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RMDs as annuitized payments

“A unique question arose late last week from an advisor with a wealthy 72-year-old client. In 2018, the client annuitized a large annuity contract to begin his required minimum distributions (RMDs) from his IRA. The client heard that because of a law change, he could suspend his RMD payment for 2020, so he wanted to skip his 2020 annuity payment. Can the client stop his 2020 RMD annuity payment from his IRA?

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk 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, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Colorado is representative of a common inquiry related to required minimum distributions (RMDs)

Highlights of the Discussion

  • While we are still awaiting additional operational guidance from the IRS on the Coronavirus Aid, Relief, and Economic Security (CARES Act), which allows for the waiver of RMDs for 2020, the answer in this scenario is most likely no—an IRA owner may not waive an annuitized payment. The form of his distribution (i.e., annuitized payments) makes the 2020 suspension or RMDs problematic and unlikely.
  • Payments from an annuity contract take several forms. The most common payout option is periodic payments, calculated on an annual basis using a contract value and life expectancy figure, which, generally, may be stopped or modified in certain circumstances [IRC Sec. 401(a)(9)].
  • A less common choice is annuitization, where the contract is surrendered to an insurance provider in exchange for a promise to make payments for a specified time and amount. Annuitized payment choices are irrevocable ([Treasury Regulation 1.401(a)(9)-6].
  • The suspension of 2020 RMDs comes from the newly enacted federal law (the CARES Act). However annuity contracts are regulated by state not Federal law. The annuity payments obligations are based the annuity contract terms. Once the contract is annuitized the payments cannot be modified. Thus, while periodic RMD payments from an annuity could be suspended for 2020, if the client annuitized the contract—no change to the payments is permitted.
  • After additional discussion with the client, we determined the IRA contract had been annuitized and, conservatively, no changes to the payments would be possible.

Conclusion

While many who are subject to 2020 RMDs have the option to waive the withdrawals pursuant to the CARES Act, there are some exceptions, including annuitized payments.

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What is 412(e) plan?

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk 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, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from New York is representative of a common inquiry related to a type of retirement plan.

Highlights of the Discussion

An IRC Sec. 412(e)(3) plan is a unique type of defined benefit plan that is funded exclusively by the purchase of life insurance contracts, fixed annuity contracts or a combination of the two. Because of this design, 412(e) plans do not require the services of an enrolled actuary to calculate the annual contributions. A fully insured 412(e)(3) defined benefit plan may be a plan solution for the owner of a small business or professional enterprise who desires a large current tax deduction for contributions and secure guaranteed retirement income. The most likely candidates for a 412(e) plan are small, professional businesses that want to maximize contributions for their owners. They work best for business that are small (five or fewer employees), well established, highly-profitable and have an older owner and younger employees.

IRC Sec. 412(e) plans are subject to the same qualification requirements that apply to traditional defined benefit plans, with two exceptions. First, if the insurance contracts meet the requirements of IRC Sec. 412(e)(3) and Treasury Regulation 1.412(i)-1(b)(2) as outlined below, the plan is exempt from the normal minimum funding requirements of IRC §412.

  1. The plan must be funded exclusively by the purchase of individual annuity or individual insurance contracts, or a combination thereof from a U.S. insurance company or companies. The purchase may be made either directly by the employer or through the use of a custodial account or trust.
  2. The individual annuity or individual insurance contracts issued under the plan must provide for level annual, or more frequent, premium payments to be paid under the plan for the period commencing with the date each individual participating in the plan became a participant, and ending not later than the normal retirement age for that individual or, if earlier, the date the individual ceases participation in the plan.
  3. The benefits provided by the plan for each individual participant must be equal to the benefits provided under his or her individual contracts at normal retirement age under the plan provisions.
  4. The benefits provided by the plan for each individual participant must be guaranteed by the life insurance company.
  5. All premiums payable for the plan year, and for all prior plan years, under the insurance or annuity contracts must have been paid before lapse.
  6. No rights under the individual contracts may have been subject to a security interest at any time during the plan year. This subdivision shall not apply to contracts which have been distributed to participants if the security interest is created after the date of distribution.
  7. No policy loans, including loans to individual participants, on any of the individual contracts may be outstanding at any time during the plan year. This subdivision shall not apply to contracts which have been distributed to participants if the loan is made after the date of distribution.

Second, a 412(e) plan will automatically satisfy the accrued benefit test if the plan satisfies items 1 through 4 above, plus provides that an employee’s accrued benefit at any time is not less than what the cash surrender value of his/her insurance contracts would be if all premiums due are paid, no rights under the contracts have been subject to a security interest at any time, and no policy loans are outstanding at any time during the year.

Note that the IRS has identified certain abusive sales practices involving 412(e)(3) plans funded only with life insurance rather than a combination of life insurance and annuities. Therefore, such plans will invite greater scrutiny by the IRS. (See EP Abusive Tax Transactions – Deductions for Excess Life Insurance in a Section 412(i)[1] or Other Defined Benefit Plan for specific guidance.)

Conclusion

A 412(e)(3) plan is a niche defined benefit retirement plan that allows for higher than usual tax deductible contributions. It is most suitable for businesses that are owner-only, or have fewer than five employees where the owner is materially older than the employees. Business owners should consult with a tax professional or attorney to determine whether a 412(e)(3) plan is the right choice for their firms.

[1] 412(e) plans were formerly know as 412(i) plans. The Pension Protection Act of 2006 renumbered the code section.

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Annuity provider selection safe harbor for defined contribution plans

“Has the Department of Labor (DOL) issued guidance on how to prudently select annuity providers for a defined contribution (DC) 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, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.  A recent call with a financial advisor from Massachusetts is representative of a common inquiry related to annuities within defined contribution plans.

Highlights of the Discussion

Yes, the DOL has described a five-step, “safe harbor” procedure for plan sponsors and their advisors to follow in order to satisfy their fiduciary responsibilities when selecting and monitoring an annuity provider and contract for benefit distributions from DC plans. (Note: The DOL is contemplating proposed amendments to the annuity selection safe harbor related to the assessment of an annuity provider’s ability to make all future payments.)

According to DOL Reg. 2550.404(a)-4, issued in 2008, and as further clarified by DOL Field Assistance Bulletin 2015-02, in order to satisfy the safe harbor selection process a plan fiduciary must

  1. Engage in an objective, thorough and analytical search for the purpose of identifying and selecting providers from which to purchase annuities;
  2. Appropriately consider information sufficient to assess the ability of the annuity provider to make all future payments under the annuity contract;
  3. Appropriately consider the cost (including fees and commissions) of the annuity contract in relation to the benefits and administrative services to be provided under such contract;
  4. Appropriately conclude that, at the time of the selection, the annuity provider is financially able to make all future payments under the annuity contract and the cost of the annuity contract is reasonable in relation to the benefits and services to be provided under the contract; and
  5. If necessary, consult with an appropriate expert or experts for purposes of compliance with these provisions.

The safe harbor rule provides that “the time of selection” means:

  • the time that the annuity provider and contract are selected for distribution of benefits to a specific participant or beneficiary; or
  • the time that the annuity provider is selected to provide annuities as a distribution option for participants or beneficiaries to choose at future dates.

The fiduciary must periodically review the continuing appropriateness of the conclusion that the annuity provider is financially able to make all future payments under the annuity contract, as well as the reasonableness of the cost of the contract in relation to the benefits and services to be provided. The fiduciary is not, however, required to review the appropriateness of its conclusions with respect to an annuity contract purchased for any specific participant or beneficiary.

Conclusion

Similar to selecting plan investments, choosing an annuity provider for a DC plan is a fiduciary function, subject to ERISA’s standards of prudence and loyalty. One way to satisfy this fiduciary responsibility is to follow the DOL’s safe harbor selection process as outlined in DOL Reg. 2550.404(a)-4 and Field Assistance Bulletin 2015-02.

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