Those who participate in qualified plans are, as a general rule, exempt from tax on the interest that they hold in the plan, until those interests are distributed. The three principal forms of distribution are annuities, lump sum distributions, and rollovers. These are discussed in this chapter and even though at times, particularly in the early period of time when employee benefits have been installed and even earlier—during the installation period—when retirement is the plan objective, then it is important that the tax ramifications are known to the agent and to the plan administrator.
Section 72 of the Internal Revenue Code addresses the taxation of annuities, including annuities from plans and certain other distributions. Basically, distributions from a qualified plan other than rollovers and some lump sum distributions, are taxable in the year in which they are made.
The Section 72 is rather complex—too complex to go into much detail in this text—basically because the annuity payments generally consist of portions to which the annuitant has contributed, and portions where only non-taxable employer contributions were made on behalf of the participant. Of course, the rule is simple where the employer has contributed the entire amount——the annuity payments are taxable in full.
The basic exclusion rule, i.e., the rules that pertain to amounts that are received as an annuity, applies to those distributions. These are the amounts that are payable at regular intervals for periods of time of more than one full year from the annuity starting date, and for which the total amount that is payable can be determined as of that starting date, either because of the terms of the annuity or from actuarial tables. For further clarification, the annuity starting date is the later of the date on which the obligations are first fixed, and the first day of the payment of the payment period that ends on the date of the first payment.320
For any amount received as an annuity, the exclusion ratio is excluded from gross income. "Exclusion ratio" is the investment in the contract as of the starting date of the annuity, divided by the expected return under the annuity as of that date.321 As an example, if the annuity pays $500 a month, and the exclusion ratio is 10%, then $50 of each monthly payment is excluded from gross income.
The investment in the contract is simply the total of the employee's contributions, plus any amount of employer contribution that was included in the employee's gross income, minus the amount received to that date under the annuity to the extent it was excludible from gross income. Or, to put it another way, it is the undistributed amount that has already been taxed. The expected return is the amount that is expected to be received from the annuity.
This exclusion continues until the participant's investment in the contract has been totally distributed, after which time, the entire amount of the annuity payment is subject to tax. If, however, annuity payments cease because of the death before the full investment in the annuity is received, the part that is not received is allowed as a deduction in the participant's final taxable year.322
This may appear complicated—and it is—so the IRS allows a simplified method to calculate the excluded amount from gross income for most single life and joint and survivor annuities from qualified plans. It is not necessary to go into detail, but participants are grouped into a number of groups determined by age and an expected number of monthly annuity payments for each group by age, both by single and by joint & survivor by using combined ages. The investment in the contract is divided by the expected number of payments for that age group.
The Code addresses amounts not received as an annuity under an annuity contract, which are not technically the same thing as lump sum distributions, and consist of such things as payments before the annuity starting date, dividends, refund amounts, and other non-periodic distributions.
Simply put, amounts received on or after the annuity starting date are included in gross income. Amounts received before the annuity starting date are excluded to the extent that they can be allocated to the investment in the annuity. The IRC furnishes rules as to how to determine the amount that is so allocated. For defined benefit plans, most often used in employee benefit situations, the present value of the vested portion of the accrued benefit is the account balance.
The IRS rules are applied separately to each distribution with respect to a separate contract—each distribution under a separate program of the employer that consists of interrelated contributions and benefits. Therefore, the portion that can be excluded from gross income for tax purposes is the sum of the exclusions for each separate contract that contributes to the entire distribution.
A separate contract, the IRS points out, is not necessarily a separate plan—but it is possible that it is a separate plan, but a single plan may have two or more separate contracts, and conversely, two plans may constitute a single contract. For instance, a profit sharing plan and a defined benefit plan of an employer constitute separate contracts.
The IRS does allow that employee contributions under a defined contribution plan may be treated as a separate contract. Without going into detail, this type of arrangement can be of considerable benefit to a participant who can treat a distribution from a defined contribution plan as a distribution in respect to that particular separate contract.
Even if the qualified plan pays its distribution in one lump sum, that does not mean that all such payments are considered as lump sum payments for tax purposes; such as payments because of the death of the employee, the employee reaching age 59 ½, the separation of the employee from service, or, for self-employed persons, the employee's becoming disabled.
Such distribution also need not be directly to the employee. In determining the balance to the credit of the employee, all pension plans of the employer are treated as a single plan, all profit-sharing plans are considered as a single plan, and all stock bonus plans of the employer are treated as a single plan. A cash-out may be a lump sum distribution.
If a lump sum distribution includes securities of the employer, then the gross income does not include net unrealized appreciation of those securities (defined as the excess of the market value of the security at time of distribution, over its cost basis) to the plan. Therefore, the amount of a lump sum distribution attributed to employer securities that is taxed at time of distribution is the amount of the original employer contribution. The net unrealized appreciation is subject to tax later, when the securities are sold.
A person who leaves an employer may wish to take their plan interests with them, and move it to an IRA or to the plan of a new employer. There are two ways to accomplish this.
First, a trustee-to-trustee transfer where the interest is directly transferred from the old plan to a new plan or an IRA, or (secondly) a rollover distribution where the participant's interest is first distributed to him so that he can contribute to a new plan or an IRA. ERISA encourages the trustee-to-trustee transfer method as it removes the temptation for the participant to use the amounts that are distributed for other purposes, instead of for retirement purposes as it was intended.
Basically, a trustee-to-trustee transfer or a rollover distribution is a distribution than can be subject to tax, but if it were taxed that would negate the stated IRS and legislators policy of deferring tax on qualified plan interests until retirement. Therefore, trustee-to-trustee transfers are not taxed, and rollovers are exempt in certain appropriate cases.323
An eligible rollover distribution is a distribution to an employee of any of the balance to his credit in a qualified plan, except for the following:
- a distribution that is a portion of a series of basically equal periodic payments made annually or more frequently over a period of the life of the employee, joint life of employee & beneficiary, or for a stated period of 10 years or more,
- required minimum distributions as specified under the tax code, or
- certain hardship distributions, as specified in the tax code.
If the distributions are to be excluded from gross income, the distribution must be transferred to an eligible retirement plan within 60 days of receipt.324This may be waived by the IRS when, as the code states, it is called for "by equity and good conscience."
An eligible retirement plan is a qualified trusteed plan, an annuity plan as stated in the tax code, [IRC 403 (3)(a)], an IRA or annuity, some specified deferred compensation plans of state and local governments, or IRC §403(b) annuities.
The maximum amount that can be rolled over and excluded from income, is the part of the distribution that would be included in gross income if the rollover exclusion rules did not apply. There is an exception for rollovers to IRAs and annuities.
A distribution after an employee's death to the surviving spouse can be rolled over if the statutory requirements would be met by the treating the spouse as the employee. A distribution from a qualified plan may be rolled over if the statutory requirements would be met by treating the alternate payee as the employee.
Even though an eligible rollover distribution is excluded from gross income, it is still subject to a withholding tax of 20%, and the withholding tax cannot be waived. A recipient who wants to rollover the entire amount of a distribution must contribute the entire amount to the new plan within 60 days—they may not contribute part this year and the remainder the following year, for example. There is NO withholding if the amount is transferred directly to the new plan, again pointing up the advantage of a trustee-to-trustee transfer.
Every qualified plan must provide that the recipient of an eligible rollover distribution may elect to have the distribution transferred directly to an eligible retirement plan—which is only a trusteed plan that is a defined contribution plan which allows acceptance of rollover distributions. After-tax amounts may be transferred to either a defined contribution plan that separately accounts for the after-tax amounts, or to an IRA or annuity.
If the plan allows for voluntary cash-outs, unless the distributee elects otherwise, any such involuntary distribution in excess of $1,000 shall be transferred directly to a specified IRA or annuity.325
Qualified benefit plans usually do not distribute participant interests before retirement, and profit sharing and stock-bonus plans are not required to do so either, basically because of
ERISA's stated purpose of promoting retirement security. To enforce this concept, a tax is imposed on premature distributions from qualified plans.
A 10% tax on the amount of the distribution that is includible in gross income is imposed on distributions made before the day on which the employee reaches age 59 ½. But, as usual, there are numerous exceptions, such as (a) those made upon the death of the employee, (b) those that are attributable to the employee's becoming disabled, (c) those that are part of a series of substantial equal periodic payments paid annually or more frequently, (d) those that begin after separation from service and made for life of the employee and designated beneficiary, (e) those made to an employee after separation from service after becoming age 55, and (f) those distributions that constitute dividends on employer stock which fall under provisions of Section 401(k). There are also other exceptions regarding the recipient of the distribution.
A qualified pension plan cannot require an employee the right to participate beyond age 21 or after completing one year or service, whichever comes first.326All years of service, except for those excluded because of service break rules, must be counted in respect to vesting requirements.
There are allowable variations, such as plans that provide 100% vesting after no more than two years of service can require the employee to be 21 years old or to complete 2 years of service—a 401(k) plan, however, may not require more than 1 year or service or age 21. For tax-exempt educational institutions that provide for 100% vesting after one year, they can condition the vesting on the later of the employee becoming 26 years old or completing one year of service.327
Employees do not necessarily have to participate the day in which they qualify. It is usually acceptable that an employee's participation start no later than the earlier of the first day of the plan year after satisfying eligibility standards; or 6 months after the date of the satisfaction of those standards.328
Conversely, a pension plan may not exclude employees from participation on the basis of their having attained a specified age (age discrimination).
The need for accrual of benefits rules stem from the possibility of "backloading"—an arrangement where the level of the benefit for the participant grows much faster in later years. To illustrate this situation, assume that the plan would base the total benefit to be paid at retirement on one year of service at $1 of benefit, increasing by $1 each year until the 20th year when the benefit would be the final pay times the years of service times 1.5%. This would in effect, nullify the importance of vesting in early years as the benefits would be trivial until much later. The other purpose of the accrual rules is to help prevent age discrimination.
Accrued benefits are defined differently for defined contribution plans and defined benefit plans.
For a defined contribution plan, the employee's accrued benefit is the balance in his account. However, employees often contribute to these plans and therefore it is important to differentiate accrued benefits attributed to the employee contributions from the accrued benefits that can be attributed to employer contributions. If the employer and employee contributions are kept separate, then the accrued benefit attributed to the employee contributions is the balance of the employee-contribution account. However, if separate accounts are not maintained, then the accrued benefit that can be attributed to employee contributions is equal to the formula of: total accrued benefit times [(employee contributions less withdrawals) divided by (total contributions less withdrawals)]. The accrued benefit attributed to the employer contributions would be the remainder—what is left.
For a defined benefit plan, the accrued benefit is "the individual's accrued benefit determined under the plan … expressed in the form of an annual benefit commencing at normal retirement age."329Simply put, the accrued benefit at any given time is the benefit that the employee would be entitled to receive at normal retirement age under the plan's benefit formula if the employee left the employer's service at that time.
The anti-backloading rules for defined benefit plans are simple to explain, but rather complicated to explain mathematically, so for purposes of this text, most mathematics will be ignored.
The rules fix the minimum standards for the rate of accrual and require that a plan's benefit formula satisfy at least one of those standards. The standards revolve around the number of years of participation, rather than the years of service as do vesting standards.
The "3%" rule compares the accrued benefit at any time with a consistently increasing proportion of the maximum normal retirement benefit of the plan. It is based upon a hypothetical normal retirement benefit to which a participant would be entitled if he started participating at the earliest possible age and worked continuously until age 65 or normal plan retirement age. Three percent (3%) of this amount then becomes the "measuring stick" which is multiplied by the number of years the employee has participated in the plan, up to a maximum of 33 1/3%. If the actual accrued benefits is greater than or equal to this amount, then the test is satisfied.329While this accomplishes what it is intended to do—combat the backloading situation—it considers the amounts accrued and not the plan's rate of accrual.
The second rule, the 133-1/3% rule, considers the rate of accrual by requiring that at any time the rate of accrual for any subsequent year must not be more than 133-1/3% of the rate of accrual for the years between the first and subsequent year of accrual. The purpose of this rule is to try to prevent a large acceleration in the rate of growth of the benefit for later years of participation.
While this second rule works well, plan amendments that increase the rate of benefit accrual can complicate application of this test. To alleviate such complications, ERISA provides than an amendment in effect for a given year is treated as if it were in effect for all years.330
It is rather simple to construct accrual schedules that do not meet this rule—for instance, suppose the plan provides for accrual of benefits at the rate of 1% of final salary for the first 5 years, 1.25% for the next five years, and 1.5% for all years thereafter. This means that the rate of accrual in years 11 and later is 150% of the rate in years 1-5, therefore the test is not satisfied.
The 133-1/3% rule has one more requirement—the accrued benefit payable at normal requirement age must be equal to the normal retirement benefit. While this seems too simple, what it does is eliminate problems such as, for example, a plan states the normal retirement benefit is $10,000 per year, while the rate of accrual of benefits is only $100 per year; then if an employee left employment before retirement (even as little as a year before) he would receive substantially less than the normal retirement benefit.
There is a third rule, and it compares a hypothetical normal retirement benefit to actual benefits accrued at the time of separation from service.331 This is a little more complicated as first one must calculate the "fractional rule benefit" which is the retirement benefit (R) to which the employee would be entitled were he to continue to work until normal retirement age, presuming the employee continues to earn the relevant salary until normal retirement age that is used in computing the normal retirement benefit, as if he had attained normal retirement age on the date of separation from service. From this, a fraction is formed (F) , which is equal to the years of actual participation at separation divided by the total number of years the employee would have participated had she retired at the normal retirement age. If the actual accrued benefit is at least equal to R times F, then the test is satisfied.
And then there is a special accrual rule for defined benefit plans that are funded exclusively through insurance contracts. If the contracts provide for level annual premium starting with participation, benefits under the plan are equal to benefits under that contract at normal retirement age, and benefits are guaranteed by the insurance company to the extent that premiums have been paid—then the anti-backloading standard has been met as long as the accrued benefit is no less than cash surrender value according to prescribed actuarial assumptions.332
In order to prevent age discrimination, ERISA prohibits defined benefit plans from ceasing accruals or reducing the rate of accrual, because of the age of the employee (with an exception for highly compensated employees). A defined benefit plan may limit the amount of benefit, however, or the years of participation used in the benefit formula as long as it is not calculated on the basis of age.333
For a defined contribution plan, the usual accrual rules respond to the age-discrimination problems and provide that contributions to an employee's account may not stop, and the rate of contribution to the employee's account not be reduced.334
A plan is subject to special accrual rules in the years that a plan is "top-heavy." For those in such defined benefit plans who are not key employees, the accrued benefit that is attributed to employer contributions may not be less than the lesser of 2% times years of service with the employer, or 20% The period of time used for such test is determined by the number of years in which the plan was top-heavy up to 5 years, in which the participant had the greatest aggregate compensation.335
For participants in top-heavy defined contribution plans who are not key employees, the employer contribution must be at least 3% of the participant's compensation, unless the 3% is larger than the highest percentage rate at which contributions are made for key employees, in which case, the contribution percentage for non-key employees must equal the maximum contribution percentage for key employees.336
One should keep in mind that not every benefit from a pension plan is an "accrued" benefit. For a defined benefit plan, ERISA defines an accrued benefit as a benefit equivalent to "an annual benefit commending at retirement age." For a defined contribution plan, an accrued benefit is "the balance of the individual's account."337
However, a plan could offer other benefits, such as life insurance or alternate forms for the distribution of plan benefits, or it could offer an early retirement subsidy (an amount paid at early retirement greater than the actuarial equivalent of a pension commencing at normal retirement age).
ERISA's anti-cutback rule does not allow plan amendments that reduce accrued benefits.338 Courts have rules that an automatic cost-of-living adjustment and similar provisions for automatic benefit increases, may be considered as an accrued benefit protected against elimination or decrease.339
Another restriction is that a plan amendment that eliminates or reduces an early retirement benefit is deemed to reduce accrued benefits to the extent that it reduces benefits attributable to service before the plan amendment.341
In case of retirement subsidies, benefits that are attributed to service before the amendment still cannot be reduced or eliminated, but only for those participants who actually satisfy the conditions that existed prior to the amendment for the subsidy, before or after the amendment. As an example, if a plan provides an early retirement subsidy for participants who retire at age 55 with 30 years of service, only those participants who meet the age and service conditions at some time, will be entitled to eliminate it. If 45-year old employee has 20 years of service at the time of the amendment, he would lose his right to the subsidy should he leave the employer within the following ten years.
There are exceptions to the anti-cutback rules, such as where the relevant benefits or subsidies create significant burdens or complexities for the plan and its participants, and the amendment has only a minimum impact on the rights of participants. It also does not apply in some cases of termination of multi-employer plans, and there are exceptions that pertain to the elimination of forms of benefit distribution from defined contributions plans.342
Amendments that reduce future rates of accrual are not prohibited. However, ERISA rules require that in cases of "significant reduction" in the rate of future accrual, participants and other parties that could be affected must be notified of the amendment. As an example, an amendment to a pension plan that eliminates or reduces an early retirement subsidy is considered as reducing the rate of future benefit accrual for ERISA purposes.343
These plans have become rather popular in recent years as a type of defined benefit plan, and the difference is in the way that the benefits accrue.
Benefits under a traditional plan usually depend on the product of years of service and final average pay, both of which increase over time. This can cause the value of the accrued benefit to grow at an accelerating rate the longer that the participant remains in service.
A cash balance plan, on the other hand, allow benefits to accrue more steadily, with the result that the accrual rate for participants in early years of service usually will be larger under a cash balance plan than under a comparable traditional defined benefit plan.
Cash balance plans usually result from an amendment of existing, traditional defined benefit plans to change the accrual formula, and are rarely started from scratch. When a plan is converted to a cash balance plan, it must address the prior accruals under the old defined benefit plan, and there are two ways in which this can be accomplished: (1) A plan can provide that every participant immediately start to accrue benefits under the new cash balance plan formula, and those benefits are added to the benefits accrued under the old formula; or, (2) the plan can provide for wear away, where a participant does not start to accrue additional benefits under the new cash balance plan until the amount of benefits that the new formula would provide is more than the accrued benefit under the old formula.
As an example, if the participant has accrued a $100,000 benefit under the old formula, additional benefits under the new plan would not start to accrue until the balance of his hypothetical account exceeded $100,000. There are two ways to experience "wear away," as with one way, the plan will retroactively credit his hypothetical account with the amount it would have had if the plan to use the cash balance formula was used in the beginning. This way, the hypothetical account could start with a substantial balance and the period during which there are no accruals would therefore be shortened. The other way would be where the plan fixes the participant's new hypothetical account at zero (no accrued balance), in which case it could be a long time before the benefits resumed their accrual!
When a plan is converted to a cash balance plan, participants that are close to normal retirement age can experience a lower accrual rate than they would have had under the old plan, which means that with wear away, there could be a period of time in which there are no further accruals to the participants, in particular, those nearing normal retirement age. The anti-cutback rule does not protect these expectations, with the result that conversions have been challenged in the courts. At the present time, the legislature and regulatory bodies are considering standards to govern cash balance plans and plan conversions
One of the most important functions of ERISA is the protection of benefit rights of the workplace. For instance, ERISA protects against an employer that has a 5-year cliff vesting plan and who would be tempted to fire employees after 4 years and 11 months in order to save pension costs.344
Specifically, ERISA prohibits an employer from discharging or disciplining an employee or discriminating against an employee for the purposes of interfering with the "attainment of any right to which such participant might become entitled under the plan." An employee may, therefore, not be discharged for the purpose of preventing vesting or experiencing future accruals on the plan. This provision basically prohibits employment discrimination for reasons based on plan rights—an area which preempts state laws, so ERISA entirely governs this provision. Even state laws for wrongful discharge are preempted by ERISA.
Section 510 of ERISA requires an employee to show that the employer had the specific intent to violate his rights and just an impact on benefit rights by itself is not sufficient, but the employee may show only that the discriminatory reason was the determining factor—the employer specifically intended to do the discriminatory act and engaged in conduct in furtherance of that intent.345
This particular regulation has created many questions, some of them having to be interpreted by the courts. For instance, this regulation is basically addressed to discrimination against individuals and/or to conduct directed against a group of employees. The unintended result is that it may protect one group of workers at the expense of another. When an employer has to reduce the work force, the question naturally arises as to what extent the employer can consider reducing pension costs rather than current wage costs. Courts have held that a critical factor in this determination is whether the desire to reduce pension costs is a "casually determinative factor"—does it make a difference to the employer's choice?346
Another problem area consists of medical and disability plans. For instance, if an employee contracts a disease that is expensive to treat—AIDS, cancer, kidney dialysis, etc., come to mind—or if the employee is at risk of contracting an expensive illness—heavy smokers, obese employees come to mind—the employer may be tempted to discharge the employee or otherwise avoid coverage under the plan. ERISA protects rights in benefits, even though such benefits do not vest.347
However, courts, in most cases, allow employers to terminate or amend a welfare benefit plan to eliminate coverage of an expensive illness, even after a participant has contracted it. The reason is the court's strong desire not to interfere with employer decisions regarding welfare plans. In addition, some courts have held that Section 510 pertains only to the employment relationship, and therefore, imposes no constraints on amendments to plans.347
A pension plan can furnish more than just retirement benefits, and these non-retirement benefits have special rules to make sure that the tax advantages for qualified plans are not abused.
A profit-sharing or stock bonus plan is primarily a plan of deferred compensation, so it can offer a wide variety of non-retirement plans, basically such distribution would be triggered by the prior occurrence of some event, such as layoff of workers, illness/injury/disability, retirement, death or severance of employment. In some cases, funds that allocated to a participant's account may be used to provide him or his family with incidental life or accident or health insurance. (Stock bonus plans allow the allocations for the same purposes.)
Defined benefit plans and money purchase plans are more restricted, but yet they can provide for the payment of a pension due to disability or the payment of incidental death benefits through insurance or otherwise.348 Also, under the same regulation, defined benefit and money purchase plans may provide medical related benefits to retired employees and spouses and dependent under rather strict conditions—principally the integrity of the plan is kept as medical benefits, for instance, must be subordinate to the retirement benefits provided. "Subordinate to" rule is abridged or breached if, after the account is established, contributions for medical benefits for retirees (when added to the contributions for life insurance under the plan) are more than 25% of the total contributions to the plan (excluding contributions to fund past service credits).
A non-retirement benefit often used in qualified plans is a pre-retirement death benefit funded by life insurance (naturally). However, such a benefit must be "incidental," according to the IRS. Basically, the cost of the death benefit for a participant cannot be more than 25% of the total cost of all plan benefits for him. But, if the death benefit is funded through whole life insurance, the 25% limitation goes to 50% as half of the premium is considered as being allocated to pure insurance and the other half to investment.349 A defined benefit plan or money purchase plan will also satisfy the incidental benefit restriction provided the policy does not create a death benefit that is greater than 100 times the normal retirement benefit.350After that time the plan funds can be used to buy insurance. (Care must be taken because with defined benefit plans, the failure to meet the incidental benefit standard could mean disqualification of the entire plan.)
Profit-sharing and stock bonus plans can lose qualification if they do not comply with the incidental benefit rule, but only if the limitations are exceeded with premiums that are paid out of funds that were contributed less than two yeas previously—in which case, there is insufficient deferral of income before distribution. After that time, then plan funds can be used to buy insurance.
It is possible for a plan to provide for part of an accrued benefit to be distributed to a beneficiary but such payment must satisfy the requirement that it be incidental to the payment of benefits to the participant (the requirement was created by the Tax Reform Act of 1986[TRA]) So far, the regulatory bodies have not prescribed standards, and are still using the pre-TRA standards where the incidental benefit rule is satisfied if, when distribution commences, more than half of the present value of the nonforfeitable accrued benefit is payable to the participant. A joint and survivor annuity where the amount of the periodic payment to the surviving beneficiary does not exceed the amount of the periodic payment to the participant, satisfies the standards.351
If the present value of a participant's vested benefit is more than $5,000, before any part of it can be distributed the participant must consent to the distribution, in writing, before he has arrived at either the retirement age or age 62, whichever is later. Thereafter, the plan may distribute benefits in the prescribed form without any further consent of the participant needed. Consent is not needed for distribution of benefits on the participant's death.352
A participant may be allowed, by plan, to delay the start of the distribution of plan benefits, but unless he does so delay, the plan must start payments no later than the 60th day after the close of the plan year during which the participant (a) attains age 65 or normal retirement age; (b) completes ten years of participation in the plan; of (c) terminates the employment service with the employer. Some plans may require a participant to file a claim in order to start benefit payments.
The plan may allow a participant to delay the start of benefit payments, but if the participant does not ask to delay the payments, the plan must start payment no later than the 60th day after the close of the plan year during which the participant complies with provisions (as above).
The rules limit the right of the participant to delay the commencement of benefit distribution, as the plan must provide for the distribution of his entire interest, either by the required beginning date, or starting by the required beginning date and extending over the life of the participant (or a number of years not greater than his life expectancy). The beginning date is usually April 1 of the calendar year following the calendar year in which the participant turns 70 ½ or retires.353
Some persons question the purpose of the restrictions on the participant's right to delay payments. These rules were enacted so as to limit the use of pay-related tax deferral for estate planning purposes instead of retirement savings purposes—which were the reasons for ERISA to start with.
If the participant dies after his benefit payments have started, but prior to his entire interest has been distributed, the remaining portion must be distributed to him at least as rapidly as they were distributed to him prior to his death.354
There are exceptions, including the exception that any amount that was payable to a designated beneficiary may be paid over the life or life expectancy of that beneficiary, starting no later than one year after the death of the participant. Also, if the designated beneficiary is the surviving spouse, commencement of distribution does not have to start until the date on which the participant would have reached age 70 ½. Further, if the surviving spouse dies before her distribution begins, the 5-year rule and the first exception are applied as if the spouse were the participant.
Every pension plan must provide that benefits under it may not be assigned or "alienated." ("Alienate" is defined as "To transfer of convey [property or a property right]) to another.")355This provision is identical in the requirements for qualification.356 The purpose of this rule is to protect the pension benefits from being dissipated. It does not pertain to benefits that have already been paid out.
This provision pertains to voluntary assignments by a participant or beneficiary, and further, it requires plan fiduciaries not to give them any effect. This provision also governs involuntary assignments as well. The question is when, if ever, third parties may obtain interests in plans? ERISA invalidates any state laws that purports to allow anyone to acquire rights in a plan.
The above restrictions do not apply to welfare plans as welfare benefits (arguably) are less vital to a participant's long-term economic well-being than pension benefits , and so they do not have to be protected over long periods of time. Therefore (again, arguably) there is less harm to participants if welfare benefits are used to satisfy creditors. Besides, some welfare benefits—hospital and medical benefits come to mind—are intended to be paid to third parties, if for convenience if for no other reason.
Courts have routinely upheld the assignability of medical benefits to health care providers, and a health care provider can subsequently assign its rights to a collection agency.
Conversely, courts have also held that ERISA does not bar welfare plans from prohibiting such assignment. This can create some problems for some providers who relay on participant's coverage under a plan in rendering treatment, therefore some courts construe this anti-alienation provision in a medical and hospital plan as applying only to unrelated assignees and not to the providers of medical or hospital care for which benefits are paid.357
Bankruptcy creates an estate comprising all the legal and equitable interests of the debtor.358 The assets of the estate are then used to satisfy the creditor's claims. However, bankruptcy laws exclude any beneficial interest of the debtor in a trust that is enforceable under applicable bankruptcy law.358 In 1992, the Supreme Court held that the law excludes all participants in ERISA-qualified plans from the participant's bankruptcy estate.
Regardless of the court decisions and ERISA laws, there still are problems, such as the practice of individuals making substantial contributions to plans shortly before filing for bankruptcy in order to shield assets from creditors. This is considered by many as an abusive practice—if it is abusive, then laws should be enacted to correct it.
The anti-alienation provision can interfere with state's laws and/or practices to try to provide support for a participant's spouse or ex-spouse, or dependents after a divorce or other family-related legal order. ERISA was amended to create a category of qualified domestic relations order (QDRO) and to require plans to pay benefits with them in accordance with the QDRO.
A "domestic relations order" is a state court decree that addresses child support, alimony and marital property rights. A QDRO is a domestic relations order that provides for an alternate payee's right to receive all or part of the benefits payable with respect to a participant, and that meets certain requirements as to procedure. An alternate payee is a spouse, former spouse, child, or other dependent of the participant who has some rights to benefits under the domestic relations order.360
The procedural requirements for a QDRO are (a) informational as to name, address of the participant and alternate payees, amount or percentage of benefits to be paid to each, number of payments or period to which the order applies, and the plans applicable, and (b) the plan may not provide any form of benefits not otherwise available under the plan, or may not require the providing of actuarially increased benefits, and may not require the payments of benefits that are already required to be paid to a different alternate payee under a previous QDRO.
In addition, there are other requirements, principally of an administrative matter, and explanation of the authority of the QDRO in requiring payments of benefits, when, and to whom. The QDRO has the authority to declare an alternate payee (usually a former spouse), as an example, to be treated as the surviving spouse for purposes of the rules.
There are two other exceptions:
- Once a benefit is being paid or in the position to start being paid, a participant may make a voluntary and revocable assignment of up to 10% of any benefit, provided such assignment is not used to defray plan administration costs. A garnishment or levy is specifically not considered as a voluntary assignment.
- A plan loan to a participant, secured by his accrued vested benefit, is not treated as an assignment, provided that the loan is an exception to the prohibited transactions regulations contained in ERISA.361
It should be noted that the Supreme Court held that "since there is a congressional policy choice … to safeguard a stream of income for pensioners and dependents, which may be and perhaps usually are, blameless" courts should be reluctant to create equitable exceptions to it.362
In the TPA of 1997, Congress provided for a limited exception to the Supreme Court ruling, by providing that a participant's benefits may be offset by the amount he is required to pay to the plan under a conviction for a crime involving the plan, a civil judgment involving a violation of the fiduciary rule, or a settlement with the IRS or PBGC in respect to a violation of a fiduciary rule—as long as the judgment or agreement expressly provides for such offset.
Further, if the survivor annuity requirements apply to the distribution, and where the spouse is not required to pay an amount to the plan for this violation, either the spouse must consent in writing to the offset or the judgment or agreement must provide for the spouse to retain the survivor annuity, subject to a statutory calculation of its amount.363
1. The basic rule of taxation of annuity benefits is
A. benefits are taxed as accumulated.
B. benefits are never taxed.
C. benefits are taxed at the death of the annuitant.
D. benefits are taxed in the year in which they are made.
2. The investment in the annuity contract is excluded from gross income and is
A. called the exclusion ratio.
B. taxed at capital gains rates.
C. taxed at the net worth of the annuity fund each taxable year.
D. taxed to the annuitant every 5 years.
3. Except for specified minimum distributions, certain hardship distributions, and a distribution that is part of a series of basically annual periodic payments over a specified period of time, a distribution to an employee of any of the balance to his credit in a qualified plan is
A. an eligible rollover distribution.
B. a qualified distribution.
C. an ad hoc distributions.
D. an IRA rollover.
4. Even though an eligible rollover distribution is excluded from gross income,
A. it is immune to any other form of taxation.
B. it is no longer subject to a withholding tax.
C. it is still subject to a withholding tax of 20%, said tax cannot be waived.
D. each year the distribution must be reduced proportionately or be taxed.
5. The accrual of benefits is subject to certain rather stringent tax rules,
A. which is an extension of the MSA and HSA legislation.
B. because of the possibility of "backloading" where benefits grow faster in later years.
C. but only in respect to benefits that are in excess of $1,000 (gross) per week,
D. however, such rules are usually ignored as the penalty is miniscule.
6. ERISA prohibits defined benefit plans from ceasing accruals or reducing the rate of accruals, because of the age of the employee, except for highly compensated employees
A. and for those employees who have less than 5 years before mandatory retirement.
B. because ERISA attempts to restrict retirement benefits until the older ages.
C. in order to prevent age discrimination.
D. in order to prevent sex discrimination as females live longer than males.
7. Every benefit from a pension plan
A. is an accrued benefit.
B. is a consolidated benefit.
C. is a retroactive benefit.
D. is heavily and unfairly taxed.
8. When a defined benefit plan allows benefits to accrue rather steadily with the result that the accrual rate for participants in early years of service usually will be larger under this plan than under other similar plans, this is called
A. a traditional defined benefit plan.
B. a cash balance plan.
C. a deferred compensation plan.
D. an increasing maturity annuity.
9. If the participant dies after his benefit payments have started and he has a designated beneficiary, but prior to his entire interest has been distributed, the remaining portion must be distributed
A. at any time within 6 months after death.
B. at least as rapidly as they were distributed to him prior to his death.
C. to his estate in a lump sum.
D. but any amount payable to a designated beneficiary may be paid over the life (or life
expectancy) of that beneficiary starting no later than one year after the death of the
10. Every pension plan must provide that benefits under it
A. may not be assigned or "alienated."
B. may be payable only for a period not to exceed 20 years or the life expectancy of the
participant or designated beneficiary.
C. shall be payable to the probate court in case of death of the participant.
D. shall not be more than $3,500 per month (indexed) or less than $1,000.
ANSWERS TO STUDY QUESTIONS
1D 2A 3A 4C 5B 6C 7A 8B 9D 10A