Pension Distributions and Restricted Employees
My client elected a lump sum payment from his traditional defined benefit plan, but received a letter telling him he could not take a lump sum payment because he was a “restricted employee.” The plan says lump sums are available. Could you explain what this means and provide options for him?”
Welcome to the Retirement Learning Center’s (RLC) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in Nevada is representative of a common question on pension distributions.
My client elected a lump sum payment from his traditional defined benefit plan, but received a letter telling him he could not take a lump sum payment because he was a “restricted employee.” The plan says lump sums are available. Could you explain what this means and provide options for him?”
Highlights of Discussion
The rules surrounding restricted employees are complex and expert counsel is necessary to ensure compliance and the best outcome. Individuals affected by these rules should see guidance from a tax or legal advisor. The following is for informational purposes only and does not constitute tax or legal advice.
Unfortunately for your client, in certain circumstances defined benefit 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 ensures large lump sum distributions made to the top HCEs do not 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:
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;
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
The value of the benefits payable to the restricted employee must not exceed $7,000 [the cash out amount described in IRC Sec. 411(a)(11)(A) related to restrictions on certain mandatory distributions].
Revenue Ruling 92-76 prescribes three workarounds or exceptions, allowing a lump sum if the client does not wish to take an annuity payment. A lump sum is permitted if
The distribution is placed in an escrow account;
A surety bond is obtained for the distributed amount; or
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.
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 (i.e., restricted employees) in the plan. Individuals affected by the rules should work with their plan administrators to explore the exceptions that may be available and seek professional guidance from a tax and/or legal advisor.