Distribution Guidance — Notice 2007-7
Rev. 01/19/07, E-mail Alert 2007-1

In Notice 2007-7, the IRS issued guidance in the form of questions and answers with respect to certain distribution provisions of the Pension Protection Act (PPA).

The sections of PPA ’06 addressed below are:
§826 hardship distributions for beneficiaries,
§829 rollovers for nonspouse beneficiaries,
§904 vesting of nonelective contributions,
§1102 the notice and consent period for distributions,
§1201 distributions from IRAs to charitable organizations, and
§303 interest rate assumptions for DB plan lump sum distributions,

(Sections §828 early distributions to public safety employees, and §845 distributions to pay for accident or health insurance for public safety officers, may be found in the notice.)

PPA §826 -- Beneficiary Hardship
401(k) and 403(b) Plans
A 401(k) or 403(b) plan that uses the safe harbor hardship events may make hardship distributions related to medical, tuition, and funeral expenses incurred by a primary beneficiary beginning August 17, 2006. A “primary beneficiary under the plan” is defined as an individual who is a named beneficiary under the plan with an unconditional right to all or a portion of the participant’s account balance upon the death of the participant. Thus, a hardship withdrawal may not be taken for the benefit of a contingent beneficiary. The normal hardship conditions such as an immediate and heavy financial need also must be satisfied.
MHC Comment: Plans that have adopted hardship provisions have the option to allow hardship withdrawals based on the need of the primary beneficiary. Theoretically, a plan amendment to add this PPA provision does not need to be adopted until 2009; however, the IRS has still not said if it will require an interim amendment..

409A or 457(b) Plans
Nonqualified deferred compensation plans described in §457(b) and §409A may make distributions on account of "an unforeseeable financial emergency." These plans also have the option to make such distributions based on the needs of the participant’s primary beneficiary in determining whether the participant has incurred an unforeseeable financial emergency. This will be expanded upon in the upcoming final regulations under §409A.

PPA §829 – Nonspouse Beneficiary Rollover
The nonspouse beneficiary of a participant in a qualified plan, 403(b) or governmental 457(b) may make a direct rollover to an inherited IRA.

Inherited IRA Title
The IRA must be identified explicitly as an IRA with respect to a decedent. The names of the decedent and the beneficiary must be included in its title; for example, “Mary Smith as beneficiary of John Smith.”

Direct Rollover Rules
An inherited IRA may only be established by a direct rollover.

If an amount distributed from a plan is received directly by a nonspouse beneficiary, the distribution is not eligible for rollover. The nonspouse distribution of an inherited benefit is not subject to the direct rollover requirements of §401(a)(31), the notice requirements of §402(f), or the mandatory withholding requirements.

A plan is not required to offer a direct rollover of a distribution to a nonspouse beneficiary. However, the opportunity to make a direct rollover is a benefit, right, or feature subject to §401(a)(4). For example, if a plan in any way limits which nonspouse beneficiaries may make direct rollovers, such program must be administered on a nondiscriminatory basis.

A terminating defined contribution plan must offer direct rollovers to nonspouse beneficiaries regardless of existing plan terms.

Trust as beneficiary
A plan may make a direct rollover to an IRA on behalf of a trust beneficiary, provided the beneficiaries of the trust meet the requirements to be designated beneficiaries within the meaning of the required minimum distribution rules of §401(a)(9)(E). In this situation, the IRA must be established with the trust identified as the beneficiary with the distribution period based on the life expectancies of the trust beneficiaries.

RMD determination if the plan participant died before required beginning date (RBD)
If the participant dies before his or her RBD, the amount eligible for rollover with respect to a nonspouse beneficiary is determined under either the 5-year rule or the life expectancy rule as set forth in the distributing plan. Under either rule, no amount is a required minimum distribution (RMD) for the year in which the employee dies.

Five-year rule. Under the 5-year rule, the nonspouse beneficiary may make a direct rollover at any time during the first 4 years after the year of death. However, no amount is eligible for rollover on or after January 1 of the fifth year following the year in which the employee died.

The 5-year rule must also apply to the IRA to which the rollover contribution is made, unless the special rule below applies.

Life expectancy rule. Under the life expectancy rule, the single life expectancy table is used to determine the applicable distribution period for the nonspouse beneficiary. The amount not eligible for rollover includes all undistributed RMDs for the year in which the direct rollover occurs and any prior year.

Special rule. If the 5-year rule applies, the nonspouse designated beneficiary may elect to use the life expectancy method instead, but only if the account is directly rolled before the end of the year following the year of death. Additionally, to use this special rule, the RMDs under the newly established inherited IRA must be determined using the life expectancy of the same designated beneficiary.

RMD determination if the plan participant died on or after required beginning date
If participant dies on or after his or her RBD, the RMD for the year of death must be paid based on the amount that would have been payable had the participant lived and elected a direct rollover. For the year after the year of death, the amount not eligible for rollover includes all undistributed RMDs for the year in which the direct rollover occurs and for any prior year, including years before the employee’s death.

RMD determination for nonspouse beneficiary after direct rollover to an inherited IRA
An IRA established to receive a direct rollover on behalf of a nonspouse designated beneficiary is treated as an inherited IRA. The RMD requirements of §401(a)(9)(B) and the regulations apply to the inherited IRA.

It is important to remember that the rules for determining RMDs from the plan with respect to the nonspouse beneficiary also apply to the IRA. Thus, if the participant dies before the RBD and the 5-year rule applies to the nonspouse beneficiary, then the 5-year rule applies for purposes of determining RMDs from the IRA unless the special rule is elected.

If the life expectancy rule applies to the nonspouse beneficiary, the RMD under the IRA must be determined using the same applicable distribution period as would have been used under the plan had the direct rollover not occurred.

Similarly, if the participant dies on or after the RBD, the RMD to be paid from the IRA for any year after the year of death must be determined using the same applicable distribution period as would have been used had the direct rollover not occurred.

PPA §904 – Vesting of Nonelective Contributions
Until the 2007 plan year, the maximum term for a vesting schedule for employer nonelective contributions to a defined contribution plan was either a 5-year cliff or a 3 to 7 year graded schedule. PPA accelerated these schedules to either a 3-year cliff or a 2 to 6 year graded schedule. These vesting schedules are also known as the top heavy vesting schedules. The change to the more rapid schedule is required for any participant who is credited with at least one hour of service in 2007 or later. Thus, those who terminated employment as of December 31, 2006, need not accrue additional vesting under the amended schedule.
A plan amendment to bring the plan’s vesting for all contributions made before 2007 as well as those made after 2006 onto the new shorter schedule requires the plan to protect the vesting of contributions made for plan years before 2007. At this time no amendment is required to implement the new required vesting schedule. However, as with other issues, the IRS may decide to require interim amendments.

Generally, a participant with at least 3 years of service must be permitted to choose whether to stay on the old vesting schedule or to move to the new schedule. However, the plan must ensure that any such election continues to satisfy the vesting requirements of PPA. Thus, the vested percentage of such a participant must be at all times no less than the minimum under a top heavy vesting schedule for post-2006 contributions and the vesting percentage determined under the plan without regard to the amendment for pre-2007 contributions.

This election does not have to provided to any participant whose nonforfeitable percentage under the amended plan is equal to or greater than the old schedule at all times. To comply with these requirements, a participant, with three or four year of vesting service, who previously was on the five-year cliff schedule and was theoretically being switched to the two-twenty vesting schedule, must be fully vested after five years and not six.

A plan can have a vesting schedule for employer nonelective contributions for plan years beginning after December 31, 2006, and another vesting schedule for other employer nonelective contributions under the plan, provided that the plan separately accounts for the nonelective contributions made under the pre-2007 vesting schedule and for post-2006 nonelective contributions. However, as suggested above, we believe that it will be easier for administrative purposes to only apply one vesting schedule to each participant. Thus, those credited with an Hour of Service after 2006 should have their entire account (including pre-2007 contributions) on the new vesting schedule.

Contributions made in 2007 for the 2006 plan year continue to be under the 2006 vesting schedule. Forfeitures and ESOP allocations from a suspense account are treated in the same manner for this purpose.

Treasury must modify the regulations under Code §411(a)(11) and ERISA §205 to require 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.

A plan will not be treated as failing to meet PPA's requirements if the plan administrator makes a reasonable attempt to comply with the new requirements during the period that is within 90 days of the issuance of regulations revising the distribution notice under §402(f) and §411.

The IRS has established a reasonable compliance safe harbor pending issuance of regulations. Under this safe harbor, such a description must be written so it is able to be understood by the average participant and it must include:

(a) in the case of a defined benefit plan, a description of how much larger benefits will be if the commencement of distributions is deferred;
(b) in the case of a defined contribution plan, a description of the available investment options (including fees) if distribution is deferred; and
(c) the portion of the summary plan description that describes any special rules that might materially affect a participant’s decision to defer.

A plan administrator of a defined benefit plan may use a description that includes the financial effect of deferring distributions, as described in §1.417(a)(3)-1(d)(2)(i), based solely on the normal form of benefit.

MHC Comment: The requirement to include plan investment options including fees negates the concept of a model 402(f) notice as each notice will require plan specific information in addition to any “model language” provided by the IRS.

PPA §1201 – IRA Distributions to Charitable Organizations
An IRA owner who is 70½ or older may make a direct, tax-free donation to a qualified charitable organization of up to $100,000 per year from his or her IRA with respect to tax years 2006 and 2007. An advantage to this option is that such distributions may be used to satisfy the IRA’s minimum distribution requirements.

The maximum total amount that may be excluded for a year by an IRA owner is $100,000 regardless of how many IRAs the individual owns. For married individuals filing a joint return, the limit is $100,000 per individual IRA owner.

The distribution may be made from any type of IRA. However, a SEP or SIMPLE may be the source of a donation only if no employer contribution was made in the year of the charitable distribution.

The income tax exclusion applies only to amounts that otherwise have been includible in gross income. In addition, the exclusion only applies if the contribution would otherwise qualify for a charitable contribution deduction under §170 (without regard to the percentage limitations of §170(b)) including the substantiation requirements under §170(f)(8). Qualified charitable distributions may be made to an organization described in §170(b)(1)(A), other than supporting organizations described in §509(a)(3) or donor advised funds that are described in §4966(d)(2).

An inherited IRA may make a qualified charitable distribution if the beneficiary has attained age 70½ before the distribution is made.

The amount of a qualified charitable distribution is not also deductible as a charitable contribution. Qualified charitable distributions which are excluded from income under §408(d)(8) are not taken into account.

A qualified charitable distribution is not subject to withholding under §3405 because an IRA owner that requests such a distribution is deemed to have elected out of withholding under §3405(a)(2). The IRA trustee, custodian, or issuer may rely upon reasonable representations made by the IRA owner for purposes of determining whether a distribution requested by an IRA satisfies the requirements under §408(d)(8).

A check from an IRA made payable to a charitable organization may be mailed to the charitable organization or given to the IRA owner to deliver to the charitable organization.

If an amount intended to be a qualified charitable distribution is paid to a charitable organization but fails to satisfy the requirements of §408(d)(8), the amount paid is treated as (1) a distribution from the IRA to the IRA owner that is includible in gross income; and (2) a contribution from the IRA owner to the charitable organization that is subject to the rules under § 170 (including the percentage limits of §170(b)).

The Department of Labor has advised Treasury and the IRS that a distribution made by an IRA trustee directly to a §170(b)(1)(A) organization will be treated as a receipt by the IRA owner under §4975(d)(9), and thus would not constitute a prohibited transaction. This would be true even if the individual for whose benefit the IRA is maintained had an outstanding pledge to the receiving charitable organization.

PPA §303 -- DB Lump Sum
If a DB benefit is payable in a form other than a straight life annuity, the benefit is adjusted to an actuarially equivalent straight life annuity.

Prior to PPA, the interest rate assumption was not to be less than the greater of the applicable interest rate as defined in §417(e)(3) or the rate specified in the plan. However, the Pension Funding Equity Act of 2004 (PFEA) provides that, for plan years beginning in 2004 and 2005, 5.5% must be used in lieu of the applicable interest rate.

PPA amended §415(b)(2)(E)(ii) to provide that the interest rate assumption for purposes of adjusting a benefit payable in a form that is subject to the minimum present value requirements of §417(e)(3) must not be less than the greatest of:

(i) 5.5%,
(ii) the rate that provides a benefit of not more than 105% of the benefit that would be provided if the applicable interest rate (as defined in § 417(e)(3)) were the interest rate assumption, or
(iii) the rate specified under the plan.

The changes apply to distributions made in plan years beginning after December 31, 2005. However, the changes do not apply to a plan with a termination date that is on or before August 17, 2006. A plan can be amended retroactively to comply with PPA without violating the anti-cutback rules provided in §411(d)(6), provided the amendment is adopted on or before the last day of the first plan year beginning on or after January 1, 2009 (2011 in the case of a governmental plan), and the plan is operated as if such amendment were in effect as of the first date the amendment is effective.

If a plan made a distribution in a plan year beginning in 2006 that satisfied the limitations prior to the enactment of PPA ’06 but which is in excess of the limitations of §415(b) taking into account the amendments to §415 made by §303(a) of PPA ’06 (a “§303 excess distribution”), the notice provides three methods of correcting this violation of the requirements of §415(b).

It is important to note that a terminating plan was given relief, but an on-going plan was not. If a distribution was made by an on-going plan in 2006, but before enactment of PPA in August, there is likely to be an excess distribution, just based on the way the law was written. The good news, the plan does not have to get the excess back. The bad news is that the participant cannot leave the amount in a rollover account if they took a lump-sum and rolled it. Similar to a rollover distribution that is later determined to be an excess contribution or excess aggregate contribution, the excess must be disgorged back to the participant and included in taxable income. For amounts that were originally distributed to participants before September 1, 2006, the excess must be corrected by March 15, 2007. Other methods are provided for correcting the excess after March 15, 2007.

While PPA is clearly written to apply to distributions after December 31, 2005, it seems to many practitioners inappropriate to require corrections of amounts that were correctly paid under the law in effect at that time.

Bill Grossman, QPA