Tag Archive for: Defined Benefit

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When might a cash balance plan be a good fit?

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“How can I determine if a cash balance plan might be a good fit for a business owner?”

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 an advisor in New Mexico is representative of a common question related to maximizing retirement plan contributions.

Highlights of Discussion

The question of whether to set up a qualified retirement plan has important tax ramifications. Therefore, business owners would be best served by seeking the guidance of a tax professional when making such a decision.

As a type of defined benefit plan, a cash balance plan requires an adopting employer to fund the plan to provide participants with a promised retirement benefit. Cash balance plans are most popular among smaller, well-established firms that have significant and consistent cash flow (e.g., law firms, medical groups, and professional firms such as CPAs, architects, and consultants). They also work well for older small business owners who are no longer making heavy investments in their businesses, and have significant amounts of pass-through income, resulting in high tax bills.

To determine suitability for a cash balance plan, consider the following questions. The more “yes” responses the greater the possibility a business could benefit from having a cash balance plan.

Question Yes No Why it Matters
1.   Is the business owner over age 50?     The potential to contribute more income to a cash balance plan increases with age.
2.   Does the business owner have less of a need to reinvest in the business?     If the owner has put money into the business in prior years, the business is now, likely, well established, freeing up capital.
3.   Does the owner have significant pass-through income?     This can lead to discussions on how to reduce a large tax bill.
4.   Does the owner want to catch-up on saving more for the future?     Cash balance plans allow for higher contribution and deduction limits than defined contribution plans.
5.   Has the business owner shown interest in setting up a nonqualified deferred compensation plan (NQDC) to save more?     NQDC plans do not reduce taxable income for business owners of pass-through entities.
6.   Has the business owner shied away from a define benefit plan due to complexity and employee coverage issues?     Cash balance plans are less complicated to maintain than traditional defined benefit plans, and design features allow owners to maximize contributions for themselves.

As the table below illustrates, cash balance plans can allow much higher levels of contributions than a profit sharing or 401(k) plan. That equates to higher tax deductions for business owners. For some businesses, having both a defined contribution and cash balance plan may be appealing.

2022 Cash Balance Chart

Conclusion

There are some key characteristics to look for in a business owner when evaluating whether a cash balance plan might be a good fit. For the right candidate, a cash balance plan—or even a combination cash balance and defined contribution plan—can provide significant benefits. Above all, whether or not to set up a qualified retirement plan is an important tax-related question that a business owner should only answer with the help of his or her tax professional.

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Relief for Variable Rate PBGC Premiums

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“My client is delaying a portion of her defined benefit plan contribution that is due in 2020 until January 1, 2021, as allowed under the Coronavirus Aid, Relief and Economic Security (CARES) Act. However, she already filed and paid her PBGC premiums for 2020, which showed an underfunding liability because of the delayed contribution. Consequently, she was required to pay more in variable rate premiums than she would have had to pay if she had made her contributions in 2020. Is she stuck with the higher variable-rate premium, or is there a way for her to get back the overpayment?”

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 Jersey is representative of a common inquiry related to the payment of Pension Benefit Guaranty Corporation (PBGC) premiums.

Highlights of the Discussion

Yes, there is a way to get a refund of an overpayment in variable-rate premiums in this unusual situation. Fortunately, the PBGC realized the discrepancy that was created, and came up with a way to rectify the matter in its September 2020 Technical Update 20-2. Under this guidance, a prior year contribution received after the PBGC premium was filed and on or before January 1, 2021, may be included in the asset value used to determine the variable-rate premium. This relief did not change the premium due dates, however, (e.g., October 15, 2020, for calendar year plans), and does not permit a premium filing to reflect a contribution that has not yet been made. Therefore, plan sponsors that want to take advantage of this relief must amend their 2020 PBGC premium filing by February 1, 2021, to revise the variable-rate premium data to add in contributions due in 2020 that are made on or before January 1, 2021. Once the PBGC approves the amended filing, it will refund any excess variable-rate premium, or credit the excess to the plan’s “My Plan Administration Account” (whichever option the plan sponsor elects).

For a bit of background, the PBGC is the governmental entity that insures private sector defined benefit plans. All single employer defined benefit plans are required to pay a flat rate premium annually to the PBGC for coverage based on the number of participants in the plan. Additionally, for plans that are underfunded (i.e., where plan liabilities exceed assets), a variable-rate premium also applies based on the plan’s unfunded vested benefits (UVBs).

Conclusion

Plan sponsors who remitted their PBGC premiums on time for 2020, who also are delaying a contribution due in 2020 until January 1, 2021, pursuant to the CARES Act, may have become subject to or were required to pay higher variable-rate premiums because of the delayed plan contribution. Such sponsors may be entitled to a refund of some or all of the variable-rate premiums paid. They can reclaim an overpayment by submitting an amended PBGC premium filing by February 1, 2021, to claim a refund or credit.

 

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CARES Act Retirement Plan Funding Relief

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“With all the recent rule changes, did Congress provide any funding relief for retirement plan sponsors?”   

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 Kansas is representative of a common inquiry related to plan funding relief.

Highlights of the Discussion

  • There is some relief for certain defined benefit (DB) plans, and for money purchase pension plans, but not for other types of defined contribution plans. The limited relief is to help sponsors of single employer pension plans handle the “one-two punch” of decreased revenue flows and devalued plan investments.
  • Under the newly enacted Coronavirus Aid, Relief, and Economic Security (CARES) Act, sponsors of single employer pension plans may delay payment of their 2020 contributions until January 1, 2021. This would include quarterly payments due in 2020 as well. (See Section 3608 on p. 133 of the CARES Act.)
  • If a pension plan sponsor delays contributions for 2020, it must increase the amount of each required contribution by any interest accrued during the period between the original due date for the contribution and the payment date, at the effective rate of interest for the plan year which includes such payment date.

Conclusion

The CARES Act included several provisions that affect qualified retirement plans. One such provision gives pension plan sponsors some funding relief for 2020.

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Purchasing Service Credits in a Defined Benefit Plan

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“My client has a job with the government. She is asking me about purchasing service credits in her retirement plan. Can you explain what she might be talking about?”

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 Minnesota is representative of a common inquiry related to governmental plans.

Highlights of the Discussion

Generally, service credit is credit for work performed for which your client may earn a benefit under a defined benefit pension plan. Many states allow their public employees to purchase permissive service credits for previous years of service which, otherwise, would not count in the pension. It commonly happens when an employee terminates governmental employment prior to vesting, but later becomes employed in another governmental position [IRC §415(n)]. In order to purchase the service credit, the employee must make a voluntary additional contribution, in an amount determined under such governmental plan, which does not exceed the amount necessary to fund the benefit attributable to such service credit [IRC §415(n)(3)(A)(iii)].

Whether a governmental worker may purchase service credits depends on the particular retirement system. If he or she is eligible, then the retirement system determines the cost of the purchase. The plan usually limits the number of years of service credit that a participant may purchase. The retirement system usually provides different payment options, which may include the following:

  • A lump-sum payment for the full cost;
  • Payroll deductions over a period of time; and
  • Direct rollovers or trustee-to-trustee transfers of amounts from a qualified plan (including a 401(k) plan, a 403(b) plan or state or local government 457 plan).[1]

Conclusion

Because the ability to purchase service credits in a governmental defined benefit plan is dependent on the particular retirement system, reviewing specific plan documentation and forms is essential to determine if the option is available, what payment methods may be used and how to request the purchase.

[1] The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) broaden the third option to permit funds from 403(b) and 457 plans to be transferred on a pretax basis to purchase service credit, or to repay prior cash-outs of benefits, in governmental defined benefit plans. Previously, these transfers were only allowed from qualified plans, such as 401(k) plans.

 

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Hybrid retirement plans

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“Is ‘hybrid’ just another name for a cash balance defined benefit 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 Colorado is representative of a common inquiry related to hybrid plans.

Highlights of the Discussion

Sort of—a cash balance plan is a type of hybrid defined benefit plan; a pension equity plan is another type of hybrid plan. The term hybrid applies to a category of defined benefit plan that uses a lump-sum based formula to determine the guaranteed benefit (rather than a formula based on years of service and compensation as is the case with most traditional defined benefit plans). A participant must refer to plan documentation to determine which type he or she may have.

Functionally, hybrid plans combine elements of traditional defined benefit plans and defined contribution plans. Hybrid plans specify contributions to an account (or balance) like a defined contribution plan, but guarantee final benefits like a defined benefit plan. Such plans grow throughout an employee’s career and allow employees to see that growth through an account balance. There are basically two types of hybrid plans: cash balance and pension equity. The account for each participant in a hybrid plan is theoretical, and is not actually funded by employer contributions. The employer contributes to the plan as a whole (covering all eligible workers in the plan) to ensure that sufficient funds will be available to pay all benefits.

Cash balance plans were the first type of hybrid plan, emerging in the late 1980s.[1] Under a cash balance plan an employee’s hypothetical account balance is determined by reference to theoretical annual allocations based on a certain percentage of the employee’s compensation for the year and hypothetical earnings on the account. In a typical cash balance plan, a participant’s account is credited each year with a pay credit (such as 5 percent of compensation from his or her employer) and an interest credit (either a fixed rate or a variable rate that is linked to an index such as the one-year Treasury bill rate).

Another common type of hybrid plan is a pension equity plan or PEP. While pension equity plans and cash balance plans share methods of accumulating value, a major difference is the earnings used to determine the benefit. Cash balance plans specify a credit each year, based on that year’s earnings, whereas pension equity plans apply credits to final earnings (IRS Notice 2016-67).

While traditional defined benefit plans specify the primary form of distribution as an annuity (with lump sums sometimes given as a optional form of benefit), hybrid plans specify the primary form of distribution as a lump sum, which can be converted to an annuity (see Treasury Regulation 1.411(a)(13)–1). Pursuant to Revenue Procedure 2019-20, the IRS provides a limited expansion of IRS’s determination letter program for individually designed retirement plans to allow reviews of hybrid plans, as well as merged plans.

The Bureau of Labor Statistics has put together the following comparison table showing the similarities and differences between cash balance and pension equity plans.

table

Conclusion

The term hybrid plan refers to a category of defined benefit plans that uses a lump-sum based formula to determine guaranteed retirement benefits. Cash balance and pension equity plans are the two most common types of hybrid plans. The provisions of the governing plan document will specify which type of hybrid plan a participant may have.

[1] Bureau of Labor Statistics

 

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What is 412(e) plan?

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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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Contribution limits with combined DB/DC plans

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“I am meeting with a new client who has a defined benefit (DB) plan and would like to add an “individual k” plan. Can he do this and, if so, what are the contribution limitations?”

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 Rhode Island is representative of a common inquiry related to an employee covered by two plans.

Highlights of the Discussion

There are several layers to consider in your client’s situation. First, keep in mind that an individual k plan is a type of 401(k) plan that is designed to cover only small business owners and their spouses, (i.e., businesses without eligible common-law employees).

To answer your question, yes, a business owner can have both a 401(k)/profit sharing plan and a DB plan. The question on contribution limitations depends on whether the DB plan is covered by the Pension Benefit Guaranty Corporation (PBCG—the governmental entity that insures private sector DB plans). If a sponsor has a question about coverage, it can ask the DOL to make the call: Requesting a coverage determination

The PBGC insures most private-sector (i.e., non-governmental) DB plans [ERISA 4021(a)]. There are some notable exceptions to coverage, however ([ERISA 4021(b)].

Among others, the PBGC does not insure the following types of plans:

  • Governmental plans;
  • Small professional service plans;
  • Substantial owner plans;
  • Certain Puerto Rico plans;
  • Certain church plans.

Please see the PBGC’s definitions for the above listed exemptions on the PBGC’s website at PBGC Insurance Coverage.    

Where a DC and DB plan are combined, and the DB plan is covered by the PBGC, then there is no combined contribution limit. The deduction limits for contributions to DC and DB plans apply separately. A business owner, in this case, can fully contribute to both a DC and a PBGC-covered DB plan within the prescribed limits for each.

In the case at hand, one must be mindful of the substantial owner exemption from PBGC coverage. A private-sector DB plan is exempt from PBGC coverage if it is established and maintained exclusively for substantial owners of the plan sponsor (i.e., if all participants are substantial owners).

A participant is a substantial owner if, at any time during the last 60 months, the participant:

  • Owned the entire interest in an unincorporated trade or business, or
  • In the case of a partnership, is a partner who owned, directly or indirectly, more than 10 percent of either the capital or profits interest in such partnership, or
  • In the case of a corporation, owned directly or indirectly more than 10 percent in value of either the voting stock or all the stock of that corporation.

Where a DC and DB plan are combined, and the DB plan is not covered by the PBGC, as would be the case in an owner-only situation, then there is a combined contribution limit as follows:

If there is an employer contribution to the DC plan, then the maximum deductible contribution to both types of plans combined is the greater of

  • 25 percent of the aggregate compensation of all participants; or
  • the amount necessary to meet the minimum funding standard for the defined benefit plan.

Consequently, the plan sponsor would fund the DB plan up to the required amount, then fund the DC plan if there is still room.

For this purpose, the IRS says the first six percent of deductible contributions made to the DC plan is ignored for the above limits; and salary deferrals to the 401(k) plan are not counted toward the deduction limit.

Conclusion

Determining the maximum deductible contribution that a plan sponsor can make to a DB and DC plan that are combined can be tricky. Business owners should always seek advice from their tax advisors when calculating plan contribution limits.

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Defined Benefit Plan Annual Funding Notice

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What information does the Annual Funding Notice for a defined benefit (DB) plan reveal and why is it important?

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, 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 an advisor in Missouri is representative of a common question related to DB plan Annual Funding Notices.

Highlights of Discussion

The Annual Funding Notice is one of several important retirement plan notifications that should be considered as part of a comprehensive financial planning process. It is one of the best tools for a participant and his or her advisor to measure the solvency or health of a DB plan.

The law requires sponsors of all DB plans that are subject to Title IV of the Employee Retirement Income Security Act of 1974 (ERISA) to provide an Annual Funding Notice to each DB plan participant and beneficiary, as well as other entities. Businesses that fail to provide an Annual Funding Notice each year face a Department of Labor (DOL) penalty of $110 per day of delay, up to a maximum of $1,100 per request. (See related final DOL Regulations, which include a model notice, at Annual Funding Notice for Defined Benefit Plans.)

The notice provides participants with information about

  • How well the pension plan is funded, measured by the funding target attainment percentage (FTAP);
  • The value of pension plan’s assets and liabilities;
  • How a pension plan’s assets are invested; and
  • Employer events taking place during the current year that are expected to have a material effect on the plan’s liabilities or assets
  • The legal limits on how much the Pension Benefit Guaranty Corporation (PBGC) can pay participants if the PBGC (the federal agency that insures private-sector DB plans) determines it is in the participants’ best interest to step in and take control of the plan.

The first thing to focus on when looking at an Annual Funding Notice is the FTAP, which is a measure of how well the plan is funded to meet liabilities on a particular date. This figure is the best single indicator of the current health of a DB plan. The FTAP must be reported for the current year and two preceding years. In general, the higher the percentage, the better funded the plan and the better able the plan is to pay promised benefits. The FTAP is a determinant as to whether the plan is considered “at risk.”

If a plan’s FTAP for the prior plan year is below 80 percent that is the first indication the plan may be entering at-risk status. The plan’s actuary calculates whether a plan is at risk using the FTAP and a multi-step process. At-risk plans require more funding by the employer because they are required to use actuarial assumptions that result in a higher value of plan liabilities. The annual funding notice must state whether the plan has been determined to be in at-risk status, and must reflect the increased at-risk liabilities due.

Beyond the FTAP, Annual Funding Notices must include important information regarding a DB plan’s assets and liabilities. For example, notices must include a statement of the value of the plan’s assets and liabilities on the same date used to determine the plan’s FTAP. Notices also must include a description of how the plan’s assets are invested as of the last day of the plan year.

Annual Funding Notices must disclose “material effect events,” which are plan amendments, scheduled benefit increases (or reductions) or other known events having a material effect on the plan’s assets and liabilities if the event is taken into account for funding purposes for the first time in the year following the notice year. If an event first becomes known to a plan administrator 120 days or less before the due date of a notice, the plan administrator is not required to explain, or project the effect of, the event in that notice.

Finally, Annual Funding Notices must include a general description of the benefits under the plan that are guaranteed by the PBGC, along with an explanation of the limitations on the guaranteed benefits and the circumstances under which such limitations apply.

Some DB plan sponsors must provide supplements to their plans’ standard Annual Funding Notices if all three of the following circumstances are true:

  1. The funding target is less than 95% of the funding target determined without regard to the adjusted interest rates of MAP-21 and HAFTA, and
  2. There is a funding shortfall greater than $500,000, and
  3. There are 50 or more participants on any day during the preceding plan year. (See supplemental Notice Guidance FAB 2013-01and FAB 2015-01. )

With the information on this supplement, participants will be able to compare the FTAP, funding shortfall in dollars, and minimum required contributions in dollars calculated with the adjusted interest rates of MAP-21/HAFTA and without MAP-21/HAFTA adjusted interest rates for the applicable plan year and the two preceding years. The most conservative approach to evaluating this information from a retirement planning standpoint is to focus on the numbers “without adjustment,” which in recent years have resulted in lower funding levels than calculations made using the MAP-21/HAFTA adjusted interest rates.

Conclusion

The Annual Funding Notice is one of several important retirement plan notifications that should be considered as part of a comprehensive financial planning process. It reveals important information about the overall health of a DB plan, such as how well the plan is funded, assets and liabilities, the plan’s investment policy, business events that may affect the plan and whether the plan is considered at risk.

 

 

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IRC §401(h) Plans

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“Can you tell me what a 401(h) plan is?”

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 plans, including nonqualified plans. 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 California is representative of a common inquiry related to plan types.

Highlights of Discussion

A “401(h) plan” is a retiree medical benefit account that is set up within a defined benefit pension plan[1] to provide for the payment of benefits for sickness, accident, hospitalization and medical expenses for retired employees, their spouses and dependents if the arrangement meets the requirements of Internal Revenue Code Section (IRC §) 401(h)(1) through (h)(6) (see page 1057 of link). A 401(h) account cannot discriminate in favor of officers, shareholders, supervisory employees, or highly compensated employees with respect to coverage or with respect to contributions and benefits.

401(h) plans are appealing because contributions to fund 401(h) benefits are deductible as contributions to a qualified plan; earnings on the account remain taxed deferred; and distributions are tax-free when used for qualified health care expenses. The amount contributed to the 401(h) account may not exceed the total cost of providing the benefits, and the cost must be spread over the future service.

According to Treasury Regulation § 1.401-14(c), a qualified 401(h) account must provide for the following:

  1. Retiree medical benefits must be “subordinate” to the pension benefits;
  2. Retiree medical benefits under the plan must be maintained in a separate account within the pension trust;
  3. For any key employee, a separate account must also be maintained for the benefits payable to that employee (or spouse or dependents) and, generally, medical benefits payable to that employee (or spouse or dependents) may come only from that separate account;
  4. Employer contributions to the account must be reasonable and ascertainable;
  5. All contributions (within the taxable year or thereafter) to the 401(h) account must be used to pay benefits provided under the medical plan and must not be diverted to any purpose other than the providing of such benefits;
  6. The terms of the plan must provide that, upon the satisfaction of all liabilities under the plan to provide the retiree medical benefits, all amounts remaining in the 401(h) account must be returned to the employer.

The subordinate requirement is not satisfied unless the plan provides that the aggregate contributions for retiree medical benefits, when added to the actual contributions for life insurance under the plan, are limited to 25 percent of the total contributions made to the plan (other than contributions to fund past service credits).

Aside from employer and/or employee contributions to a 401(h) account, plan sponsors may make tax-free “qualified transfers” of excess pension assets within their defined benefit plans to related 401(h) accounts. A plan is deemed to have excess assets for this purpose if assets exceed 125 percent[2] of the plan’s liability (IRC §420).  The requirements of a qualified transfer include the following:

  1. The transferred amount can be used to pay medical benefits for either the year of the transfer or the year of transfer and the future transfer period (i.e., a qualified future transfer);
  2. The transferred amount must approximate the amount of medical expenses anticipated for the year of transfer or the year of transfer and future years during the transfer period;
  3. An employer can make only one such transfer in a year;
  4. All accrued benefits of participants in the defined benefit plan must be fully vested; and
  5. The employer must commit to a minimum cost requirement with respect to the medical benefits.

Conclusion

Pension plan sponsors may find 401(h) accounts appealing as one way to provide for the payment of retiree medical benefits. Depending on the terms of the plan, a 401(h) account can receive employer and/or employee contributions as well as transfers of excess pension benefits, provided certain requirements are met. 401(h) account contributions are tax deductible; earnings are tax-deferred; and distributions can be tax free.

[1] Or money purchase pension plan or annuity plan

[2] For qualified future transfers, substitute 120 percent

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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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