IRS Simplifies Rules for Allowing Participants to Take Partial Lump-Sum Distributions
The Internal Revenue Service ("IRS") has issued a final regulation that changes and simplifies the rules for paying a participant his or her benefit partly in the form of an annuity and partly in a more accelerated form, for example a partial lump sum and a life annuity. The new rules go into effect for distributions with annuity starting dates after December 31, 2016, but plan sponsors may put them into effect earlier. The regulation may be found at this link.
Action Needed Now
Sponsors of plans that allow lump-sum or other non-annuity forms of payment for a portion of accrued benefits should review their plans to determine if the provisions of the new regulation apply and make any changes deemed desirable. Sponsors of plans that do not now provide for the partial lump-sum payment of accrued benefits may wish to consider whether to allow payment in such accelerated form.
Prior to the change, the regulations required that if a benefit is paid partly in an annuity form and partly in an accelerated form (such as a lump sum), the value of the entire benefit must be at least equal to the value of the accrued benefit determined using the statutory mortality table and interest rates ("§ 417 rates"). Thus, even if the plan allows a participant to elect to receive 20% of his or her benefit as a lump sum, the current rules require that the annuity benefit be recalculated using the prescribed mortality table and interest rate. The result can be that the participant's annuity benefit may be greater or less than the percentage provided by the plan. For example, if the plan allows a participant to elect payment of 25% of the accrued benefit in a lump sum, a participant with a benefit of $1,000 a month could not simply take $250 as an actuarial equivalent lump-sum value and $750 as a monthly annuity. Instead, the plan would need to determine the remaining annuity using the § 417 rates, which may not be equal to $750.
Policy makers are concerned that participants who cash out their entire benefit may find themselves without adequate income during their retirement years and so decided to make it easier for a plan to allow a retiring participant that desires some immediate cash to retain some of their annuity benefit.
The new regulation permits a plan to bifurcate a participant's benefit and have the present value requirements of § 417(e) apply only to the portion of the benefit that is payable in an accelerated form. The determination of the remaining percentage payable as an annuity depends on how the plan determines the accelerated form.
Accelerated Form Available for a Specified Portion of the Benefit
If a plan explicitly provides that a participant can elect to receive a specified portion (such as a fixed percentage) of the accrued benefit in a lump sum (or other accelerated form subject to § 417(e))1, the lump sum (or other accelerated form) is determined by applying § 417 rates to the specified portion. The remaining annuity is determined as if it was a separate benefit. For example, if a plan provides that a participant is permitted to elect to receive 25% of the accrued benefit in a lump sum. The accrued benefit of $1,600 per month is valued at $200,000 under the statutory present value rules using the applicable interest rate and the applicable mortality table. If the participant elects to receive $400 (25% of $1,600) as a lump sum, the plan pays $50,000 in a lump sum. The remaining annuity is $1,200 per month payable at normal retirement age. The plan can then permit the $1,200 to be paid in some other annuity form over the participant's lifetime using the plan's factors and not the § 417 rates.
Lump Sum Not Determined by Specified Portion of the Benefit
If the plan provides for the distribution of a lump-sum amount by another method, the remaining annuity is determined by converting the lump sum into an annuity form payable at normal retirement using the statutory present value rules. This converted annuity amount is then subtracted from the accrued benefit to determine the remaining annuity payable at normal retirement age. The remaining annuity can then be paid in some other life annuity form determined using the plan's annuity factors and not the § 417 rates. For example, a plan may provide that a participant can receive a lump sum of up to $10,000 with the remaining benefit payable as an annuity. The amount of the lump sum is converted into an equivalent annuity payable at normal retirement age which is then subtracted from the accrued benefit to determine the remaining benefit that can be paid in any life annuity form available under the plan using the plan's factors.
Lump Sum Available for Entire Accrued Benefit
If the plan allows a participant to elect a lump-sum payment of the entire accrued benefit, then a special rule applies if a participant can receive a partial lump sum. Under the special rule, the plan must provide that the portion of the accrued benefit that is settled by the lump sum is determined by multiplying the entire accrued benefit by the ratio of the amount paid as a lump sum to the lump-sum value of the entire accrued benefit calculated using the § 417 rates. For example, if the value of the accrued benefit were $100,000 using the § 417 rates and the participant could elect to receive a partial lump sum of $25,000, the remaining annuity would be 75% of the accrued benefit.
Annuity Determined Under Separate Formulas
Where the accrued benefit is determined under two or more formulas in a plan and the plan allows payment of an accelerated form for a portion of the benefit, the plan must specify which portion of the benefit is subject to accelerated payment in order to avoid the § 417 rates being applicable to the entire accrued benefit. For example, a plan may provide that a participant's accrued benefit is equal the amount accrued prior to a certain date under one formula, plus the amount accrued after that date and that a participant may elect to receive the amount accrued after the specified date in a lump sum. In that case, the § 417 rates will apply only to the benefit accrued after the specified date.
Relief from Anti-cutback Rule
The final regulation provides that the prohibition on amendments that reduce benefits (the "anti-cutback rule") is not violated merely because a plan is amended to determine the portion of a distribution not subject to the § 417 rates using the rules of the final regulation provided the amendment is made by December 31, 2017.
The new regulation can be very helpful when changing benefit formulas or changing a plan to remove forms of benefits for future accruals. For example, a plan could provide for the payment of a lump sum of the accrued benefit as of a specified date (so as to satisfy § 411(d)(6) requirements) but specify that the benefits accrued after that specified date cannot be paid as a lump sum.
Cheiron consultants can assist plan sponsors in evaluating whether and how to amend their plans to reflect the options for partial payment of lump sums available under the final regulation.
Cheiron is an actuarial consulting firm that provides actuarial and consulting advice. However, we are neither attorneys nor accountants. Accordingly, we do not provide legal services or tax advice.
1 An example of another accelerated form subject to § 417(e) is an annuity payable for a term certain period only, such as 10 years.