IRS Proposes Guidance Simplifying Use of Annuities in Retirement Plans

Practical Law Legal Update 3-517-7921 (Approx. 5 pages)

IRS Proposes Guidance Simplifying Use of Annuities in Retirement Plans

by PLC Employee Benefits & Executive Compensation

Purchase of Longevity Annuity Contracts under Tax-Qualified Defined Contribution Plans

The IRS issued proposed regulations relating to the purchase of longevity annuity contracts that would modify the RMD rules under IRC Section 401(a)(9) to allow a participant to use part of his plan account balance to purchase a longevity annuity. A longevity annuity is an income stream that is scheduled to commence at an age in the future and that continues as long as the individual lives, for example, an annuity under which payments begin at age 80 or 85. Currently, IRC Section 401(a)(9) requires that the distribution of a participant's entire interest begin by April 1 of the calendar year following the later of the calendar year in which the participant attains age 70 1/2 or the calendar year in which the participant retires.

Under the proposed regulations, the participant would be able to exclude the value of a longevity annuity contract (that meets certain requirements) from the account balance used to determine RMDs and would only be required to receive RMDs during the period before the annuity begins. Therefore, the annuity contract could be designed with a fixed annuity starting date (ASD) at an advanced age since a participant would not need to commence distribution from the annuity contract to satisfy the RMD rules. These annuity contracts are referred to in the proposed regulations as qualifying longevity annuity contracts (QLACs). The proposed regulations set out numerous requirements for QLACs, including:

Limiting the amount a participant would be permitted to use to purchase a QLAC to the lesser of:
- 25 percent of the participant's account balance; or
- $100,000.
Requiring that the annuity contract provide that distributions commence no later than an ASD that is no later than the first day of the month coincident with or next following the employee's attaining age 85. If the contract provides, a participant would be permitted to elect an earlier ASD.
Requiring that the only benefit to be paid after the employee's death is a life annuity payable to a designated beneficiary that meets certain requirements. If the employee dies before the specified ASD, the date by which benefits must commence to the designated beneficiary depends on whether the beneficiary is the surviving spouse:
- if the sole beneficiary is the surviving spouse, the life annuity is not required to commence until the employee's ASD; or
- if the sole beneficiary is not the surviving spouse, the life annuity must commence by the last day of the calendar year immediately following the calendar year of the employee's death.
Reporting and disclosure requirements for the issuer of the QLAC, including:
- a report furnished to the individual in whose name the contract has been purchased (containing content set out in the proposed regulations); and
- annual reporting requirements, including annual calendar-year reports and statements to individuals in whose name the contract has been purchased regarding the status of the contract (forms and instructions containing a filing deadline and other information will be issued at a later time).

The regulations will not be effective until finalized, and the proposed regulations may not be relied on until final regulations are issued.

The proposed rules are not applicable to:

Roth IRAs, since the RMD rules do not apply to them.
Defined benefit plans, since they already offer annuities which provide longevity protection.

Partial Annuity Distribution Options for Defined Benefit Plans

The IRS also issued proposed regulations that would provide guidance relating to the minimum present value requirements applicable to certain defined benefit plans. Under the current regulations, if a participant elects both a lump sum and annuity distribution, both portions are subject to the minimum present value requirements of IRC Section 417(e)(3), which are statutorily prescribed actuarial assumptions (interest rates and mortality assumptions) for both portions elected.

Under the proposed regulations, if a participant chooses two different distribution options for separate portions of a bifurcated accrued benefit, the two options would be treated as two separate optional forms of benefit for purposes of IRC Section 417(e)(3). This means that the minimum present value requirements would only be applicable to the portion of the distribution paid as a lump sum (rather than to the entire benefit), and the plan could use its usual annuity equivalence factors for the annuity portion (rather than being required to make a special calculation for the annuity portion using the IRC Section 417(e)(3) assumptions).

The regulations will not be effective until finalized.

Annuities in Defined Contribution Plans

The IRS also issued two revenue rulings that clarify how annuities can be offered in defined contribution plans:

Revenue Ruling 2012-3 addresses the 401(k) plan spousal protection rules when an employee chooses a deferred annuity from their plan. Plan sponsors have previously been hesitant to offer certain annuity options in their defined contribution plans due to uncertainty in how these rules would apply to deferred annuities (including longevity annuities). Revenue Ruling 2012-3 describes how the qualified joint and survivor annuity (life annuity to the participant and survivor annuity to his spouse after the participant's death) and qualified pre-retirement survivor annuity (annuity paid to a surviving spouse when a participant dies before receiving benefits) rules apply when a deferred annuity contract is purchased under a profit sharing plan.
Revenue Ruling 2012-4 provides that employees receiving lump-sum distributions from their defined contribution plan can transfer some or all of those amounts to their employer's defined benefit plan (if permitted under the plans' terms) to receive an annuity from the defined benefit plan. The defined benefit plan must convert the single-sum rollover amount to an annuity in an actuarially equivalent manner to the amount the plan received based on the same assumptions that are used to convert annuity benefits to lump sums.

Practical Implications

Employers generally have been hesitant to offer annuities in their defined contribution plans due to regulatory barriers, which increased costs and were administratively burdensome. Overall, this guidance should allow retirement plans to more easily offer their participants annuity options, which will give participants a wider range of choices in how they receive their benefits. It is still unclear whether this guidance will be enough to entice employers to provide for annuities in their defined contribution plans. Comments on both sets of proposed regulations must be received by May 3, 2012.

For more information, see Practice Note, Requirements for Qualified Retirement Plans.

IRS Proposes Guidance Simplifying Use of Annuities in Retirement Plans | Practical Law