Final RMD Regulations for Defined Benefit Plans and
a Change to the Defined Contribution Plan Separate Account Establishment Deadline
Rev. 06/22/04, E-mail Alert 2004-13

On June 14, 2004, the IRS released final regulations describing the required minimum distribution (RMD) rules under IRC §401(a)(9) that apply to defined benefit plans and annuity contracts that provide benefits for qualified retirement plans, IRAs and 403(b) annuity contracts. In addition, the IRS also modified the separate account rules that apply to defined contribution plans. These final regulations supersede earlier proposed regulations that were issued in 1987, 2001, and 2002. In 2002, the IRS had issued final and temporary regulations that would have applied to both defined contribution and defined benefit plans, but during the public comment period it determined that the provisions that would have applied to defined benefit plans were not appropriate for finalization. As a result, implementation of the 2002 rules was delayed for defined benefit plans, and they were permitted to make RMDs using either the 1987 or 2001 versions of RMD rules while the IRS's reexamined this issue. The final regulations are effective as of June 15, 2004, and they apply to distributions occurring on or after January 1, 2004. However, affected plans may continue to satisfy the RMD rules for tax years 2003 through 2005 based on a “reasonable and good faith interpretation” of IRC §401(a)(9). A plan that complies with the provisions of the 1987, 2001, or 2002 proposed regulations or the 2002 regulations will be considered as having met this standard.

PART A — Overview of the Defined Benefit Required Minimum Distributions Rules

The entire interest of a plan participant in a qualified plan must be distributed in the form of periodic annuity payments beginning not later than the participant's required beginning date over the lifetime of the participant or over the lives (or life expectancies) of the participant and a designated beneficiary or over a comparable period certain. (A designated beneficiary is any individual designated as a beneficiary by the plan participant.)

The required beginning date is defined (for individuals other than a more than 5-percent owner and IRA owners) as April 1 of the calendar year following the later of the calendar year in which the individual attains age 70½ or the calendar year in which the individual retires. More than 5-percent owners and IRA owners must commence distribution as of the April 1 of the calendar year following the calendar year in which they attain age 70½ regardless of their employment status.

In the event the participant dies after the required beginning date, the participant's interest must be distributed at least as rapidly as under the method used by the participant. However, if the participant dies before the required beginning date has occurred, the participant's interest must either be distributed over the life or life expectancy of the designated beneficiary beginning not later than one year after the participant's death or be completely distributed within 5 years after the participant's death. Surviving spouses may delay distribution, however, until the date the decedent would have attained age 70½.

It is important to remember that defined benefit plans may not provide additional payments after the participant's death that are based on the elections made by the participant. These rules assume a design allowing for continuing payments.

PART B — What the Final RMD Regulations Do for Defined Benefit Plans

1. Cost of Living Increase Flexibilty.
   In general, periodic annuity payments may not increase over a period of time, except as permitted under the regulations. The regulations permit an increase if it constitutes an adjustment to reflect cost of living increases, or results from a plan amendment, or is a “pop up” resulting from the death of the designated beneficiary or a divorce, or results from the return of employee contributions after the participant's death.
   
   The final rules clarify that a COLA increase may be provided so long as the increase does not exceed the increase in an approved cost-of-living index, such as the CPI, for a 12-month period during which the increase occurs or the prior year. Such increases may be provided on an annual basis, or, if not annual, may be cumulative (assuming no actuarial increases during the interim years). If the plan establishes a ceiling on COLA adjustments, the regulations permit a carry over of the unused portion of the increase to a subsequent year. Non-governmental plans with provisions that provided COLAs based on compensation increases provided for persons in the last job held may continue to do so only if such provisions were in the plan document before April 17, 2002.
   
   COLAs may also be provided under variable annuity contracts that provide benefits to a qualified plan if the contract specifies that the conversion from a level annuity is based on an interest assumption of at least 3-percent interest. Both fixed-rate annuities will be able to provide increased payments if the increase does not exceed 5-percent per year.
   
   
2. 100-percent Joint and Survivor Annuities may be provided to certain non-spouse beneficiaries.
   The incidental benefit rules required a table that limited the amount of payments that could be provided under a joint and survivor annuity to a non-spouse beneficiary. Effectively, a 100% annuity could not be provided under the existing tables if such beneficiary was more than 10 years younger than the participant. The final regulations keep the present table in place for participants aged 70 and older, but adjust the table to increase the percentage payments for participants who are younger than age 70. For example, a participant who is age 55 will be given a 15-year adjustment factor (the number of years to attainment of age 70). This will permit payment of a 100-percent joint survivor benefit to a beneficiary who is not more than 25 years younger than the participant
   
   The regulations provide an exception from the non-spouse incidental benefit rules for annuities paid to a minor child, if the benefit provides that the annuity payments will become payable to the surviving spouse upon the child attaining the age of majority, generally age 21. However, the age of majority may be extended indefinitely if the child is disabled, or may be extended to up to age 26 if the child has not completed schooling.
   
   
3. Acceleration of payments is made easier for survivors.
   The final regulations now permit the beneficiary of a joint and survivor annuity payments from a qualified plan to elect a lump sum payment upon the death of the participant.
   
   
4. Participants may change distribution forms prospectively if there are changed personal circumstances .
   If certain requirements under IRC §§401(a)(9), 415, and 416 are met changes may be made in how future distributions are made in the event of changed circumstance such as death or retirement. If the current form of distribution is period certain only, the change may be made at any time. Likewise, prospective changes may be made when the participant retires or if the plan is terminated. The regulations also allow a conversion of the form of benefit to a joint and survivor annuity if the participant marries.
   
   
5. Account Balance Method eliminated for Defined Benefit Plans.
   Most importantly, the regulations did not address the concerns of small plans with regard to the use of the “Account Balance Method”. The proposed regulations removed the account balance method as one of the acceptable methods for distributions from defined benefit plans. When the proposed regulations were issued, this method was not addressed. The Service's reason was that it was not used. The IRS was then informed that its use was very common for small employer plans, especially when dealing with the owners who were still employed at the RBD. At the time the IRS finalized the DC rules, but held up the DB rules, one of the reasons given was that the account balance method had to be addressed. Much to the dismay of many practitioners, they have addressed the issue by saying that it should not be allowed in DB plans. Under the transitional rule discussed above, the account balance method can still be used through 2005 and then will have to be adjusted for 2006.
   

PART C — Defined Contribution Plans

Separate Account Establishment Deadline

Several comments were received concerning the administrative challenges posed in trying to establish separate accounts for beneficiaries if a participant dies late in the year. Thus, the IRS has modified the 2002 rules to permit separate accounts to be established as late as the end of the calendar year after the year in which the participant dies. If established in the year after the participant's death occurred, RMDs will be determined for that year and future years using the separate account rules. However, investment experience will be shared on a pro-rata basis until the date the separate accounts are actually established.

Rich Hochman and Steve Oberndorf

Click here for the Final RMD Regulations