of how much larger benefits will be if distribution is deferred;

(b)       For defined contribution plans, a description of the investment options available under the plan if distribution is deferred (including fees); and

(c)        For both types of plans, the portion of the SPD that contains any special rules that might materially affect a decision to defer.

The PPA expanded the circumstances under which a hardship distribution may be made. This is permissive -- plans are not required to add this feature. Under this optional feature, plans may treat a participant’s beneficiary the same as the participant’s spouse or dependent in determining whether the participant has incurred a hardship. For 401(k) and 403(b) plans, a beneficiary for this purpose is an individual who is named as a beneficiary under the who has an unconditional right to all or a portion of the participant’s account upon the death of the participant. For 457(b) and 409A plans, the plan may treat an individual who is named as a beneficiary the same as the participant’s spouse or dependent in determining whether the participant has incurred an unforeseeable financial emergency.

The PPA revised the direct rollover rules to allow a direct rollover of an eligible rollover distribution by a non-spouse designated beneficiary. This is another optional provision. The direct rollover must be made to an IRA established on behalf of the designated beneficiary that will be treated as an inherited IRA. The guidance provides that the option is available to qualified plans, 403(a) and (b) plans, and eligible governmental plans under 457(b). The title of the IRA must appropriately identify the participant and the beneficiary, for example, “Tom Smith as beneficiary of John Smith.” The beneficiary may be a trust or an individual. The distribution is not, however, subject to the direct rollover rules under IRC §401(a)(31), the notice requirements of IRC §402(f), or mandatory withholding requirements. The guidance also describes how the required minimum distribution rules apply. If the participant dies before the required beginning date, the five year rule or the life expectancy rule applies. Either way, no amount is required to be distributed for the year in which the employee dies. Under the five year rule, any distributions made during the first four years after the employee’s death may be eligible for rollover. In the fifth year, however, no distribution is eligible for rollover. Under the life expectancy rule, there is a required minimum distribution amount for each year following the year of the employee’s death. If the employee dies on or after the required beginning date, the required minimum distribution for the year of death is not eligible for rollover. Once the rollover IRA is established, the same required minimum distribution rules that applied under the distributing plan to a non-spouse beneficiary apply to the IRA (because the IRA is treated as an inherited IRA).