Employee interests are best served by maximum flexibility in plan distribution provisions. However, plan designers may find it necessary to reduce this flexibility somewhat to meet the employer's management objectives.
First of all, flexibility increases administrative complexity and costs. In addition, flexibility can potentially cause cash-flow and liquidity problems to the plan fund. Finally, flexibility can create extremely complex federal income tax problems, due to the inordinately complex rules in this area. The rules are merely summarized, but the reader will undoubtedly note that even this summary is startlingly complicated. The complexity is probably due more to congressional inattention to this issue rather than to any clear policy rationale. Simplification is on the congressional agenda.
The complex distribution rules are management's problem as well as the participant's because employees often ask employers about the tax treatment of a plan distribution. An employer's wrong answer likely will subject the employer to liability to reimburse the employee for any excess tax payments that result. And management cannot simply "stonewall" on this issue by refusing to advise employees on tax treatment of distributions because employee resentment as well as legal liability may result that can negate the value of the plan as an employee incentive.
The planner's objective in designing plan distribution provisions is to provide employees with the maximum amount of distribution flexibility that is consistent with management's needs as outlined above. In a small business with limited personnel management resources, this may dictate only very limited distribution flexibility. For example, some smaller plans provide for distributions only in the form of a lump sum at retirement or termination of employment.
Normal Form of Benefit
A qualified plan must specify not only the amount of the benefit but the form of the benefit. In a defined-benefit plan, the normal form of benefit is the basic "defined benefit," the form that quantifies the benefit due and provides a standard for calculating equivalent alternative benefits. At one time, the normal form was the form a participant received if he or she did not choose an alternative form, but this is not necessarily true because of joint and survivor provisions.
The normal form in a defined-benefit plan is usually either a straight-life annuity or a life annuity with period certain. A straight-life annuity simply provides periodic (usually monthly) payments for the participant's life. A life annuity with period certain provides periodic payments for the participant's life, but additionally provides that if the participant dies before the end of a specified period of years, payments will be continued until the end of that period to the participant's designated beneficiary. Specified periods of 10, 15, and 20 years are commonly used.
In comparing defined-benefit plans, it must be remembered that straight-life and life annuities with periods certain are not equivalent; a plan providing an annuity of $100 per month for life with period certain as the normal form of benefit provides a significantly larger benefit than a plan providing $100 per month as a straight-life annuity. Period-certain annuities as the normal form of benefit are most commonly found in plans using insurance contracts for funding.
A pension plan must provide a qualified joint and survivor annuity for the participant and spouse automatically to a married participant (unless the participant elects otherwise). To avoid discrimination against single participants, most plans provide that the qualified joint and survivor annuity is "actuarially equivalent" to the normal form. For example, if the normal retirement benefit would be $1,000 per month as a straight-life annuity, the qualified joint and survivor annuity might be something like $800 per month to the participant for life, then $400 per month to the spouse for life. However, the plan can partially or fully subsidize the joint and survivor annuity; for example, it might provide a straight-life annuity of $1,000 per month or a $1,000/$500 joint and survivor annuity. This might be desirable to the employer even though it would discriminate against unmarried participants.
Defined-contribution pension plans can provide an annuity as the normal benefit form. This is particularly common if an insurance contract is used for funding. The amount of the annuity depends on the participant's account balance at retirement, with annuity purchase rates specified in the insurance contract, if any. Optional forms of benefit, particularly a lump sum, are usually provided in defined-contribution plans.
Optional Alternative Forms of Benefit
Participants generally benefit from having a choice of benefit forms as an alternative to the normal form. Participants can then choose a benefit that is structured in accordance with their individual financial needs, family situations, and retirement activities. In defined-benefit plans, the most common alternative forms (assuming a straight-life annuity as the normal form) are, in addition to the qualified joint and survivor annuity that must be offered, (1) joint and survivor annuities for the participant and spouse or other beneficiary, with varying survivorship annuity percentages such as 50 percent, 75 percent, and 100 percent, and (2) annuities for the participant and beneficiary, with varying periods certain, such as 5, 10, 15, or 20 years. The plan also can allow payouts over a fixed period of years without a life contingency. All these options are subject to the limitations described below.
To avoid undesirable or prohibited discrimination among employees in different situations, the plan should provide that any optional benefit is actuarially equivalent to the normal form of benefit. Under Code Section 401(a)(25), the actuarial assumptions used for this purpose must be specified in the plan, either by stating the actuarial interest and other factors or by specifying an equivalency table for the various benefits, to avoid employer discretion in favor of highly compensated employees.
Lump-Sum Option
A lump-sum distribution can provide planning flexibility for participants. Lump-sum distribution provisions are most common in defined-contribution plans; in fact, in a profit-sharing plan, the lump sum is often the only distribution option. However, even a defined-benefit plan can offer a lump-sum option. The Code provides in Section 417(e) that the lump sum must be at least that determined on the basis of interest and mortality factors specified in the Code.
Higher-income participants often would like a lump sum because they have other sources for retirement income and wish to invest their plan funds in riskier, high-return investment vehicles. A defined-contribution plan can be designed to accommodate this need to some extent within the plan, however, by providing participant investment direction. Also, investment results within the plan are enhanced by the tax deferral on plan income and may provide an effective rate of return that the participant cannot match outside of the plan. However, funds cannot be left in the plan indefinitely; distributions must generally begin at age 70½ or retirement, if later.
In some defined-benefit plans, particularly insured plans, the assumptions used for funding are too conservative. For example, a plan may have accumulated $140,000 to fund a benefit of $12,000 per year to a retiree. In many cases, however, it might be possible for a retiree to individually invest $140,000 and receive a better return than $12,000 per year for life. Thus, the retiree might rather have a $140,000 lump sum from the plan fund than the plan's annuity benefit. In some cases, this situation results from bad plan design, while in others it is done deliberately to increase the benefit for key employees. The Code limits the extent to which this can be done by prescribing minimum interest and mortality assumptions.
Distribution Restrictions
Plan distributions can be designed to provide considerable flexibility, but they must be designed within a rather complex network of rules that have been accumulating in the law over many years. These rules are aimed at protecting the financial interests of participants and, more significantly, they are designed to limit the use of qualified plans merely as a tax-sheltered investment medium for key employees. The significant rules are as follows:
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Distinctions between the types of distributions permitted in pension plans as opposed to profit-sharing plans
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Rules preventing employers from unjustly delaying benefit payments
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Minimum distribution requirements
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Early distribution penalties
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Incidental benefit requirements
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Nonalienation rules
Pension versus Profit-Sharing Plans
The IRS generally will not allow a pension plan to pay benefits prior to retirement, early retirement, death, or disability, although some limited cash-out provisions may be allowed in the event of termination of employment prior to these events, as previously discussed. With a profit-sharing plan, there is much more flexibility, and the plan may allow in-service distributions. However, the 10 percent penalty described below may deter employees from making certain withdrawals.
Delaying Benefit Payments
Under Code Section 401(a)(14), all qualified plans must provide for payment not later than the 60th day after the latest of the following three dates:
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The earlier of age 65 or the plan's normal retirement date
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The tenth anniversary of the participant's entry into the plan
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The participant's termination of service with the employer
The plan may allow the participant to elect a payout that begins at a date later than this maximum limit. However, the extent to which a participant can stretch out payments is limited by the rules.
Minimum Distribution Rules
Congress does not like qualified plans to be used as tax shelters for funds that are not actually needed by participants for retirement income. Therefore, Code Section 401(a)(9) requires that plan distributions begin no later than April 1 of the calendar year following the later of the year in which the employee attains age 70½ or the year of actual retirement. If the employee owns more than 5 percent of the employer, deferral to the actual retirement date is not permitted.
Furthermore, the distribution must be either in a lump sum or a periodic distribution over a specified period. Basically, the distribution must be paid in substantially equal annual amounts over the life of the employee or the joint lives of the employee and a designated beneficiary. Alternatively, the distribution may be made over a stated period that does not exceed the life expectancy of the employee or the life expectancy of the employee and a designated beneficiary. This permits period-certain annuity payouts, as long as the period certain does not exceed the life expectancy limits. A periodic distribution based on an ongoing recalculation of life expectancy is permitted, which tends to stretch out payments somewhat because life expectancy is extended by continuing survival. However, life expectancy can be recalculated no more often than annually. Cost-of-living increases in pension payments to retirees are permitted as long as they are not designed to circumvent the minimum distribution rules.
The minimum distribution rules also have provisions applicable to distributions made to a beneficiary if the employee dies before the entire plan interest is distributed. If distributions to the employee have already begun, the remaining portion of the employee's interest must be distributed at least as rapidly as under the method in effect prior to death. For example, if the employee elected a 20-year period certain annuity and the employee died after ten years, the remaining interest could be distributed in equal annual installments over a term not exceeding ten years. The beneficiary could, however, elect to accelerate these payments.
If the employee dies before distributions have begun, the plan's death benefit must be distributed within five years after the employee's death, with an exception. The five-year restriction is not applicable if (1) any portion of the plan benefit is payable to a designated beneficiary, (2) the beneficiary's interest will be distributed over the life of the beneficiary or over a period not extending beyond the life expectancy of the beneficiary and (3) distributions begin no later than one year after the employee's death. If the designated beneficiary is the surviving spouse, the beginning of the distribution can be delayed to the date on which the employee would have attained age 70½.
Early Distribution Penalty
Code Section 72(t) provides a tax penalty for early distributions from qualified plans. This penalty provision was added by Congress to encourage plan participants to use qualified plans primarily for retirement and not merely for deferral of compensation. The 10 percent penalty tax applies to distributions from a broad range of tax-advantaged retirement plans. As applied to regular qualified plans and 403(b) plans, the penalty applies to all distributions except distributions
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made on or after attainment of age 59½;
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made to a beneficiary or employee's estate on or after the employee's death;
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attributable to disability;
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that are part of a series of substantially equal periodic payments made at least annually over the life or life expectancy of the employee, or the joint lives or life expectancies of the employee and beneficiary (separation from service is required);
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made after a separation from service after age 55;
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related to certain tax credit ESOP dividend payments;
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to the extent of medical expenses deductible for the year under Code Section 213, whether or not actually deducted.
The penalty also applies to IRAs and IRA-funded plans (SEPs and SIMPLE/IRAs), with a somewhat different list of exceptions. Under this penalty provision, a plan may be permitted to make a distribution to an employee without disqualifying the plan, but the distribution may nevertheless be subject to penalty. For example, many hardship distributions from 401(k) plans or 403(b) tax-deferred annuity plans will be subject to the penalty tax.
Despite the penalty, withdrawals from qualified plans may still be important to participants in many situations—to obtain emergency funds, for example. Therefore, plan designers may wish to provide withdrawals in plans, where permitted, despite the existence of the 10 percent penalty.
Incidental Benefit Requirements
Some types of optional benefit forms provide substantial payments to persons other than the participant after the participant's death—for example, a 20-year-certain annuity with payments continued to a beneficiary. Because these are death benefits, they must be incidental.
Code Section 401(a)(9)(G) and corresponding regulations provide rules for determining whether survivorship benefits are incidental. For example, if a participant has a 10-year life expectancy at retirement, he or she could not elect a 25-year certain annuity because this would result in too much of the expected benefit to be paid as a death benefit. This incidental rule does not apply to a survivor annuity for spouses; thus, for example, a plan could provide a joint and 50 percent survivor annuity for a 65-year-old retiree and his 25-year-old spouse, even though actuarially, the participant's present interest in the benefit would be less than half of the total.
Nonalienation Rules
A qualified plan must provide that plan benefits may not be assigned or alienated [Code Section 401(a)(13)]. This means, for example, that a plan participant can't pledge future anticipated qualified plan payments as security for a bank loan. For divorce, child support, and similar domestic disputes, there are special provisions.
Examples
The distribution restrictions described in the preceding pages appear so complex as to defy summary. Probably the best way to see how these restrictions work is to look at some examples. Consider the following proposed plan distribution options, offered to a married male participant in a qualified defined-benefit plan retiring at age 65. Assume that the participant and his spouse have waived any required joint and survivor annuity. The following options will be analyzed to see if they are permissible under the distribution restrictions:
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A joint and 100 percent survivor annuity for the lives of the participant and his daughter, age 35
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A 25-year period-certain annuity for the lives of the participant and his spouse
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Equal periodic distributions over five years beginning when the participant reaches age 75
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Equal monthly payments over a fixed period equal to the participant's life expectancy, but if the participant survives, the payout period is extended (the monthly payments are actuarially reduced) annually to reflect the increased life expectancy
The first potential distribution would meet the first restrictions of Section 401(a)(9), because it extends over the lives of a participant and named beneficiary, but it does not meet the incidental benefit tests under the regulations. According to tables in the regulations, no more than a 60 percent survivor annuity could be payable to the daughter.
The second distribution—the 25-year period-certain annuity for the lives of the participant and spouse would meet Section 401(a)(9) as long as the joint life expectancy of the participant and spouse is at least 25 years. As for the incidental test, the regulations provide that a survivor annuity for a spouse will generally qualify regardless of the difference in ages.
The third option, a distribution beginning at age 75, is not permitted because distributions must begin not later than April 1 following the calendar year in which the employee reaches age 70½.
Finally, a fixed-period payout over the participant's life expectancy, with annual recalculations of life expectancy, is permitted. This can be an advantageous way of receiving the benefit because payments can continue to a relatively advanced age, reducing the danger that retirement income will stop while the participant is still living.
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