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Definition of Disability for Early Distribution Penalty

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What is the definition of disability for purposes of the early distribution penalty tax?

“How does the IRS define disability for the purposes of allowing a 401(k) plan participant to take a distribution before the age of 59 ½ without a penalty tax?”  

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • Generally, amounts an individual withdraws from an IRA or retirement plan before reaching age 59½ are called ”early” or ”premature” distributions. Beyond including the pretax portion of an early distribution in taxable income for the year taken, the recipient must pay an additional 10% early withdrawal penalty tax, unless an exception applies [Internal Revenue Code Section (IRC §) 72(t)].
  • There are several exceptions to the early withdrawal penalty tax found in IRC §72(t)(2)(A)-(G), including an exception for disability (IRC §72(t)(2)(A)(iii).
  • The IRS defines disability for this purpose in IRC §72(m)(7),  and the definition is quite strict:

 

“… an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof …”

 

  • Some disabled individuals file IRS Schedule R, Credit for the Elderly or Disabled, with their IRS Form 1040s.  The schedule requires a physician’s certification that a person meets the IRC §72(m)(7) definition of disabled. Alternatively, a physician’s signed statement attesting to an individual’s permanent and total disability can serve as proof of the condition.
  • See the IRS’ Retirement Topics – Exceptions to Tax on Early Distributions for other penalty exceptions.
  • It is important that plan administrators review their disability claims procedures, including acceptable forms of documentation. While the final disability claims regulations and accompanying FAQs (in particular Q&A 9) reference the Social Security Administration or the employer’s long-term disability plan benefit awards as two examples of disability documentation, the rules for pension plans do not seem to preclude other forms, as long as the disability finding is made by a party other than the plan for purposes other than making a benefit determination under the plan. Here is the wording from Q&A 9 of the DOL’s FAQs

 

“However, if a plan provides a benefit the availability of which is conditioned on a finding of disability, and that finding is made by a party other than the plan for purposes other than making a benefit determination under the plan, then the special rules for disability claims need not be applied to a claim for such benefits.”

 

Conclusion

While disability can qualify a distribution recipient for an exception to the early withdrawal penalty tax, the definition of disability for this purpose is rigorous and requires proof.

 

 

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403b plan
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Nonprofit with 401(k) and 403(b)

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Can a 403(b) plan merge with a 401(k) plan?

“I have a tax-exempt client that currently offers a 401(k) plan. The group is taking over another IRC Sec. 501(c)(3) tax-exempt entity that has a 403(b) plan.  Can the acquiring entity merge the 403(b) plan into the 401(k) plan?”  

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • No, generally the IRS does not allow mergers or transfers of assets between 403(b) and 401(k) plans [Treasury Regulation 1.403(b)-10(b)(1)(i)]. The IRS has stated in private letter rulings (PLRs) that if a 403(b) plan is merged with a plan that is qualified under IRC Sec. 401(a), the assets of the 403(b) plan will be taxable to the employees PLR 200317022.
  • One option would be to terminate the 403(b) plan, which would allow its participants to receive distributions (See the IRS’ Terminating a 403(b) Plan for more information).
  • The participants in the terminated 403(b) plan who receive eligible rollover distributions from the 403(b) plan would have the option to roll the amounts to the 401(k), provided the 401(k) plan permits rollover contributions (Revenue Ruling 2011-7 and IRS Rollover Chart.)

Conclusion

IRC Sec. 501(c)(3) tax-exempt entities have the ability to maintain both 401(k) and 403(b) plans independently. The IRS does not allow a sponsor to merge the two plan types, however.   A plan termination followed by participant rollovers may be a viable alternative to merging the plans.

 

 

 

 

 

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retirement pension
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Plan Participation and IRA Contributions

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 Plan Participation and IRA Contributions

“A client of mine who participates in a 401(k) plan at work was told by his tax preparer that he cannot make an IRA contribution.  Is that correct?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

  • If your client is under age 70 ½ and has earned income for the year of contribution, he is eligible to make a traditional IRA contribution, provided he does so by the contribution deadline.  But because he participates in a 401(k) plan, the contribution may not be fully tax deductible.
  • Deductibility of a traditional IRA contribution depends on whether the individual (or his or her spouse) is an active participant in an employer-sponsored plan, tax filing status and the amount of modified adjusted gross income (MAGI) for the year (IRC Sec. 219(g).

Deductibility of a 2016 traditional IRA contribution when the individual (or spouse) is covered by a workplace retirement plan

IF your filing
status is …		 AND your modified adjusted gross income (modified AGI)
is …		 THEN you can take …
single or
head of household		 $61,000 or less a full deduction.
more than $61,000
but less than $71,000*		 a partial deduction.
$71,000 or more no deduction.
married filing jointly or
qualifying widow(er)		 $98,000 or less a full deduction.
more than $98,000
but less than $118,000**		 a partial deduction.
$118,000 or more no deduction.
married filing separately2 less than $10,000 a partial deduction.
$10,000 or more no deduction.
Not covered by a plan, but married filing jointly with a spouse who is covered by a plan  $184,000 or less a full deduction.
more than $184,000
but less than $194,000***		 a partial deduction.
Source:  IRS 2016 IRA Contribution and Deduction Limits $194,000 or more no deduction.

*$62,000-$72,000 for 2017; **$99,000-$119,000 for 2017; and ***$186,000-$196,000 for 2017

 

Conclusion

If a person meets the age and income requirements for a year, he or she is eligible to make a traditional IRA contribution by the deadline.  But the tax deductibility of the contribution will be affected by participation in a workplace retirement plan, tax filing status and MAGI.

 

 

 

 

 

 

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money
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Education Policy Statement

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Education Policy Statement

“What is an Education Policy Statement for a 401(k) plan and does the Department of Labor (DOL) require a plan have one?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • While the DOL does not requirement qualified retirement plans to have an education policy statement (EPS), it can be a helpful fiduciary liability reduction tool for plan sponsors who offer plan participants the ability to self-direct their account balances. It is often viewed as an extension of a plan’s investment policy statement. The EPS is the blueprint for how the fiduciaries of the plan will implement, monitor and evaluate an employee education program with respect to the plan.

 

  • ERISA 404(c) provides a mechanism for plan sponsors to shift investment responsibility to participants, provided the plan meets certain requirements. Generally, to meet the requirements of ERISA 404(c), participants must have the opportunity to 1) exercise control over their individual account; and 2) choose from a broad range of investment alternatives (DOL Reg. 2550.404c-1). As part of the ability to exercise control participants must have “…the opportunity to obtain sufficient information to make informed investment decisions.” The EPS can be the means by which plan fiduciaries document how this requirement is met.

 

While there is no prescribed format for an EPS, answering the following questions may be helpful in designing the document:

What is the purpose of the EPS?

What are the objectives of the EPS?

What are the educational goals?

Who are the responsible parties and what are their duties?

How will the education be delivered?

How will results be measured?

 

Conclusion

An EPS is a blueprint for how plan fiduciaries will implement, monitor and evaluate an employee education program with respect to a retirement plan. Although not required, an EPS could be a prudent addition to a plan sponsor’s fiduciary fulfillment file.

 

 

 

 

 

 

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Compliance Rules Guidelines Regulations Laws
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The “High 25” and Benefit Restrictions

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The “High 25” and Benefit Restrictions

“My client, a senior partner with an engineering firm, called and was upset because the administrator of his firm’s cash balance plan told him he can’t take a lump distribution, even though the plan document specifically permits lump sums. How can this be? I thought the plan sponsor had to follow the plan document.”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • Unfortunately for your client, in certain circumstances, defined benefit (including cash balance) plans, cannot make lump sum distributions to highly compensated employees (HCEs), despite the option being available under the terms of the plan.  This restriction, sometimes known as the “High 25” or claw back rule, affects the top 25 highest paid HCEs. The rule is intended to ensure large lump sum distributions made to the top HCEs don’t jeopardize the funding status of the plan and its ability to make benefit payments to other participants.
  • Treas. Reg. 1.401(a)(4)-5(b)(3)(ii) states that a plan cannot make certain benefit payments (including a lump sum payment) to an HCE (a restricted employee) who is in the top 25 of employees in terms of compensation unless one of the following is satisfied:

 

  1. After taking into account the payment to the restricted employee of all benefits payable to or on behalf of that restricted employee under the plan, the value of plan assets must equal or exceed 110 percent of the value of current liabilities;
  2. The value of the benefits payable to or on behalf of the restricted employee must be less than one percent of the value of current liabilities before distribution; or
  3. The value of the benefits payable to the restricted employee must not exceed $5,000 [the amount described in section 411(a)(11)(A) of the Internal Revenue Code (IRC) related to restrictions on certain mandatory distributions].

 

  • Revenue Ruling 92-76 prescribes three workarounds, permitting a lump sum if the client does not wish to take an annuity payment.  A  lump sum is permitted if

 

  1. The distribution is placed in an escrow account;
  2. A surety bond is obtained for the distributed amount; or
  3. A letter of credit is secured that allows the plan to recoup all or a portion of the distribution in the event of future funding shortfall.

These rules are complex and expert counsel is necessary to ensure compliance.

Conclusion

When discussing benefit restriction rules for defined benefit plans with your clients, do not forget the well-entrenched benefit restrictions that may apply for the High 25 HCEs in the plan.

 

 

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Compliance Rules Guidelines Regulations Laws
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Rollovers as Business Startups (ROBS)

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Rollovers as business startups (ROBS)

“One of my clients, who participates in his employer’s 401(k) plan, asked me about an arrangement whereby he could use a tax-free rollover from the plan to start his own new business?  Are you aware of such a scheme?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • Your client is likely referring to “Rollovers as Business Start-Ups” (ROBS). The IRS has commented that promoters in the industry are aggressively marketing ROBS (described below) as a means for prospective business owners to access accumulated tax-deferred retirement funds, without paying applicable distribution taxes, in order to cover new business start-up costs. While the IRS does not consider all ROBS to be abusive tax avoidance transactions, it has found that some forms of ROBS violate existing tax laws and, therefore, are prohibited.
  • Anyone considering a ROBS transaction should consultant with a tax and/or legal advisor before proceeding as there are several issues the IRS has identified that must be considered on a case-by-case basis in order to determine whether these plans operationally comply with established law and guidance. These issues and guidelines for compliance are detailed in a 2008 IRS Technical Memorandum.
  • Here is an example of a common ROBS arrangement.  An individual sets up a C-Corporation and establishes a 401(k)/profit sharing plan for the business.  The plan allows participants to invest their account balances in employer stock. (At this point the business owner is the only employee in the corporation and the only participant in the plan.)  The new business owner then executes a tax-free rollover from his or her prior qualified retirement plan (or IRA) into the newly created qualified plan and uses the assets from the rollover to purchase employer stock. The individual next uses the funds to purchase a franchise or begin some other form of business enterprise. Note that since the rollover is moving between two tax-deferred arrangements, the new business owner avoids all otherwise assessable taxes on the rollover distribution.
  • The two primary issues that the IRS has identified with respect to ROBS that would render them noncompliant are 1) violations of nondiscrimination requirements related to the benefits, rights and features test of Treas. Reg. § 1.401 (a)(4 )-4; and 2) prohibited transactions resulting from deficient valuations of stock.
  • Other concerns the IRS has with ROBS relate to the plan’s permanency (which is a qualification requirement for all retirement plans, violations of the exclusive benefit rule, lack of communication of the plan when other employees are hired, and inactive cash or deferred arrangements (CODAs).
  • The Employee Plan Compliance Unit of the IRS completed a research project on ROBS in 2010. The research revealed that while some of the ROBS studied were successful, many of the companies in the sample had gone out of business within the first three years of operation after experiencing significant monetary loss, bankruptcy, personal and business liens, or having had their corporate status dissolved by the Secretary of State (voluntarily or involuntarily).

 

Conclusion

Caution should prevail when considering a ROBS arrangement. Those interested should seek the guidance of a tax and/or legal advisor, and consider the guidance from the IRS’ 2008 Technical Memorandum.

 

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Five percent Owner and Stock Options to Consider

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Stock Options and Determining a “Five-Percent Owner”

“One of my clients in a 401(k) plan has been given stock options, which have not been exercised.  When determining a five percent owner for plan purposes, does ownership of stock options count?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • The answer to your question is clearly addressed in Internal Revenue Code Sections (IRC) §§416 and 318 and underlying regulations.
  • Under IRC §416(i)(1)(B)(I), the term “five-percent owner” means the following:
  • If the employer is a corporation, any person who owns (or is considered as owning within the meaning of IRC § 318) more than five-percent of the outstanding stock of the corporation or stock possessing more than five-percent of the total combined voting power of all stock of the corporation, or
  • If the employer is not a corporation, any person who owns more than five-percent of the capital or profits interest in the employer.
  • A person might be a more than five-percent owner through the “constructive ownership” rules of IRC § 318. IRC §318(a)(4) states:  If any person has an option to acquire stock, such stock shall be considered as owned by such person. For purposes of this paragraph, an option to acquire such an option, and each one of a series of such options, shall be considered as an option to acquire such stock.

 

Conclusion

When determining ownership for plan purposes, if any participant has an option to acquire stock, such stock shall be considered as owned by such person.

 

 

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H-1B Workers in the Retirement Plan?

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H-1B Workers

“What are H-1B workers, and must a plan sponsor include them in the business’ retirement plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • H-1B workers are nonimmigrant aliens in specialty occupations or fashion models of distinguished merit and ability. They are authorized under the Immigration and Nationality Act, section 101(a)(15)(H).
  • A specialty occupation for this purpose is one that requires the application of a body of highly specialized knowledge and the attainment of at least a bachelor’s degree or its equivalent. The intent of the H-1B provisions is to help employers who cannot otherwise obtain needed business skills and abilities from the U.S. workforce by authorizing the temporary employment of qualified individuals who are not otherwise authorized to work in the United States.
  • Initial H-1B status may be granted for up to three years.
  • H-1B workers are often categorized as resident aliens (as apposed to nonresident aliens) under the substantial presence test.
  • Generally, employers must offer benefits to H-1B workers on the same basis, and in accordance with the same criteria, as the benefits they provide to similarly employed U.S. workers (See DOL Fact Sheet #62L: What benefits must be offered to H-1B workers?). This would include participation in a retirement plan, unless by the terms of the plan document such workers are excluded.

Conclusion

Plan sponsors who employ H-1B workers must be aware that they are entitled to participate in workplace retirement plans if they otherwise meet the eligibility requirements as specified in the governing plan documents.

 

 

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Time to Deal with Mergers

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Time for Managing a Plan Merger

“My client is working through a business acquisition, which will involve merging two 401(k) plans.  He is concerned about how quickly they will be able to merge the plans.  Are there guidelines on compliance testing for the plans during the merger process?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • A special “transition rule” under Internal Revenue Code Section (IRC §) 410(b)(6)(C) applies for meeting employee coverage requirements in situations where an acquisition involves the merging of two plans. Under these rules, the plan will continue to be considered in compliance with minimum coverage requirements during a “transition period.”
  • The transition period is the period that begins on the date of the transaction and ends on the last day of the first plan year beginning after the date of the transaction.  For example, for an acquisition that takes place on September 1, 2017, the transition period that would apply for a calendar year plan would last until December 31, 2018.
  • The transition rule is only available if 1) both plans satisfy the coverage rules immediately before the acquisition; and 2) there are no significant changes in either the terms of the plan or the coverage of the plans following the transaction.

Conclusion

The merging of two employer plans is a complicated and time consuming process. Fortunately, from an employee coverage perspective, there are transitional rules that give the employer some relief.

 

 

 

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money
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What is the Definition of Compensation for HCEs

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What is the definition of compensation for determining HCEs?

“What definition of compensation is used to determine who is considered an HCE for nondiscrimination testing in a 401(k) plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

A plan must use an Internal Revenue Code Section (IRC §) 415 definition of compensation when determining which employees are HCEs under IRC §414(q).

  • More specifically, according to  Temporary Treasury Regulation 1.414(q)-1T, Q&A 13, the term “compensation” for HCE determination means compensation within the meaning of IRC §415(c)(3) without regard to §§125, 402(a)(8), and 402(h)(1)(B) and, in the case of employer contributions made pursuant to a salary reduction agreement, without regard to § 403(b). Thus, compensation for this purpose includes elective or salary reduction contributions to a cafeteria plan, cash or deferred arrangement or tax-sheltered annuity.

 

  • Only compensation an employee received during the “applicable period” is considered in determining HCE status.  HCE status based on compensation (not on ownership) is determined using compensation earned during the preceding year or 12-month period, referred to as the “look-back year.” If the year for which HCE status is being determined is not a calendar year, the sponsor may make a calendar year election so that HCE status is determined based on compensation earned during the calendar year beginning with or within the look-back year.

 

  • A compensation threshold applies for determining HCE status. This amount is subject to indexing.  When the amount is indexed, the new dollar amount applies to the year in which the compensation is earned, not the year in which HCE status is determined.  For example, when determining HCE status for 2017 based on compensation, plans must use the indexed amount for 2016, which was $120,000.  When determining HCE status for 2018 based on compensation, plans must use the indexed amount for 2017, which is $120,000.

Conclusion

Plans must follow a specific definition of compensation as defined in the IRC and supporting Treasury regulations when determining whether an employee is or is not an HCE.

 

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