The IRS recently released Notice 2007-7 (“Notice”) providing new guidance on changes in employee benefits law created by the Pension Protection Act of 2006 (the “PPA”). This guidance addresses changes to minimum vesting requirements, hardship distributions, rollovers to non-spouse beneficiaries, notice requirements for distributions, and interest rate assumptions for lump sum distributions from defined benefit plans.
Changes to the Minimum Vesting Requirements
The PPA amended the minimum vesting requirements for defined contribution plans to require faster vesting of employer nonelective contributions for plan years beginning after December 31, 2006. Before the change, plans were permitted to maintain either a 5-year cliff vesting schedule or a 3- to 7-year graded vesting schedule; but under the amended Code Section 411(a), plans must provide for either a 3-year cliff vesting schedule or a 2- to 6-year graded vesting schedule.
The Notice provides that plans must still meet the requirements of Code Section 411(a)(10)(B), which permits a participant with at least 3 years of service to elect to have his vested accrued benefit determined under the pre-amended plan. The Notice also provides that a plan may choose to continue to use its prior vesting schedule for employer nonelective contributions made for plan years beginning before 2007.
Hardship Distributions
The PPA requires the IRS to issue regulations allowing employees with cash or deferred arrangements (e.g., 401(k) accounts) to make hardship withdrawals based on a beneficiary’s expenses. Prior law only allowed plans to grant hardship distributions based on expenses of a participant or a participant’s spouse or dependents. Beginning August 17, 2006, 401(k) plans and 403(b) plans may permit hardship distributions to a participant for a beneficiary’s medical, tuition and funeral expenses. 457(b) and 409A plans may treat a participant’s beneficiary the same as a participant’s spouse or dependent for purposes of determining whether an unforeseen financial emergency has occurred and distributions may be made. The Notice clarifies that sponsors have the option to include such hardship distributions in the plan, and the provisions are not mandatory. The change for 409A plans will be reflected in upcoming final regulations.
Rollovers to Non-Spouse Beneficiaries
The PPA permits certain transfers to a non-spouse beneficiary’s IRA to qualify as non-taxable rollover distributions, beginning January 1, 2007. The Notice makes clear for the first time that plans are not required to offer direct rollovers to non-spouse beneficiaries. However, if a plan offers direct rollovers to non-spouse beneficiaries of some but not all participants, the plan must ensure that the rollovers are offered on a nondiscriminatory basis.
Distribution Notice Requirements
Under current law, a plan must provide participants with a notice (called a Section 402(f) notice) explaining a participant’s right to defer receipt of a distribution from the plan. The PPA requires the IRS to amend the regulations to add a requirement that the Section 402(f) notice explain the consequences of failing to defer receipt of a distribution.
The Notice makes clear that each plan administrator must make a reasonable attempt to meet the new requirements for Section 402(f) notices, even though the regulations have not been issued. The Notice also provides a safe harbor list of information to include in the Section 402(f) notice that is intended to satisfy the reasonable compliance requirement.
Interest Rate Assumptions for Lump Sum Distributions
The PPA revised the rules for determining whether a benefit that is payable in a form other than a straight life annuity, such as a lump sum distribution, meets the limitations on annual benefits under a defined benefit plan. The Pension Funding Equity Act of 2004 changed for 2004 and 2005 the formula used to determine the interest rate that could be used in actuarial assumptions to determine if distributions met the Section 415(b) limitations. The PPA modifies the formula again for distributions in plan years that begin in 2006 or later.
The Notice confirms that plans must meet the new limitations under Section 415(b) even for distributions beginning in 2006. The Notice provides three methods for correcting “excess distributions” above the Section 415(b) limits. Under the first method, if the excess distribution is made before September 1, 2006 and the correction is completed by March 15, 2007 the plan can follow a modified Employee Plans Compliance Resolution System (“EPCRS”), which will not require the excess amount to be returned to the plan. However, participants receiving excess distributions must include the distributions in gross income in the year of distribution. If the plan does not qualify for the first method, two other methods using EPCRS are available but each requires the excess amount be returned to the plan.
Plan sponsors may retroactively amend plans to comply with the PPA changes to Section 415(b), and if the changes are adopted by the deadline set in the Notice, the plan will not violate the anti-cutback rules. For calendar year plans, the amendment must be adopted by the end of 2009. To avoid violating the anti-cutback rules, the plan also must operationally comply with the new rules as of the date the amendment becomes effective.
This is only a brief summary of some of the major provisions of IRS Notice 2007-7. If you have any questions or would like additional information concerning the Notice or any other provisions of the Pension Protection Act of 2006, please contact SGR’s Employee Benefits Group.