Qualified Retirement Plans

To retire in comfort requires careful planning. Longer life spans and ever-present concerns over the future of Social Security retirement benefits are just two of the reasons why clients seek out advice on preparing for retirement.

The Social Security system provides significant retirement benefits for the vast majority of American workers, but it was never intended to be an individual's sole means of support. Recognizing the need for a robust and systematic approach to retirement planning, the IRS provides tax incentives for those employer-sponsored retirement plans that qualify for favorable federal income tax treatment—hence the name qualified retirement plans.

For many, qualified retirement plans are the keystone of sound retirement planning. Qualified plans are broadly categorized into two distinct groups:

Defined benefit plans are designed to pay a promised benefit at a stated retirement date in accordance with a specified formula—in other words, they "define" a certain future benefit. The employer bears the investment risk when it comes to funding the promised benefits.

Defined contribution plans are designed to allow for tax-deferred growth on annual employer and/or employee contributions allocated to individual accounts for the benefit of plan participants—in other words, they "define" certain contributions which will then accumulate over time. The employee bears all investment risk and the ultimate retirement benefit is uncertain.

Click here to see a chart that summarizes the contribution and benefit limits for qualified retirement plans.

Requirements of Qualified Retirement Plans

Before a plan can qualify for tax-favored treatment, the employer must comply with various requirements. For example, the employer must:

meet certain standards regarding minimum participation, coverage, vesting and funding

Certain qualified retirement plans must also provide a qualified joint-and-survivor annuity as a benefit option for married plan participants.

These requirements are drawn from the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA).

Minimum Participation Requirements

Defined benefit pension plans must meet minimum requirements regarding employee participation. Generally, the plan must cover at least 50 employees. If an employer has less than 50 employees, the plan must cover the greater of 40% of all employees, or two employees.

The plan may exclude certain employees. When applying the minimum participation requirements, the employer may omit the following employees:

union members whose retirement benefits have been the subject of good-faith bargaining with the employer.

Minimum Vesting Requirements

All qualified plans must meet minimum vesting standards, which means that the participant's accrued benefits or accrued allocations in the plan must become nonforfeitable (vested) within the time frames prescribed by federal tax law:

The participant must be fully vested in his or her normal retirement benefit at normal retirement age (either the retirement age stated in the plan, or the later of age 65 or the fifth anniversary of the date plan participation began).

The plan may not discontinue benefit or allocation accruals due to the participant's attainment of a specified age.

A participant in a defined contribution plan that is not top-heavy* must become vested in all employer contributions in accordance with one of the following vesting schedules:

a participant is 100% vested after three years of service (the "three-year cliff" schedule), or

a participant is vested gradually over six years of service (the "six-year graded" schedule)—at least 20% vested after two years of service, 40% after three years, 60% after four years, 80% after five years, and 100% after six years.

A participant in a defined benefit plan that is not top-heavy* must acquire nonforfeitable rights to all employer contributions no later than provided under either of the following schedules:

a participant is 100% vested after five years of service (the "five-year cliff" schedule), or

a participant is vested gradually over seven years of service (the "seven-year graded" schedule)—at least 20% vested after three years of service, 40% vested after four years, 60% after five years, 80% after six years, and 100% after seven years of service.

An employer must take an employee's prior service into account when complying with the special vesting requirement for employer matching contributions. A plan’s vesting schedule may be quicker than that required by law.

Section 415 Limits

the "annual additions" (i.e., total dollar amount) that may be contributed to a participant's account in a defined contribution plan (such as a 401(k) plan, 403(b) plan, profit-sharing plan, or money-purchase pension plan), and

the annual benefit that may be provided by a defined benefit pension plan, including a 412(e)(3) plan.

The Section 415 limits are indexed annually for inflation. The following table shows the recent history of these ceilings:

Note: The 415 limit for a defined contribution plan is the lesser of the dollar amount stated above or 100% of the participant's compensation. The 415 limit for a defined benefit plan is the lesser of the dollar amount stated above or 100% of the participant's average highest three consecutive years of compensation. The 415 limit for defined benefit plans is also reduced for employees who have less than 10 years of participation in the plan.

Nondiscrimination Requirements

An employer retirement plan must pass nondiscrimination tests to qualify for federal income tax benefits. The nondiscrimination requirements are very technical, and vary with the type of retirement plan. A detailed discussion is beyond the scope of this service, but in broad terms, the requirements are:

Contributions and benefits may not discriminate in favor of "highly compensated employees," as defined below (although "permitted disparity" rules allow contributions and benefits to be weighted in favor of highly compensated employees to make up for the fact that wages over the Social Security taxable wage base—$118,500, indexed for 2016—are not included in calculating such individuals' Social Security retirement benefits.

The benefits, rights and features provided under the plan must be available to employees in a nondiscriminatory manner.

Past service credits, plan amendments, and plan terminations must be nondiscriminatory.

Highly Compensated Employee

We have noted that a qualified retirement plan may not discriminate in favor of a highly compensated employee. Such a person is defined as someone who:

received compensation of more than $120,000 (indexed amount for 2016) in the preceding year and, if the employer so elects, is a member of the top-paid 20% group of employees.

Top-Heavy Plans

The definition of a top-heavy plan varies slightly depending on the type of plan:

A defined benefit plan is considered "top-heavy" if more than 60% of the present value of all accrued benefits under the plan is for key employees.

A defined contribution plan is considered top-heavy if more than 60% of the value of all account balances under the plan is for key employees.

Whether an individual is a key employee for top-heavy testing purposes is based on the employee's status in the previous plan year only. A key employee is defined as:

an officer of the employer whose compensation exceeded $170,000 (indexed amount for 2016);

an employee who owned (directly or through attribution) more than 5% of the employer, regardless of compensation; or

an employee who owned (directly or through attribution) more than 1% of the employer if the employee's annual compensation exceeded $150,000.

Top-heavy defined contribution plans must make a minimum annual contribution on behalf of all non-key employees of the lesser of (1) 3% of compensation, or (2) the percentage of compensation at which contributions were made for key employees, including employer matching contributions and employee elective deferrals that are treated as employer contributions.

Top-heavy defined benefit plans must provide a minimum annual benefit to all non-key employees of the lesser of (1) 20% of compensation, or (2) 2% of compensation multiplied by the employee's years of service.

All top-heavy plans—both defined benefit and defined contribution—must either vest 100% all at once after three years of service (three-year cliff vesting), or use the six-year graded vesting schedule, gradually phasing in to 100% (20% after two years of service and 20% additional for each of the following four years).

Minimum Funding Requirements

Defined benefit pension plans, money purchase pension plans, and target benefit plans must satisfy minimum funding requirements. [IRC §412 and §430.] A money purchase pension plan satisfies the minimum funding requirements simply by making the contributions required by the plan's contribution formula. The same is true for a target benefit plan when a participant’s age and compensation are taken into account and the plan specifies an interest rate in calculating the employer's minimum periodic contribution to the plan. An excise tax is imposed if the employer fails to meet the minimum funding requirements.

Complying with the minimum funding requirements with regard to defined benefit plans is much more complicated and requires the services of an enrolled actuary. Employers must set up defined benefit plans on an actuarially sound basis that ensures that all benefits are adequately funded. If the plan fails to meet the minimum funding standards, an excise tax is imposed under IRC §4971.

For a brief history of changes to the funding rules under the 2006 Pension Protection Act (PPA), click here.

Qualified Plans Can Have an IRA Feature

Certain employer retirement plans that permit voluntary employee contributions may elect to set up traditional or Roth Individual Retirement Accounts or Annuities to which employees may contribute under the plan. Eligible employer plans include not only qualified plans but also 403(b) and governmental 457(b) plans. Contribution-tracking and separate accounting requirements are imposed on employers and third party administrators (TPAs), which will increase the administrative responsibilities of creating plans with an IRA feature.

Supreme Court Decision in Obergefell v. Hodges—Effects on Retirement Planning

An individual's marital status is of key importance in the administration of numerous employment-related plans and programs. The 1996 Defense of Marriage Act (DOMA) denied federal benefits to married couples of the same sex. However, with the advent of the Supreme Court's decision in Obergefell v. Hodges, 135 S.Ct. 2017 (2015) legalizing same-sex marriage in all 50 states, employers are now required to recognize legally married same-sex couples when providing benefits under employer-sponsored benefit programs.

The Obergefell decision was preceded by United States v. Windsor, 133 St.Ct. 2675 (2013), which struck down certain DOMA provisions. The Windsor decision extended federal rights to same-sex couples, but only with regard to those who married in states where such marriages were legal.

For citations to guidance resulting from Windsor, click here.

To clarify the applicability of Obergefell to employee benefit plans, the IRS published Notice 2015-86 (amplifying Notice 2014-19, which had been published in response to Windsor). Notice 2015-86 provides further guidance to employers in documenting and administering qualified plans and health and welfare plans in light of the need to provide benefits to spouses in same-sex marriages. The IRS comments in the Notice that it does not anticipate that Obergefell will have a significant impact on the application of federal tax law to employee benefit plans.

Benefits for Employers

For employers, reasons for implementing a qualified retirement plan go far beyond securing federal income tax benefits for the business and its employees. Qualified plans can help businesses:

When it comes to attracting and keeping good employees, firms without qualified retirement plans may be at a competitive disadvantage to those with these plans in place.

Federal Income Tax Benefits of Qualified Retirement Plans

Let's take a closer look at the specific federal income tax benefits of qualified retirement plans to see why these plans are so popular among employers and employees in all types of businesses.

Contributions

Employer contributions to a qualified retirement plan are immediately tax-deductible by the employer within prescribed limits. If a plan is nonqualified, employers do not receive current deductions for contributions made to the plan (unless taxed immediately to the employee). Thus, an employer that wants immediate federal income tax deductions for contributions made should consider establishing a qualified retirement plan.

Employer contributions are not currently taxable to plan participants. If an employer makes a contribution to a qualified plan on behalf of a participant, that contribution is not subject to current federal income tax until the money is distributed.

Tax-Deferred Growth

Participants do not pay tax on investment returns until they take the money out as plan distributions. That means more money is left to accumulate, thus potentially accelerating the growth of these funds when compared to a currently taxable funding vehicle. Qualified retirement plans provide the best of both worlds for the participant—no current taxes on contributions (up to specified limits), and no current taxes on earnings. If the qualified retirement plan includes life insurance, the participant must report the taxable economic benefit as income each year.

Defined Benefit Plans

How Defined Benefit Plans Work

As the name implies, a defined benefit plan promises to provide a specified benefit at retirement. The employer bears the responsibility of providing an adequate retirement income based on the benefit promised or the benefit formula utilized.

The administration of a defined benefit plan is quite complex. The employer must engage a licensed actuary to ensure compliance with all funding obligations set forth in the official plan document. In addition, the employer must appoint a designated plan administrator to oversee the administrative details of the plan and monitor the investment performance of the fund. The services of an attorney are not legally required, but generally recommended for purposes of ensuring that the plan and the plan administrator comply with all applicable legal criteria under ERISA and the Internal Revenue Code.

The employer bears the risk that the plan earnings may be insufficient to pay the promised benefits.

There are various options for determining the benefit, including a formula based on the employee’s final pay, meaning the benefit can be higher than if pay were averaged over the entire working career.

Determining the Benefit Amount

Flat Amount Benefit. Each employee receives a flat amount at retirement, without regard to earnings or years of service. This method is most appropriate for groups of employees who have relatively uniform compensation. Everyone who qualifies would receive the same pension benefit at retirement.

Flat Percentage Benefit. Each employee receives a fixed percentage of compensation as a pension benefit, usually without regard to years of service. For example, assume a retirement benefit formula equal to 25% of a participant's average compensation over the three years of highest consecutive earnings. An individual with average compensation of $60,000 would receive a yearly pension benefit of $15,000.

Unit Benefit. Each employee receives a fixed benefit amount per month for each year of completed service. This formula (and the flat amount formula) is most commonly found in union-negotiated or collectively bargained plans. For example, if a unit benefit formula provides for $30 of monthly pension benefit for each year of service, an employee who worked for 10 years would receive a monthly pension of $300.

Unit Benefit Percentage Formula. Each employee receives a fixed percentage of compensation for each year of service or participation. This method is popular with employers who want to reward years of service. For example, assume the benefit formula is 2% of monthly compensation for each year of service. An employee with 20 years of service who earns $2,000/month would have a pension benefit of $800 per month. An employee with 30 years of service who earns $2,000/month would have a monthly pension benefit of $1,200.

Who Uses Defined Benefit Plans

While some larger employers still use defined benefit plans, they often appeal to smaller firms with older, higher paid employees who are owners or shareholders. Defined benefit plans appeal to these firms because the benefit formula can be based on recent compensation levels, largely ignoring time of service requirements for accumulating a sizeable pension benefit, subject to IRS limits. If there is not much time to build a substantial retirement fund for key employees (including owners) and the company has the financial ability to fund the plan, a defined benefit plan is often a good choice.

The benefits in traditional defined benefit plans subject to ERISA are afforded limited protection through the Pension Benefit Guaranty Corporation (PBGC). It is worth noting that many of the changes to the funding limitations under the Pension Protection Act of 2006 (such as those related to benefit increases, lump sum payments, shutdown benefits and the ability to "freeze" ongoing benefit accruals) were designed to prevent employers from dumping the benefit liabilities of a poorly funded plan onto the PBGC.

Benefit Limits

There are limits to the benefit amounts that an employer can provide under a defined benefit plan. The highest annual benefit that can be paid for any limitation year ending in 2016 is the lesser of:

100% of the participant's average compensation for the employee's three highest consecutive calendar years, or

In order to obtain the full maximum benefit, the employee must have 10 years of participation. For 2016, only the first $265,000 of an employee's annual compensation may be taken into account in determining benefits.

Eligible Combined Plans

Professionals and other highly compensated self-employed individuals may find themselves at a point where they would like to increase their retirement savings by an amount greater than the limits of the qualified plan in which they participate. To address this issue, Congress created the eligible combined plan (ECP), which essentially allows small employers (with 2 – 500 employees at the time the plan is established) to combine a defined benefit plan and a 401(k) plan to achieve a significant increase in retirement savings. The plan assets are held in a single trust governed by a single plan document, which results in lower administrative burdens and costs than maintaining two separate qualified plans.

By law, an employer may not add a cash or deferred arrangement (CODA) (whereby a plan participant may choose to defer a portion of salary to an account under the plan or receive cash) to a defined benefit plan, only to certain defined contribution plans (e.g., a profit-sharing or stock bonus plan). However, the ECP is an exception to this rule available only for small employers.

consists of a defined benefit plan and an "applicable" defined contribution plan;

holds the assets in a single trust forming part of the plan and clearly identifies and allocates the assets to the defined benefit plan and the applicable defined contribution plan; and

meets certain benefit, contribution, vesting, and nondiscrimination requirements.

These plans, available under IRC §414(x) since January 1, 2010, are subject to same Internal Revenue Code requirements as other qualified plans. However, if an employer wants to terminate an ECP, the defined benefit and defined contribution portions must be terminated separately.

Benefit Limits and Vesting—Defined Benefit Portion

The defined benefit plan portion of an ECP must provide each participant with a minimum accrued benefit in an amount not less than the "applicable percentage" of a participant’s final average pay. Final average pay is based on the consecutive years (not more than five) during which the participant had the greatest compensation. The applicable percentage is the lesser of:

Service counting rules are the same as those for other qualified plans, except that the plan may not disregard any year of service merely because a participant makes, or fails to make, elective contributions under the qualified cash or deferred arrangement.

A participant must be fully vested in the employer-provided accrued benefit under the defined benefit portion of the plan after three years of service.

Benefit Limits and Vesting—Defined Contribution Portion

Employees must be automatically enrolled in the CODA portion of the 401(k) plan and have 4% of their compensation deferred, unless they opt out or elect a lower contribution amount. A CODA meeting these minimum requirements is treated as meeting the actual deferral percentage test under §401(k) on a safe harbor basis.

The employer must provide a basic matching contribution on employee deferrals in an amount equal to 50% of employees’ elective deferrals up to 4% of pay. Alternative matching rates are allowed as long as each rate is equal to or greater than the basic matching requirement. The rate of matching contributions for highly compensated employees cannot exceed the rate of matching contributions for non-highly compensated employees.

The employer is allowed to make additional nonelective employer contributions, but these cannot be taken into account in determining whether the matching contribution requirements are met.

All participants must be fully vested in matching contributions, including any matching contributions exceeding the requirement. In addition, a participant must become fully vested in any nonelective contributions after completion of three years of service.

Other Benefit and Contribution Requirements

All contributions and benefits, including all rights and features under the plan, must be provided uniformly to all participants. The minimum benefit and contribution requirements cannot be met through applying the permitted disparity rules under IRC §401(l). For more on permitted disparity, click here.

In addition, both the defined benefit and defined contribution portions must meet:

Cash-Balance Pension Plans

A cash-balance pension plan is a special type of defined benefit plan that has features of both a defined benefit plan and a defined contribution plan.

Both younger workers and employers may have concerns regarding traditional defined benefit plans that promise to pay a specific benefit at retirement. Benefit accruals under traditional defined benefit plans are usually backloaded (i.e., faster accruals in later years of service), and thus tend to favor older workers with more years of service. Also, many traditional defined benefit plans do not permit lump-sum payments, so benefits are not portable. Employers (especially public companies) may not like the unpredictable funding obligations of traditional defined benefit plans, and the resulting fluctuations in corporate earnings. Cash-balance pension plans were designed to address these concerns.

A cash-balance pension plan generally credits participants with a percentage of their pay each year, along with interest on these amounts. When participants become entitled to receive benefits under the plan, benefits are normally paid as an annuity. However, cash-balance plans often permit lump-sum payments. This permits benefit portability and faster accruals for certain employees, while also resolving some employers' funding concerns.

Employer contributions are determined actuarially to ensure sufficient funds to provide the benefits promised by the plan, and the employer bears the investment risk. Thus, increases and decreases in the value of the plan's investments will not affect the benefit amounts promised to the participants. As a defined benefit plan, the benefits in cash-balance plans are protected, within certain limitations, through the PBGC.

There has been a significant amount of litigation involving the conversion of traditional defined benefit plans into cash balance plans, with the focus of the litigation being on age discrimination issues because, in some cases, older participants did not fare as well under the cash balance plan as they would have if the defined benefit plan had continued in effect.

The PPA provides that a plan is not treated as violating the prohibition on age discrimination under ERISA, the Internal Revenue Code, or the Age Discrimination in Employment Act (ADEA) if a participant's accrued benefit, as determined as of any date under the terms of the plan, would be equal to or greater than that of any similarly situated, younger individual who is or could be a participant. For this purpose, an individual is similarly situated to a participant if the individual and the participant are (and have always been) identical in every respect (including period of service, compensation, position, date of hire, work history, etc.) except for age.

In addition, the PPA clarifies that cash balance plans are not inherently age discriminatory as long as the benefits are fully vested after three years of service and the interest credits under the plan's formula do not exceed a market rate of return. The PPA provisions for cash balance plans were effective for periods beginning on and after June 29, 2005; however, for a plan that was in existence on June 29, 2005, the interest credit and vesting requirements generally apply to years beginning after December 31, 2007.

Final and proposed regulations on cash-balance plans released in September 2014 clarify what constitutes a permissible interest crediting rate (in determining the market rate of return). The final rules increase the maximum fixed interest credit from 5% to 6%, and for certain bond-based rates, from 4% to 5%.

Defined Contribution Plans

Defined contribution plans allow both employers and employees to make contributions to the plan. The amount of each employee's retirement benefit ultimately depends on the amount of contributions and the investment performance of that particular employee's account, rather than the employer's promise (as in the defined benefit plan).

The employer's contributions are frequently based on a percentage of compensation. The employer's only obligation is to make these contributions if required by the plan; the employee generally bears the risk of investment performance. (With a defined benefit plan, the employer bears this risk.) In fact, defined contribution plans often permit participants to direct the investment of their plan accounts.

Money Purchase Pension Plans

Under this type of defined contribution plan, employer contributions are based on a set percentage of each employee's compensation. The employer is required to make annual contributions, and an employee's ultimate pension benefit is equal to the total employer contributions plus the earnings (or minus any investment losses) on those contributions, and minus any administrative expenses. Under a money purchase plan, an employer is obligated to make annual contributions.

Money purchase pension plans are relatively easy to set up, administer, and explain to employees. Employers favor the predictable costs and the fact that they do not bear the plan's investment risk. Employer contributions to a money purchase plan are deductible, but the deduction is limited to 25% of the total compensation of participating employees.

Profit-Sharing Plans

Profit-sharing plans are similar to money purchase pension plans in that the amount of an employee's retirement benefit depends on the amount in an individual employee's account at retirement. The distinguishing feature of this plan, however, is that the employer is not obligated to make contributions each year, but there must be recurring and substantial contributions.

When designing a profit-sharing plan, the employer has great flexibility in determining how and when it will make contributions. For example, contribution amounts could be:

Not-for-profit organizations can also adopt a "profit-sharing" plan by indicating that profits will not be considered in determining the contribution level.

In addition to identifying a method for determining overall annual contribution amounts, the plan must also have a method for allocating funds to the accounts of individual plan participants. Allocations can be based on total compensation, integration with Social Security, weighted average, comparability, or a point system which considers both compensation and years of service. Employer contributions to a profit-sharing plan are deductible, but the deduction is limited to 25% of the total compensation of participating employees.

Employers can manage the cost through a contribution formula that is based on profitability or at the discretion of the board of directors.

the desire to utilize the concept of defined contributions without being obligated to a specific contribution in lean income years.

Savings or Thrift Plans

Employee savings or thrift plans are a form of defined contribution plan that may require mandatory employee contributions as a condition of plan participation. The employer matches the employee contributions under a formula specified in the plan. For example, the employer may contribute 50 cents for each dollar contributed by the employee up to a stated cap (e.g.,3% of compensation). The employee may be permitted to make contributions over the maximum that the employer will match (i.e., over 6% of compensation in our example). Because the employee contributions are made with after-tax dollars, thrift plans have largely been supplanted by 401(k) plans, which allow employees to make before-tax contributions.

Savings or thrift plans are typically set up by employers who want to provide a retirement plan for employees but at a modest cost to the employer. Such plans can be set up as a money purchase pension plan or a profit-sharing plan. Sometimes a thrift plan supplements another retirement plan of the employer.

Employee contributions to a thrift plan are not deductible, but employer contributions are not taxed currently to the employee, and all funds in the plan accumulate on a tax-deferred basis.

Employee Stock Ownership Plans (ESOPs)

An employee stock ownership plan (ESOP) is a special type of defined contribution plan in which the plan assets are invested primarily in employer securities. The employer's contribution deduction is generally limited to 25% of covered annual compensation.

A basic advantage of the ESOP is that the employer makes its contributions in cash or employer securities. In other words, an employer that is strapped for cash in a particular year can make its contribution in the form of securities and still enjoy the tax deduction. As in the case of a profit-sharing plan, the employer is not required to make an annual contribution unless the ESOP has borrowed to acquire employer securities. If the employer does borrow to purchase the securities, the interest paid on the loan is deductible.

Dividends paid on employer securities held by an ESOP are deductible by the employer. Cash dividends received by participants are taxable distributions.

When employees leave the company, they receive their vested interest in the ESOP. Depending on the plan terms, the distribution may be made in cash or the employee may demand employer securities. If the securities are not readily tradable in an established market, the employee has a right to sell the securities to the company at fair market value.

An ESOP, by definition, is limited to corporations, including S corporations. However, certain of the special tax benefits that are available in the case of ESOPs established by C corporations are not available to S corporation ESOPs. For example, the interest paid on an ESOP loan is included in the overall deduction limitation of 25% of compensation, resulting in less of a deduction. Furthermore, there is no deduction for dividends paid on employer securities held in the ESOP. And finally, the special rule that allows sellers of shares of stock to defer recognition of the gain on such sale if certain requirements are met does not apply to ESOPs maintained by an S corporation.

The IRS has ruled privately that a limited liability company (LLC) can establish an employee stock ownership plan (ESOP) without first converting to a C or S corporation in order to have the "qualifying employer securities" defined under IRC §4975(e)(8) necessary to adopt an ESOP. [See PLR 201538021.] This private letter ruling allowed an LLC to establish an ESOP under the following conditions, once the LLC elected to be taxed as a corporation:

Ownership interests are expressed in the form of "unit shares" with identical voting, dividend and liquidation rights, each share equal in voting/dividend power to the employer stock having the greatest such powers.

Dividends on the unit shares are paid in proportion to the outstanding unit shares.

Profits and losses are allocated in proportion to the number of unit shares held by each shareholder.

As with all private letter rulings, a particular PLR applies only to the facts presented by the taxpayer requesting the ruling, so before adopting an ESOP, an LLC should be strongly encouraged to apply for its own PLR.

ERISA imposes significant penalties on plan sponsors who fail in their fiduciary responsibilities to adequately diversify qualified plan investments or who make imprudent or inappropriate investment decisions. One appeal of the ESOP is that its contributions are intended to be invested primarily in employer securities, without the need of satisfying ERISA diversification or prudence requirements with respect to investments. However, "qualified participants" (i.e., those with 10 years of plan participation and who have reached age 55) must be allowed to diversify up to 25% of their accounts during the 6-plan-year period beginning on the date they first become qualified participants. In the last year of that 6-plan-year period, qualified participants must be allowed to diversify up to 50% of their accounts.

The Pension Protection Act added certain additional investment diversification requirements to ESOPs that hold publicly traded employer securities. Participants holding such securities are allowed to diversify pre-tax elective deferrals and any associated matching employer contributions out of publicly traded employer securities and into other investments with materially different risk and return characteristics. Participants with more than three years of service (and their beneficiaries) are allowed to diversify other employer contributions out of employer securities as well.

With respect to employer matching and nonelective contributions (and earnings thereon) that are invested in employer securities that (1) consist of preferred stock, and (2) are held within an ESOP, under the terms of which the value of the preferred stock is subject to a guaranteed minimum, the diversification requirements apply to such preferred stock for plan years beginning after the first date as of which the actual value of the preferred stock equals or exceeds the guaranteed minimum.

Target Benefit Plans

While it is classified as a defined contribution plan for federal income tax purposes, a target benefit plan is really a hybrid between a defined benefit plan and a money purchase pension plan. It is similar to a defined benefit plan because the annual employer contribution is initially based on the amount required to accumulate a fund that will pay a target benefit at the employee's normal retirement age utilizing an assumed interest rate. In addition, a target benefit plan can take into account a participant’s age and service when calculating benefits. These predetermined actuarial assumptions determine the ongoing contribution an employer must make annually to provide the "targeted benefit" amount specified under the terms of the plan.

After each contribution is determined, the target benefit plan is similar to a money purchase pension plan. As with all defined contribution plans, the employee bears the investment risk and the success of the plan is based on investment performance. There is no guarantee the employee will attain the target benefit. Conversely, the retirement benefit provided could exceed the target benefit if actual earnings exceed the interest rate assumed in determining contributions.

Target benefit plans are popular among many types of companies, but they are especially attractive when a company has not had a plan in place and wants to provide retirement benefits for older, well-paid employees. The structure of the target benefit plan allows the employer to make higher contributions for these employees in order to provide the desired retirement benefit in a relatively short period of time, subject to IRS limits.

Contribution Limits for Defined Contribution Plans

Money purchase pension plans, profit sharing plans, and target benefit plans—all have the same general limitations regarding annual additions on behalf of individual employees. The annual additions may not exceed, for the limitation year beginning in 2016, the lesser of $53,000 or 100% of compensation.

Defined Benefit vs. Defined Contribution

Both defined benefit and defined contribution plans have the same ultimate objective: providing retirement funds for employees. Defined benefit plans are more expensive for the employer, since they require the services of an enrolled actuary and regular administrative attention. Moreover, the employer bears the investment risk—if investments do not perform well, the employer is obligated to increase contributions in order to reach the defined benefit objective.

Defined contribution plans are often simpler and more economical, and pose less of a risk to the plan sponsor. One of the employer's obligations is to make the annual contribution under the terms specified in the plan. The employer also has other obligations in its role as plan fiduciary. The employee bears the investment risk and generally has control over the investment account.

Note that defined contribution plans that invest in publicly traded employer securities must provide participants the right to diversify their accounts and lower the risk of being "over-invested" in employer stock. So, participants have the right to immediately diversify out of employer securities for the portion of their accounts attributable to employee contributions and elective deferrals. Amounts attributable to employer contributions can be diversified out of employer securities after the participant has completed three years of service. These provisions do not apply to ESOPs that do not accept any employee after-tax or elective deferral contributions.

While there are no hard and fast rules for determining which type of plan is best for a business, you should be aware of these distinctions. In addition, keep in mind that a defined benefit plan is usually the best tool for developing a substantial retirement benefit in a short period of time.

Finally, you should be aware that employers providing defined benefit plans must pay the premiums required to be insured by the Pension Benefit Guaranty Corporation (PBGC), a wholly owned government corporation which oversees pension funds. Thus, most defined benefit plans have insurance to protect or guarantee certain employee benefits. Defined contribution plans are not insured by PBGC.

Fully Insured Plans–Section 412(e)(3) Plans

During the 1980s and 1990s, a combination of statutory changes and regulatory/compliance burdens made defined benefit plans increasingly less popular. The net effect of these changes was to:

Some of these problems related to the intricacies of the minimum funding standards of IRC Sec. 412. For example, the "full funding limitation" restricted the amount that employers could contribute and deduct. Many employers opted to avoid the necessity of complying with the minimum funding limitation by adopting a defined benefit plan known today as an IRC §412(e)(3) plan. These plans are fully funded solely through insurance products and are subject to fewer funding rules, including the full funding limitation.

Section 412(e)(3) Plans Defined

Plan benefits are funded entirely by individual annuity contracts or a combination of annuity and life insurance contracts issued by an insurance company (i.e., a fully insured plan).

The contracts must provide for level annual premiums that begin when an employee becomes a plan participant and end no later than the employee's retirement age under the plan.

The plan benefits must be equal to the benefits provided under each contract at the plan's normal retirement age, and must be guaranteed by an insurance company to the extent premiums have been paid.

All premiums due on these contracts are paid for the current plan year and for all prior plan years.

Rights under these contracts are not subject to a security interest at any time during the plan year.

No policy loans against these contracts are outstanding at any time during the plan year.

Advantages

Section 412(e)(3) plans are attractive for many reasons, including the following:

There is no full funding limitation or current liability test to limit the employer's deduction, thus making larger contribution deductions possible.

Due to the insurer's rates used in 412(e)(3) plans, the contributions (and, therefore, tax deductions) available for older owner-employees can be significantly higher.

With increased funding, larger benefit payouts are likely at retirement, subject to IRS limits.

If death occurs before retirement, a portion of the beneficiaries' death benefit is income tax free rather than fully taxable (as is the account value typical in other retirement plans).

Plan assumptions are not subject to attack, since they coincide with the guarantees in the insurance contracts.

Disadvantages

limited appeal outside small and/or family corporations, where large allocations can be made to the accrued benefits of the owner(s).

IRS Response to "Abuses" in Fully Insured Plans

In the early 2000s, the IRS identified what it characterized as "abuses" in §412(e)(3) plans (formerly 412(i) plans). One of these abuses was the claim by some promoters that the plan could be used to generate high tax deductions for employer contributions, with little taxation of employees on retirement distributions or death benefits. This was supposedly accomplished by the use of "springing cash value" policies in which the cash values are artificially depressed at the time a policy is distributed out of the plan to a participant. After the policy distribution, the cash value increases to a more normal amount. The result was that participants recognized little income even though employers had taken large tax deductions while the policy was held inside the plan.

To address this abuse (and others), the IRS released proposed regulations in February 2004, along with revenue rulings and one revenue procedure. The IRS issued final regulations in August 2005.

For more detail on IRS regulatory activity designed to curb §412(i) plan abuses, click here.

Section 401(k) Plans

An IRC §401(k) plan is a well-established type of employer-sponsored retirement plan. It is a qualified defined contribution plan containing a "cash or deferred arrangement" (CODA), which allows plan participants to defer a portion of their salary on a tax-deferred basis. These "elective deferrals" are contributed to the accounts of employees who choose to participate.

The Appeal of 401(k) Plans

Elective deferrals (except Roth deferrals) are not included in the employee's taxable income, which means contributions are made with before-tax dollars.

Distributions from the plan may be made in a lump sum or annuitized and are taxed as ordinary income.

Salary Deferral and Catch-up Limits

The annual limit on elective salary deferrals into a 401(k) plan is set forth under IRC §402(g) and the additional "catch-up" contribution permitted for participants age 50 and over is set forth under IRC §414(v). These are the limits for the past three years:

The annual limits apply to participation in all cash or deferred arrangements and may be reduced by an individual's elective deferrals to a 403(b) plan, SIMPLE IRA, or SIMPLE 401(k).

A plan is not required to allow additional catch-up contributions by participants age 50 and over. A participant is deemed to be age 50 for a particular year if the participant turns 50 during that year.

Many employers elect to match all or a portion of the amount deferred by each participant. Thus, the amount actually deposited on behalf of an employee can exceed the dollar limit mentioned above. However, the combination of elective deferrals, employer matching contributions, additional employer profit-sharing contributions, and forfeitures contributed on behalf of any employee cannot exceed the IRC §415(c) limit ($53,000 for 2016) applicable to all defined contribution plans.

Employers cannot compel 401(k) participants to put more than 10% of their elective salary deferrals into stock of the employer. The participants can, however, exceed the 10% limit voluntarily.

Roth Deferrals

An employer may (but is not required to) include a provision within a 401(k) plan that allows participants to designate all or part of their elective salary deferrals as Roth contributions.

Roth deferrals are taxed immediately to the participant, but the deferral amounts and the earnings on them are distributed federal income tax free, provided the distribution occurs:

at least five years after the participant began making Roth deferrals to the plan, and

after the participant reaches age 59½, or following the participant's death or disability.

The employer's 401(k) plan must specifically authorize Roth deferrals, but cannot offer only Roth deferrals.

The participant must irrevocably designate the deferral as a Roth contribution on the election form.

The employer must report the Roth contribution as W-2 wages, just as if the employee had received the amount in cash.

No contributions other than designated Roth deferrals and rollover Roth contributions may be allocated to a Roth account (e.g., matching contributions may not be allocated to a Roth account).

Roth deferrals are counted with traditional (excludable) deferrals in applying 401(k) nondiscrimination testing. They are also aggregated with traditional deferrals in applying the annual elective deferral limits under IRC §§402(g) and 414(v) as well as the overall defined contribution limit under IRC §415(c). Participants can designate part of their overall deferral as a Roth contribution and the balance as a traditional deferral.

Roth deferrals are available to all participants regardless of income level (unlike Roth IRAs). An employer may amend a 401(k), 403(b), or 457(b) governmental plan to allow in-service employees to roll over amounts from their traditional accounts to their designated employer Roth accounts in taxable transfers within the 401(k) plan, even if the employees are under age 59½.

A 401(k) participant can designate deferrals as Roth deferrals regardless of AGI, whereas individuals cannot make Roth IRA contributions at higher levels of AGI.

Lifetime distributions from Roth deferral accounts are subject to the required minimum distribution (RMD or age 70½) rules, whereas lifetime distributions from Roth IRAs are not.

Distributions from Roth deferral accounts are taxed under the Section 72 annuity rules, whereas Roth IRA distributions are subject to special statutory ordering rules [IRC §408A(d)(4)].

How 401(k) Plans Work

When a 401(k) plan is in place, the employee elects the amount of compensation to contribute to the plan (subject to the limitations already discussed). The employer also makes a contribution (if the employer provides matching funds). In effect, three significant things happen:

The employee invests with pre-tax dollars. For someone in the 28% income tax bracket, every $1,000 of deferred income represents $280 in current federal income tax savings, and that $280 can be put to work in a retirement account.

The employer receives a tax deduction for contributions made to the plan—both the deferred amount and any matching contributions, within prescribed limits.

The employee defers income tax on any growth within the plan, allowing a potentially greater accumulation than would be possible under currently taxable investments.

Nondiscrimination Rules

In addition to the requirements of all qualified plans, a 401(k) plan must meet certain other nondiscrimination requirements:

Distributions cannot be made based on the completion of a stated period of plan participation or a fixed period of time.

Contributions on behalf of highly compensated employees may not exceed specified limitations based on the contributions made on behalf of non-highly compensated employees. Deferrals by highly compensated employees are limited by the average deferrals of non-highly compensated employees, and employer matching contribution rules must apply uniformly to all employees.

Note: The PPA affected the distribution rules otherwise applicable to 401(k) plans in the following respects:

Older workers. Code Section 401(a)(36) permits distributions to employees who have reached age 62 but who have not yet separated from employment at the time of the distribution, but only if the plan document allows such distributions.

Military. "Qualified reservist distributions" of elective deferrals only are allowed for participants who are reservists and who are called to active duty after September 11, 2001, for a period in excess of 179 days (or for an indefinite period). Distributions must be made during the period beginning on the date of the call to duty and ending at the close of the active duty period. The qualified reservist distribution is not subject to the 10% penalty tax on premature distributions from qualified plans. See Notice 2010-15 for more details.

Individual 401(k) Plan

An individual 401(k) plan permits a business owner without eligible employees to create and operate a 401(k) plan solely for his or her own benefit (or for a spouse). If the business has employees who are excludable from the plan (i.e., seasonal or temporary workers, employees under age 21, union employees or nonresident aliens), the owner may still have an individual 401(k) plan.

Advantages

Save for retirement at higher contribution levels than other defined contribution plans currently available.

Save up to 25% of their annual compensation as a discretionary, tax-deductible, employer contribution.

Make pre-tax salary deferral contributions as an employee of the business of up to $18,000 in 2016 (individuals age 50 or older may be eligible to make an additional catch-up contribution of up to $6,000 in 2016, for a total of $24,000). Total contributions in 2016, including employer and deferral contributions, are limited to the lesser of $53,000 or 100% of compensation.

Typically pay less in administrative expenses (since an individual 401(k) is designed for owner-only businesses, there is not the same level of complexity compared to a traditional 401(k) covering employees).

Access a broad array of investment options (depending on the restrictions imposed by the plan document or investment provider).

Roll over existing 401(k), traditional IRA, SEP-IRA, SIMPLE IRA, qualified plans or Keoghs, 403(b) and governmental 457 assets into an individual 401(k)—the management of retirement savings may be easier and distributions less complicated when all assets are under one plan.

Complete less paperwork than is required for a traditional 401(k) and avoid the necessity of performing complex nondiscrimination tests.

Establishing and Maintaining an Individual 401(k)

An individual 401(k) plan requires a plan document, recordkeeping, and administration. In addition, the plan must remain compliant with law changes. A self-employed business owner may decide to take on some of the tasks of maintaining the plan. However, most business owners seek the help of various financial services professionals—attorneys, CPAs, third party administrators and investment providers.

In addition to ongoing plan administration, the plan must annually file an IRS Form 5500 to account for contributions and activity. IRS Form 5500 must be filed for individual 401(k) plans once the plan's asset balance is greater than $100,000.

Drawbacks

Business owners should consider the appropriateness of this plan if they anticipate hiring eligible employees in the near term. If the business adds an eligible employee who is not the owner's spouse, the individual 401(k) plan must convert to a traditional 401(k) plan. Upon conversion, the 401(k) plan will be subject to anti-discrimination tests and other rules and restrictions that may effectively reduce the contribution limits of the self-employed business owner.

Keogh Plans

A Keogh plan is a qualified retirement plan maintained by a sole proprietor or partnership. The name "Keogh" (for former Congressman Eugene Keogh) has persisted, despite its more formal introduction as an "HR-10 Plan" (after the number assigned to an early version of the enabling legislation). Keogh plans have largely fallen out of favor due to the proliferation of plans for self-employed individuals and smaller organizations that are far easier to establish and administer, such as SEP-IRAs.

The Tax Reform Act of 1986 standardized qualification requirements for many employer-sponsored plans, meaning that in general, Keogh plans are now subject to the same requirements and limitations as any other qualified retirement plan, and receive the same favorable federal income tax treatment. However, self-employed individuals who are "owner-employees" cannot participate in a Keogh plan unless they provide coverage for essentially all full-time employees. An owner-employee is defined as either:

A Keogh plan must be either a defined benefit plan or a defined contribution plan. The applicable contribution or benefit limits generally applicable to qualified plans also apply to Keogh plans. An employer choosing a defined benefit plan will require the services of an enrolled actuary to determine the amount of the allowable contributions and benefits for owner-employees. This plus the extensive paperwork required (including annual filing of IRS Form 5500) is why today, Keoghs are rarely advised for self-employed individuals.

Summary of the Different Qualified Retirement Plans

Defined Benefit Plan

Employers provide a specified retirement benefit and bear the investment risk. Annual employer contributions must be determined by an enrolled actuary.

Defined Contribution Plan

Participants set aside funds to individual accounts based on the plan's written contribution requirements and bear all investment risk. Employers are generally committed only to making annual contributions called for under the terms of the plan. Defined contribution plans are often easier to administer than defined benefit plans.

Money Purchase Pension Plan

A defined contribution plan under which employers make annual contributions based on an established contribution formula (typically a set percentage of the employee's compensation).

Profit Sharing Plan

A defined contribution plan under which employers base contributions on profits or income, or a determination by a governing body such as the board of directors. The employer is not necessarily obligated to make annual contributions, but contributions must be recurring and substantial.

Employee Stock Ownership Plan (ESOP)

A defined contribution plan in which plan assets are invested primarily in securities of the employer corporation.

Target Benefit Plan

A cross between a defined benefit and a money purchase pension plan. Employers base contributions on a target benefit formula established at the plan's inception, which includes an assumed earnings rate. Because the contribution formula is not adjusted in subsequent years to reflect actual plan earnings, the employee bears all investment risk. Contributions are allocated to separate accounts maintained for each participant.

Section 412(e)(3) Plan

A defined benefit pension plan funded entirely by annuity contracts or a combination of annuity and life insurance contracts.

Section 401(k) Plan

A defined contribution plan under which employees or self-employed individuals can make elective deferrals to the plan. Employers may make matching contributions.

Individual 401(k) Plan

A defined contribution plan under which a business owner without eligible employees can make elective deferrals to the plan, as described above, but solely for his or her own benefit (or for a spouse).

Keogh Plan

A qualified retirement plan maintained by a self-employed person or partnership. Keogh plans may be defined benefit or defined contribution plans.

Two types of plans that are technically not qualified retirement plans also deserve mention:

Simplified Employee Pension (SEP) Plan

A special type of employer retirement plan under which the employer makes contributions to each participant’s separate individual retirement account (IRA), reducing plan administration, recordkeeping, and reporting. Click here for information on SEP plans.

SIMPLE Retirement Plan

Life Insurance and Qualified Retirement Plans

Where Life Insurance Fits

Life insurance fits into the qualified retirement planning picture in one of two ways:

(1) Fully insured plans (i.e., 412(e)(3) defined benefit plans) use plan contributions to purchase annuity contracts only or a combination of life insurance policies and annuity contracts for the express purpose of accumulating retirement funds.

(2) Split-funded plans use life insurance to fund part of the retirement benefits, and a trustee-managed investment account to fund the rest.

Split-funded plans are more common than fully insured plans because they provide two distinct benefits: life insurance protection and a flexible investment fund. However, it is worth noting that a fully insured 412(e)(3) defined benefit plan may be exempt from funding standards and regulations applicable to other qualified plans, making them particularly attractive to some employers.

The Incidental Tests

There are limits to the amount of life insurance a qualified retirement plan can purchase on behalf of a participant. Under a defined benefit plan, the face amount of insurance generally cannot exceed 100 times the participant's projected monthly retirement benefit. Under a defined contribution plan, life insurance coverage can be purchased if less than 50% of the employer's contribution on behalf of the participant is used to purchase whole life insurance, or no more than 25% of the employer contribution is used to purchase term or universal life insurance.

When insurance is purchased inside a qualified plan, the covered participant must report as income the taxable cost of the coverage. The participant must generally value the current life insurance protection provided under a qualified plan using Table 2001. If the insurance company's published one-year term insurance rates are lower than Table 2001 rates, the participant can use the company's own rates to determine the taxable income amount each year, provided the insurer makes the availability of such rates known, and regularly sells term insurance policies at such rates.

Transfers of Policies from Qualified Plans

ERISA generally prohibits the sale of qualified plan assets to a "party-in-interest." Any employee of the sponsoring employer, not just an owner-employee, is a party-in-interest. In the absence of a special exemption, any sale of a life insurance policy by the plan to an employee would trigger the prohibited transaction penalty.

Prohibited Transaction Exemption (PTE) 92-6 specifically permits sales of life insurance and annuity contracts between ERISA-covered plans and plan participants, certain relatives, employers, and other plans, provided certain conditions are met. The Department of Labor has expanded this exemption to include sales to life insurance trusts and certain other personal trusts of participating employees.

Although PTE 92-6 refers to "individual life" policies, the DOL has indicated that sales of second-to-die policies that cover a spouse of the participant are also covered by PTE 92-6 [DOL Advisory Opinion 98-07A]. The status of second-to-die policies covering a non-spouse is unclear.

Taxation of Qualified Plan Distributions

As a general rule, distributions from a qualified plan are included in the recipient’s gross income and taxed under the annuity rules. If the participant has a basis in the distribution (which usually means the participant made after-tax contributions to the plan) the portion of any distribution which is attributable to that basis is not taxed. Any costs paid by a common-law (rank-and-file) employee toward the economic benefit of life insurance coverage provided by the plan can be recovered tax-free from benefits paid under the plan [Reg. Sec. 1.72-16(b)(4)]. Self-employed individuals with life insurance in their plan cannot use the taxable economic benefit to add to their basis.

Annuity Payments

Qualified retirement plans must state the normal form of benefit under the plan. A qualified joint-and-survivor annuity (QJSA) must be the normal form of benefit paid to married participants by all plans that are required to satisfy minimum funding standards (i.e., defined benefit, money purchase and target benefit plans). However, subject to certain exceptions, a married participant may elect a form of benefit other than a qualified joint-and-survivor annuity with the spouse's written permission.

In addition, all plans that pay benefits in the form of a QJSA are further required to offer a "qualified optional survivor annuity" (QOSA). If the survivor annuity provided by the QJSA under the plan is less than 75% of the annuity payable during the joint lives of the participant and spouse, the QOSA annuity percentage must be 75%. If the survivor annuity provided by the QJSA under the plan is greater than or equal to 75% of the annuity payable during the joint lives of the participant and spouse, the QOSA annuity percentage must be 50%.

Distributions under a qualified retirement plan must meet the minimum distribution requirements established under IRS guidelines. These rules exist so that tax authorities can harvest taxes from previously untaxed resources, as qualified plans provide a way to defer taxes, not avoid them entirely. This government policy is intended to discourage an unlimited delay of taxation of these funds.

a period certain which does not extend beyond the life expectancy of the participant or the joint life expectancies of the participant and his or her beneficiary.

Payments under a plan may increase if they are directly tied to a designated cost of living index. A variable annuity can also be used as a distribution mechanism, which means payment amounts will fluctuate.

The Section 72 annuity taxation rules generally provide for a tax-free recovery of the cost basis on a pro-rata basis over the expected payout period. Once the participant has fully recovered his or her basis (i.e., upon the attainment of life expectancy), the remaining payments are fully taxable as ordinary income.

Lump-Sum Distributions

A lump-sum distribution is also taxed under the annuity rules. Most lump sums will be taxed as ordinary income since a participant will have no basis in the distribution.

Employer Securities

An employer that maintains a qualified retirement plan may contribute its own securities to the plan, which are then allocated to employees' accounts. If such employer securities are included as part of a lump-sum distribution, the "net unrealized appreciation" (NUA) in the securities is excluded from the participant's (or beneficiary's) gross income, unless the employee elects out of this treatment. The remaining value of the stock is taxable in accordance with the general rules applicable to lump-sum distributions.

For the purpose of determining the NUA on a distributed employer security, the basis of such security is computed in accordance with the rules in Reg. §1.402(a)-1(b)(2)(ii).

The exclusion is also available if the plan acquired employer securities with nondeductible employee contributions rather than employer contributions [IRC §402(e)(4)(B)]. If employer securities are distributed in a manner other than a lump-sum distribution, the net unrealized appreciation is excludable only to the extent acquired with nondeductible employee contributions [IRC §402(e)(4)(A)].

The NUA excluded at the time of the plan distribution is subject to tax when the recipient sells the securities. Gain (or loss) is determined by the difference between the amount realized upon the sale of the securities and the amount taxable at the time of the plan distribution related to those securities.

Any gain attributable to NUA is taxed as long-term capital gain, regardless of how long the employee held the securities. Any gain after distribution (in excess of the value at time of distribution) is long-term or short-term, depending on how long the employee held the securities.

A participant who has appreciated employer securities in a qualified plan should consult with tax advisers before taking a distribution. Failure to take a lump-sum distribution is fatal to the NUA exclusion. Remember also, if the participant rolls employer securities over into an IRA, distributions from IRAs are generally taxed as ordinary income, so the individual would stand to forfeit the special tax treatment of NUA on the employer securities. Participants should make informed choices before taking distributions.

10% Federal Income Tax on Early Distributions

Distributions from a qualified retirement plan are not only subject to the regular federal income tax, but also to a premature distribution tax if made before the employee reaches age 59½, unless an IRC §72(t) exception applies. The penalty tax is a flat 10% of the taxable amount distributed.

In addition to the age-59½ safe harbor, the 10% tax does not apply to distributions that are:

made to a beneficiary (or to the employee's estate) following the death of the employee;

made following the disability of the participant only—not a spouse's or child's disability (disability is defined for this purpose as the owner's inability to "engage in any substantial gainful activity by reason of a medically determined physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration") [IRC §72(m)(7)];

part of a series of substantially equal periodic payments made not less frequently than annually, for the life (or life expectancy) of the employee or for the joint lives (or joint life expectancies) of the employee and the designated beneficiary;

transferred directly or properly rolled over within the 60-day rollover period, so that the distribution is not subject to the regular income tax;

made following the employee's separation from the service of the employer maintaining the plan after reaching age 55 (employer plans only; does not apply to IRAs);

made following a "qualified public safety employee's" separation from the service of the employer maintaining the plan after reaching age 50 (employer plans only; does not apply to IRAs);*

taken to pay deductible medical expenses of the participant or a family member and do not exceed the amount deductible under IRC Sec. 213—i.e., only those medical expenses paid out-of-pocket and not covered by insurance that exceed 10% of adjusted gross income (7.5% for taxpayers 65 and over from 2013-2016);

made pursuant to a qualified domestic relations order from the employer retirement plan of one divorcing or separating spouse to the other spouse; or

considered "qualified reservist distributions," which are distributions from an individual retirement plan or from amounts attributable to pre-tax salary deferrals from a qualified plan or 403(b) annuity if the individual receiving the distributions was called to active duty after September 11, 2001, for a period in excess of 179 days.

*For purposes of this exception, a "qualified public safety employee" is one who participates in a governmental plan, whether a defined benefit or defined contribution plan, and includes employees whose duties include services requiring specialized training (e.g., police protection, firefighting services, or emergency medical services) for any area within the jurisdiction of the State or the political subdivision of the State. That definition includes specified federal law enforcement officers, customs and border protection officers, federal firefighters, nuclear materials couriers and air traffic controllers.

Remember that a participant who satisfies one of these exceptions only avoids the 10% penalty on premature distributions, not the applicable income tax on the distribution.

Caution: The preceding list of exceptions to the 10% premature distribution penalty applies only to qualified retirement plans. A different but similar list of exceptions applies to IRAs. Click here to jump to the exceptions for IRAs.

Phased Retirement Distributions

Under IRS regulations, a pension plan must exist primarily to pay benefits after retirement [Reg. §1.401-1(b)]. However, some employers allow employees to phase into retirement with a reduced work week. When the employer maintains a defined benefit pension plan or a money purchase pension plan, the question arises whether the plan can begin to pay a portion of the retirement benefit to supplement the reduced wages of such employees.

The IRS has issued proposed regulations that permit pension plans to pay a pro rata portion of a partially retired employee's accrued benefit under the plan when certain requirements are met [Prop. Reg. §§1.401(a)-1(b)(1); 1.401(a)-3]. Some of the key requirements in the proposed regulations are:

The employer must have a written program offering the phased retirement option to employees, but not before they reach age 59½.

The maximum payment from the plan must be no more than a portion of the accrued benefit proportionate to the reduction in work.

The employee must continue to accrue benefits under the plan during the phased retirement proportionate to the employee's hours of work.

The proposed regulations apply to defined benefit pension plans and money purchase pension plans, but not to defined contribution plans that are not subject to minimum funding standards.

The PPA added Code Section 401(a)(36) and amended ERISA Section 3(2), which provides that a trust forming part of a pension plan may not be treated as failing to constitute a qualified trust solely because the plan provides that a distribution may be made from such trust to an employee who has attained age 62 and who is not separated from employment at the time of such distribution.

Required Minimum Distributions

To ensure that retirement accounts are not merely vehicles used to transfer assets to heirs, thereby avoiding income and estate taxes, IRS rules require that participants must withdraw specified minimum amounts each year. In this way, the government "harvests" taxes that participants avoided through pre-tax contributions and tax-deferred growth during the accumulation phase of their retirement saving.

These required minimum distribution (RMD) rules apply to traditional IRAs and qualified defined contribution plans including profit sharing, money purchase, 401(k), and 403(b) plans. For convenience, we will use "account owner" or simply "owner" to refer to both individual account owners in qualified defined contribution plans and owners of traditional IRAs.

The Age 70½ Requirement

Participants in qualified retirement plans, SEP-IRAs, SIMPLE IRAs, and traditional IRAs (but not Roth IRAs) may not accumulate tax-deferred earnings indefinitely. Eventually, they must begin to take required minimum distributions (RMDs) or suffer a heavy penalty tax. RMDs are included in the recipient’s gross income (with tax-free recovery of basis, if any) as paid out.

Required Beginning Date

The required beginning date (RBD) is April 1 of the year following the year in which the account owner attains age 70½. This is the latest date on which the owner can take the first RMD from the account without a penalty tax.

For example, if the owner reaches age 70½ on August 20, 2015, the latest date for the 2015 distribution is April 1, 2016. By waiting until the RBD, the owner has two distributions in 2016—the 2015 distribution by April 1 and the 2016 distribution by December 31. Depending on the situation, it may be better tax planning to take the 2015 distribution by December 31, 2015. The owner will need to take future RMDs by December 31 of each new tax year to avoid the excise tax.

However, an account owner may delay the RBD until April 1 of the year following the year they actually retire (if later than age 70½) under two conditions:

(1) the distribution is from a qualified retirement plan and not an IRA (including SEP IRAs and SIMPLE IRAs), and

50% Excise Tax

Account owners who fail to comply with the RMD rules pay a severe penalty—a 50% excise tax on the difference between the amount that should have been distributed (the RMD) and the amount that was actually distributed. For example, if an owner should have taken a $50,000 RMD but only took a $30,000 distribution, the penalty would be $10,000 (50% of the $20,000 the owner failed to take). This penalty tax is in addition to the ordinary income tax due on the distribution (assuming zero basis).

Uniform Lifetime Table-Reg. Sec. 1.409(a)(9)-9

This table is used to calculate lifetime required minimum distributions from qualified defined contribution plans (including 401(k) and 403(b) plans) and IRAs unless the employee's beneficiary is a spouse who is more than 10 years younger, or unless the spouse is not the sole beneficiary.

If the employee's sole beneficiary is a spouse, and that spouse is more than 10 years younger than the employee, use the appropriate life expectancy from the Joint and Last Survivor Table.

To determine the required minimum distribution for any "distribution calendar year" (a calendar year for which a minimum distribution is required), find (1) the account balance on the last valuation date of the preceding year, (2) the account owner's age on his or her birthday in the distribution calendar year, and (3) the divisor that corresponds to that age in the Uniform Lifetime Table. The required minimum distribution for the distribution calendar year is (1) divided by (3).

First Year Distribution

Required minimum distributions must begin when the account owner attains age 70½. However, the owner may delay the first RMD until April 1 of the following year.

Sarah, a retired account owner, was born on November 20, 1945. On November 20, 2015 she turned 70. Sarah turns 70½ on May 20, 2016. Her first distribution is due by December 31, 2016. However, as we said, she could choose to delay the first distribution until April 1 of the year following the year she turns 70½ (which, in our example, would be April 1, 2017). Any deferral beyond April 1, 2017, will result in the 50% excise tax penalty.

Sarah’s first distribution calendar year is the year she attains age 70½ (2016). Valuation of her account is based on the account value on December 31 of the preceding year (December 31, 2015).

The account value is divided by the applicable distribution period taken from the Uniform Lifetime Table and based on the owner’s age on the owner’s birthday in the relevant distribution calendar year. Continuing with our example, Sarah is 71 in 2016 and the factor for age 71 is 26.5. So, assuming an account value of $1,000,000, the RMD is $37,736 ($1,000,000 divided by 26.5).

Second Year Distribution

The RMD for the first distribution calendar year is the only one that can be distributed after December 31 without penalty. For any subsequent distribution calendar year, the required minimum distribution must be distributed by December 31 of that year.

Continuing with our example, Sarah’s second RMD will be due by December 31, 2017, regardless of whether she took her first RMD in 2016 or delayed until April 1, 2017.

The 2017 RMD is calculated based on the account value on December 31, 2016 and the owner’s age at the end of 2017.

The following table converts the factors from the Uniform Lifetime Table into percentages of the account balance that must be distributed. These percentages are rounded to two decimal places, so don’t rely on them to calculate the actual RMD! The Table illustrates that a strategy to defer taxation as long as possible by taking only required minimum distributions is fairly easy. For example, at age 80 the RMD is only about 5.35%. Account earnings greater than 5.35% would cause the account to continue to grow even while the owner meets the RMD rule and avoids the 50% excise tax penalty.

The Inherited IRA and Distributions Following an Account Owner's Death

Until now, we have discussed the RMD rules as they apply to distributions made during the owner’s life. The rules that follow apply to beneficiaries after the owner's death. These rules apply to traditional IRAs, qualified defined contribution plans, and 403(b) plans. We will continue to use "account owner" and "owner" to refer to both qualified plan account owners and owners of traditional IRAs.

Determining the 'Designated Beneficiary'

The importance of being a "designated beneficiary" is that this beneficiary can use the Single Life Table below to calculate the required minimum distribution.

The designated beneficiary for tax purposes is the beneficiary of record as of September 30 of the year following the year of the owner's death. Thus, qualified disclaimers and lump-sum distributions can be used after the owner's death (and before the September 30 deadline) to narrow down the designated beneficiary, but only from among the group of beneficiaries named by the owner. For example, the owner's surviving spouse could disclaim his or her interest in order to permit an account to pass to a child named by the owner, but an executor or trustee cannot add a beneficiary after the owner's death.

Of course, for purposes of determining RMDs, only an individual can be a designated beneficiary. If a non-individual (such as a charity) is named as a beneficiary of a plan account, the account will be treated as having no designated beneficiary, unless the non-individual is no longer a beneficiary on September 30 of the year following the year of death. This applies even if there are individuals designated as beneficiaries along with the non-individual.

The deceased owner’s estate cannot be a designated beneficiary and there are no provisions that allow for a "look through" to the individual beneficiaries of the estate.

However, when the owner names a trust as beneficiary of a retirement plan or IRA account, the trust beneficiaries can qualify as designated beneficiaries if all of the following are true:

(1) The trust is a valid trust under state law, or would be but for the fact that there is no corpus.

(2) The trust is irrevocable or will, by its terms, become irrevocable upon the death of the owner.

(3) The trust instrument identifies the beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the owner’s benefit.

(4) The trustee must be provided a copy of the trust with an agreement that if the trust is amended, the plan administrator will be provided a copy of the amendment.

Trusts can provide numerous advantages including creditor protection, divorce protection, special needs, and investment management. There can be other advantages to using trusts as beneficiaries where, for example, the account owner has young beneficiaries and large dollar amounts. Because trusts can be complicated, clients should seek legal counsel before making such planning decisions.

If the beneficiary dies during the period between the owner's date of death and the September 30 deadline, the life expectancy of the deceased beneficiary may still be used to calculate RMDs. In the absence of this rule, the deceased beneficiary's estate could have been deemed the distributee with the result that there would be no designated beneficiary (and no stretch-out) for RMD purposes.

Single Life Table

Designated beneficiaries must use the Single Life Table to calculate RMDs on inherited IRAs and plan accounts. The Uniform Lifetime Table is only used for distributions during the owner’s lifetime.

The designated beneficiary uses his or her age as of his or her birthday in the calendar year following the account owner’s death, which is the year that distributions must begin. After the first distribution year, the beneficiary reduces life expectancy by one for each subsequent year.

EXAMPLE: You are the owner’s designated beneficiary figuring your first required minimum distribution. The owner died in 2015. In 2016, you turn 57 years old. The Single Life Table life expectancy factor for age 57 is 27.9. The account value on December 31, 2015, was $1,000,000 and your RMD was $35,843 ($1,000,000/27.9). In 2017, the factor is 27.9-1=26.9 so you would divide the December 31, 2016, account balance by 26.9 to determine the 2017 RMD. In 2018 the factor is 25.9 (27.9-2).

If the owner’s sole designated beneficiary is the surviving spouse, the first distribution year is the year in which the owner would have reached age 70½. After the first distribution year, the spouse will use their own age as of their birthday in each subsequent year.

EXAMPLE: The owner died in 2015. You are the owner’s surviving spouse and the sole designated beneficiary. The owner would have turned age 70½ in 2016 so distributions must begin in 2016. You, as the surviving spouse, become 69 in 2016 and your life expectancy from the Single Life Table for age 69 is 17.8. If the account balance on December 31, 2015, was $1,000,000, your RMD is $56,180 ($1,000,000/17.8).

As illustrated above, a designated beneficiary uses the life expectancy factor that corresponds to the beneficiary's age in the year after the owner’s death. The factor is then reduced by one for each succeeding distribution year.

Beneficiaries who are spouses, and who do not elect to roll over the account or treat it as their own, also use the Single Life Table, but they can recalculate the RMD each year using the factor for their then-current age.

Single Life Table—Reg. Sec. 1.401(a)(9)-9

The final regulations on required minimum distributions (RMDs) promulgate a "Single Life Table" that designated beneficiaries are to use to calculate RMDs on inherited IRAs and plan accounts. The factors in this table are used instead of those in the Uniform Lifetime Table, which is only for distributions during the owner's lifetime.

Death of an Owner BEFORE the Required Beginning Date

When the owner dies before reaching the required beginning date, there are two options for distributing the owner's account. Absent a plan provision to the contrary, distributions must be made as follows:

(1) The life expectancy method requires that any portion of the owner’s account payable to a designated beneficiary must be paid at least annually starting on or before the end of the calendar year following the calendar year in which the employee died. This method applies if the employee has a designated beneficiary.

(2) The five-year rule requires that the account owner’s entire interest must be paid out by the end of the calendar year which contains the fifth anniversary of the owner's death. For example, if an owner died on January 1, 2010, the entire account must be paid out no later than December 31, 2015. This rule applies if there is no designated beneficiary.

Since the owner did not reach age 70½ (the age at which required minimum distributions must begin) no distribution is required in the year of death.

However, if the sole designated beneficiary is the owner's surviving spouse, distributions must commence on or before the later of:

the end of the calendar year in which the participant would have attained age 70½.

Death of an Owner AFTER the Required Beginning Date

Minimum distributions after the owner's death (for all years after the year in which death occurs) are available based on the remaining life expectancy of the designated beneficiary. The beneficiary's remaining life expectancy is calculated using the beneficiary's age in the year following the year of the owner's death reduced by one for each subsequent year. However, the distribution period will never be shorter than the owner's life expectancy in the year of death.

The beneficiary must also take a required minimum distribution for the year of the owner's death using the owner's age/life expectancy from the Uniform Lifetime Table. If the owner did not take this RMD prior to death, the beneficiary would generally receive it as income in respect of a decedent.

The designated beneficiary can use his or her own life expectancy or the deceased owner's remaining life expectancy at death, whichever is longer, to calculate RMDs.

Election by Surviving Spouse

If the deceased owner designated the surviving spouse as beneficiary of the account, the spouse may elect to treat the account as her own IRA (we'll discuss this as appropriate to our later example of Tom and Debbie in which the surviving spouse is female). The spouse accomplishes this by having herself designated as the new account owner.

For a surviving spouse to roll an account over into her own name, she must be the sole beneficiary of the account and must have an unlimited right of withdrawal. Before she can roll over the IRA, she must take the RMD for the year of her husband's death. If she has reached her own required beginning date, RMDs for the years following the year of death are determined by entering the Uniform Lifetime Table with the surviving spouse's age.

When a spouse is the sole designated beneficiary and decides not to roll over the IRA into her own name, and the owner dies before reaching his required beginning date, then the spouse may defer payments until the year the deceased owner would have reached age 70½. Thereafter, required minimum distributions are calculated based upon her life expectancy as measured by the Single Life Table. For each succeeding year this process is repeated. If the owner dies after age 70½, the spouse must take the owner's required minimum distribution for the year of death if the owner dies before taking the distribution. Beginning in the year after the owner's year of death, the surviving spouse takes required minimum distributions based on the spouse's life expectancy as calculated using the Single Life Table.

Let's look at an example. Tom died in 2015 at age 77, before taking his RMD for the year. Tom’s wife Debbie is his sole beneficiary. Tom’s account balance at the end of 2014 was $1,000,000, so his final RMD amounts to $47,170 ($1,000,000/21.2, which is the divisor from the Uniform Lifetime Table). This distribution is paid to Debbie. The following year, Debbie is 71. With a December 31, 2015, account balance of $1,050,000, Debbie takes the factor for age 71 from the Single Life Table (16.3) and calculates an RMD of $64,418 ($1,050,000/16.3).

No Designated Beneficiary

If the owner dies before the required beginning date, and if there is no designated beneficiary as of the date of death, the entire account balance must be distributed no later than December 31st of the fifth anniversary year of the owner's death. If there is a named beneficiary but no "designated beneficiary" (e.g., a charity is named as beneficiary), the account balance is distributed to the named beneficiary. If no beneficiary is named under the plan, state law will govern to whom the account balance will ultimately be paid. Generally, the recipients would be the beneficiaries named in the participant's will or identified under state intestacy laws.

If the owner dies after reaching the required beginning date and if there is no designated beneficiary, the distribution period available is the owner's life expectancy based on the age in the year of death, reduced by one for each year thereafter. Note that the life expectancy of the estate beneficiary may not be used in this situation. It is no longer required that the entire amount be distributed in the year after the owner's death. A required minimum distribution must be taken for the year of death based on the owner's age in the year of death using the Uniform Lifetime Table.

Multiple Beneficiaries

The general rule when the account owner named multiple beneficiaries for post-death distributions (e.g., "I designate my spouse and child as beneficiaries of my IRA in equal shares") is that RMDs have to be based on the life expectancy of the oldest beneficiary. However, if the owner's account is split into separate accounts for each beneficiary, then each beneficiary can use his or her own life expectancy to compute RMDs. Some important points to remember:

The beneficiaries must have separate interests as of the owner's death, even if the separate accounts are not established until later. A person cannot be a "designated beneficiary" unless named as a beneficiary by the decedent. Single trusts must be divided into separate sub-trusts before the participant's death if the beneficiaries wish to use their own individual life expectancies; otherwise, the age of the oldest beneficiary will apply. However, for individual (non-trust) beneficiaries, as long as the separate shares are created by December 31 of the year following the participant's death, each beneficiary may use his or her own age [Ltr. Ruls. 200306008, 200306009, 200307095, 200308046].

In settling the identity of the designated beneficiary, the separate accounts have to be established by September 30 of the year following the year of the owner's death. For example, if the owner's niece and a charity were named as equal beneficiaries of an IRA, separate accounts would have to be set up by September 30 of the year following the year of death. Otherwise, the result for RMD purposes would be that no beneficiary would be deemed to have been "designated" because of the charity's presence in the "beneficiary pool" (since the charity is an entity without a life expectancy).

To determine the applicable distribution period, the separate accounts have to be established by December 31 of the year following the year of the owner's death. If separate accounts are not set up by then, the oldest beneficiary's life expectancy would have to be used to determine RMDs for all of the beneficiaries.

Section 72(t) Payments

Individuals who are using the "minimum distribution method" to calculate their "substantially equal periodic payments" under IRC Section 72(t) can switch to the applicable IRS tables under the §401(a)(9) regulations to calculate their payments. The IRS will not consider this change an impermissible "modification" that disqualifies the payments for Section 72(t) treatment.

Roth IRA Beneficiaries

The RMD rules do not apply to lifetime distributions from Roth IRAs, but do apply after the owner's death. However, the tax code inadvertently failed to extend the 50% excise tax to Roth IRA beneficiaries. The final regulations indicate that Roth IRA beneficiaries must pay the 50% excise tax for failure to comply with the RMD rules, but the tax code itself still needs to be amended by a technical correction.

When RMD Exceeds Account Balance

Suppose this year's RMD, based on last year's account balance, exceeds the current value of the account due to a precipitous decline in value of the underlying investments. How can the owner or beneficiary withdraw more than the account's current value? The final regulations allow the owner or beneficiary to avoid the 50% excise tax in this situation by withdrawing the entire account balance.

Reporting Requirements

IRA issuers, custodians, and trustees must notify IRA owners, but not the IRS, that a distribution is required under the RMD rules, and either report the amount of the required distribution or offer to compute the amount for them. For the time being, IRA issuers, custodians, and trustees do not have to report to beneficiaries of deceased owners.

IRA issuers, custodians and trustees must identify (using IRS Form 5498) each IRA for which a minimum distribution is required, but are not required to report the amount of the required minimum distribution [Notice 2002-27, 2002-18 I.R.B. 814].

Annuity-Type Required Minimum Distributions

At the same time the Treasury finalized the regulations on RMDs from defined contribution plans and individual retirement accounts in April 2002, it issued proposed and temporary regulations on RMDs in the form of annuities, which were then finalized in 2004. They affect defined benefit pension plans and annuity contracts purchased to make RMDs from IRAs and defined contribution plans.

Annuities Paid for a Period Certain. RMDs during the lifetime of a defined benefit plan participant generally can be made in the form of annuity payments for:

(3) a period certain that ends on or before the life expectancy of the participant or the joint life expectancy of the participant and a beneficiary (the period certain can be as long as the life expectancy period in the Uniform Lifetime Table that corresponds to the participant's age in the year in which the annuity starting date occurs).

The only exception is for a spouse who is the participant's sole beneficiary and is more than 10 years younger than the participant. Here, the period certain can be as long as the joint life and last survivor expectancy of the participant and spouse. Moreover, the required period is unchanged when the participant dies, even if the beneficiary's single life expectancy is shorter (or longer) than the remaining period certain.

Minimum Distribution Incidental Benefit (MDIB). Suppose an employee's (or IRA owner's) annuity starting date is before age 70. In this case, an adjustment is made to the age difference between the employee and beneficiary. For example, if the employee's annuity starting date is age 55, a joint and 100 percent annuity can be paid to a surviving beneficiary who is not more than 25 (the usual 10 plus 15 additional) years younger than the employee.

increases (so-called "pop-ups") due to the death of a designated beneficiary or the divorce of the employee,

Form of Distribution. The regulations permit certain prospective changes in the form of distribution. These include:

a change to a qualified joint-and-survivor annuity upon the employee's marriage,

Payments to a Child. Payments to the employee's child may be treated as if the payments were made to a surviving spouse until the child reaches the age of majority. The age of majority may be extended through age 25 if the child is pursuing a course of education, or for so long as the child is disabled. The payments must be payable to the surviving spouse after payments to the child cease.

Separate Accounts. Separate accounts under a defined contribution plan can be used to determine RMDs if they are established by the end of the calendar year following the year of the employee's death.

Commercial Annuity Contracts. IRAs and defined contribution plans can meet the RMD requirements by purchasing a commercial annuity contract from an insurance company, and Treasury regulations contain a number of examples to show how this can be done.

Tax-Free Distributions from IRAs for Charitable Purposes

The PPA allowed the owner of a traditional or Roth IRA to exclude from income a "qualified charitable distribution" of up to $100,000 per year, which counts toward the owner’s required minimum distribution. A "qualified charitable distribution" is any distribution from an IRA directly to a charitable organization described in Code Section 170(b)(1)(A) [other than an organization described in Code Section 509(a)(3) or a donor advised fund, as described in Code Section 4966(d)(2)]. The distribution qualifies for favorable tax treatment only if it is made on or after the IRA owner’s required beginning date.

Qualified Longevity Annuity Contracts

A qualified longevity annuity contract (QLAC) is an annuity contract intended to protect individuals from exhausting their retirement savings as they age. It works by paying a stream of income at a future date selected by the contract owner. A 55-year old, for example, could buy a QLAC and choose to begin benefits at age 75. This type of annuity serves to guarantee that a retiree has stable source of income late in life.

Final Treasury regulations issued in July 2014 provide that assets in the following types of retirement arrangements can be used to purchase a QLAC:

Defined contribution plans (e.g., 401(k), profit sharing plans, money purchase plans)

The final regulations do not apply to defined benefit pension plans, though the Treasury left the door open to this possibility by requesting further public comment on whether this should be allowed (see IRB 2014-30, July 21, 2014).

Advantages

Individuals who purchase QLACs with retirement assets do so for a number of reasons:

A QLAC provides the security of knowing assets will remain available late in life.

Periodic annuity payments are certain, whereas other retirement assets invested in the markets will fluctuate in value.

QLACs are purchased at a younger age and well in advance of the date they begin paying out, making them less expensive than immediate annuities.

Paying the lump-sum premium with pre-tax dollars makes them even less expensive than a similar deferred annuity purchased outside of the retirement plan.

It is significant to understand that a QLAC offers individuals the ability to plan for a definite end point for their other retirement income. With coverage assured at a specified age, the individual can reallocate other assets so that they need only last until the QLAC begins. Because of this, a QLAC can be used to help cover the high costs of managed care in retirement.

QLAC Dollar Limits

Participants in the arrangements listed above can direct that assets be used to purchase a QLAC which will guarantee a lifetime income stream beginning years later—perhaps well into an individual’s 70s or 80s. Only 25% of a participant’s account balance can be used to purchase a QLAC, with an overall dollar limit of $125,000 (adjusted annually for inflation). Multiple QLAC contracts can be purchased, provided the cumulative premium for all contracts does not exceed the dollar or percentage limit.

Required Minimum Distributions

The final Treasury regulations exempt QLACs from the RMD rules as long as the QLAC does not comprise more than 25% of the account balance (or $125,000, if less), and benefits begin no later than age 85.

Annuity providers can make buying the QLAC more attractive by including features that:

guarantee beneficiaries will receive the premium amounts originally paid (minus payments already made), or

Distributions After Death

A QLAC may offer a return-of-premium (ROP) feature that is payable before and after the employee’s annuity starting date. So, a QLAC may pay a beneficiary a lump-sum death benefit equal to the excess of the premium payments over the QLAC payments received. If a QLAC is providing a life annuity to a surviving spouse, it may also provide a similar ROP benefit after the death of both the employee and the spouse.

An ROP payment must be paid by the end of the calendar year following the year in which the employee (or surviving spouse) dies. If the death is after the required beginning date, then the ROP payment is treated as a required minimum distribution for the year in which it is paid and is not eligible for rollover.

If the sole beneficiary of an employee is the surviving spouse, the only benefit that can be paid after the employee’s death (other than an ROP) is a life annuity payable to the surviving spouse that does not exceed 100% of the annuity that was being paid to the employee. If the surviving spouse is one of multiple beneficiaries, the special rules for a surviving spouse apply. [See, Treas. Reg. §1.401(a)(9)–6.] For more information on these special rules, click here to jump back to the Multiple Beneficiaries section.

Example. Eric advises Samuel to use $125,000 of his IRA to purchase a QLAC that will start lifetime payments at age 85 with a 15-year guarantee. Samuel receives the following benefits from the QLAC:

At age 85, Samuel will receive a lifetime payout of roughly $25,000 per year with guaranteed payments for 15 years.

If Samuel dies during the 15-year period after age 85, his designated beneficiary (spouse or non-spouse) will receive the remaining guaranteed payments.

If Samuel dies prior to age 85, his beneficiary will receive a return of premium ($125,000) as a taxable lump-sum death benefit.

The QLAC payments are fully taxable as ordinary income, regardless of whether received by Samuel or a beneficiary, since contributions to the IRA were fully deductible. Also, any lump-sum death benefit paid to the designated beneficiary prior to age 85 is also taxable as income in respect of decedent (IRD). For more information on IRD, click here.

Fiduciary Concerns

Advisors should be aware that offering a QLAC in a qualified plan gives rise to fiduciary concerns on the part of a plan sponsor. Since QLACs can be purchased as many as 20 or even 30 years in advance of the time distributions become necessary, plan fiduciaries are obligated to choose QLAC providers that can reasonably be expected to fulfill their obligation to pay benefits. The Department of Labor has issued Field Assistance Bulletin (FAB) 2015-2, which gives employers guidance on the extent of their fiduciary duties to monitor and review providers with respect to the inclusion of QLACs in their defined contribution plans.

Qualified Domestic Relations Order

What Is a QDRO?

A qualified domestic relations order (QDRO) is a directive issued by a court in the course of a divorce (or other judicial proceeding related to matters of alimony, child support or marital property rights) that specifies how retirement assets are to be divided between contesting parties. This diversion of benefits to parties other than the plan participant is an exception to the general rule under ERISA that prohibits both the assignment and alienation of qualified plan assets.

The QDRO assigns to an "alternate payee" the right to receive all or a portion of the benefits payable with respect to a participant under a plan. A QDRO is "qualified" because it meets requirements set out in the Internal Revenue Code. In some states the state instrumentality charged with handling divorces may not be a court, but will still be authorized to issue a QDRO. A QDRO may be integrated within the divorce order or issued as a separate order by the court.

Elements of a QDRO

A QDRO is a very technical legal document and should be drafted by an attorney experienced in drafting QDROs. The Internal Revenue Code requires that a QDRO must state:

a) the name and last known mailing address (if any) of the participant and the name and mailing address of each alternate payee covered by the order;

b) the amount or percentage of the participant’s benefits to be paid by the plan to each alternate payee, or the manner in which the amount or percentage is to be determined;

After determining that the QDRO meets these requirements, the plan administrator will follow the instructions in the QDRO to provide for payments to the alternate payee(s). The actual payment of benefits will be done according to the rules of the plan, and may be a lump sum transfer or simply a percentage of the regular payments.

providing an alternate payee or participant with any benefit or option not otherwise provided under the plan,

paying benefits from an alternate payee under a prior QDRO to new alternate payee under a new QDRO, and

paying benefits to an alternate payee in the form of a qualified joint and survivor annuity for the lives of the alternate payee and his or her subsequent spouse.

This service is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that neither the publisher nor any of its licensees or their distributees intend to, or are engaged in, rendering legal, accounting, or tax advice. If legal or tax advice or other expert assistance is required, the services of a competent professional should be sought.

While the publisher has been diligent in attempting to provide accurate information, the accuracy of the information cannot be guaranteed. Laws and regulations change frequently, and are subject to differing legal interpretations. Accordingly, neither the publisher nor any of its licensees or their distributees shall be liable for any loss or damage caused, or alleged to have been caused, by the use of or reliance upon this service.

70	27.4	93	9.6
71	26.5	94	9.1
72	25.6	95	8.6
73	24.7	96	8.1
74	23.8	97	7.6
75	22.9	98	7.1
76	22.0	99	6.7
77	21.2	100	6.3
78	20.3	101	5.9
79	19.5	102	5.5
80	18.7	103	5.2
81	17.9	104	4.9
82	17.1	105	4.5
83	16.3	106	4.2
84	15.5	107	3.9
85	14.8	108	3.7
86	14.1	109	3.4
87	13.4	110	3.1
88	12.7	111	2.9
89	12.0	112	2.6
90	11.4	113	2.4
91	10.8	114	2.1
92	10.2	115+	1.9

Uniform Lifetime Table Factors Converted to Percents
Age	Percent	Age	Percent
70	3.65	93	10.42
71	3.77	94	10.99
72	3.91	95	11.63
73	4.05	96	12.35
74	4.20	97	13.16
75	4.37	98	14.08
76	4.55	99	14.93
77	4.72	100	15.87
78	4.93	101	16.95
79	5.13	102	18.18
80	5.35	103	19.23
81	5.59	104	20.41
82	5.85	105	22.22
83	6.13	106	23.81
84	6.45	107	25.64
85	6.76	108	27.03
86	7.09	109	29.41
87	7.46	110	32.26
88	7.87	111	34.48
89	8.33	112	38.46
90	8.77	113	41.67
91	9.26	114	47.62
92	9.80	115+	52.63

Age	Factor	Age	Factor
0	82.4	56	28.7
1	81.6	57	27.9
2	80.6	58	27.0
3	79.7	59	26.1
4	78.7	60	25.2
5	77.7	61	24.4
6	76.7	62	23.5
7	75.8	63	22.7
8	74.8	64	21.8
9	73.8	65	21.0
10	72.8	66	20.2
11	71.8	67	19.4
12	70.8	68	18.6
13	69.9	69	17.8
14	68.9	70	17.0
15	67.9	71	16.3
16	66.9	72	15.5
17	66.0	73	14.8
18	65.0	74	14.1
19	64.0	75	13.4
20	63.0	76	12.7
21	62.1	77	12.1
22	61.1	78	11.4
23	60.1	79	10.8
24	59.1	80	10.2
25	58.2	81	9.7
Age	Factor	Age	Factor
26	57.2	82	9.1
27	56.2	83	8.6
28	55.3	84	8.1
29	54.3	85	7.6
30	53.3	86	7.1
31	52.4	87	6.7
32	51.4	88	6.3
33	50.4	89	5.9
34	49.4	90	5.5
35	48.5	91	5.2
36	47.5	92	4.9
37	46.5	93	4.6
38	45.6	94	4.3
39	44.6	95	4.1
40	43.6	96	3.8
41	42.7	97	3.6
42	41.7	98	3.4
43	40.7	99	3.1
44	39.8	100	2.9
45	38.8	101	2.7
46	37.9	102	2.5
47	37.0	103	2.3
48	36.0	104	2.1
49	35.1	105	1.9
50	34.2	106	1.7
Age	Factor	Age	Factor
51	33.3	107	1.5
52	32.3	108	1.4
53	31.4	109	1.2
54	30.5	110	1.1
55	29.6	111	1.0

Year	Ceiling on annual additions to a defined contribution plan account	Ceiling on annual benefit payable by a defined benefit plan
2014	$52,000	$210,000
2015	$53,000	$210,000
2016	$53,000	$210,000

Year	Deferral Limit Under Age 50	Deferral Limit Age 50 and Over
2014	$17,500	$23,000
2015	$18,000	$24,000
2016	$18,000	$24,000

Qualified Retirement Plans

The Keystone of Retirement Planning

Requirements of Qualified Retirement Plans

Minimum Participation Requirements

Minimum Vesting Requirements

Section 415 Limits

Nondiscrimination Requirements

Highly Compensated Employee

Top-Heavy Plans

Minimum Funding Requirements

Qualified Plans Can Have an IRA Feature

Supreme Court Decision in Obergefell v. Hodges—Effects on Retirement Planning

Benefits for Employers

Federal Income Tax Benefits of Qualified Retirement Plans

Contributions

Tax-Deferred Growth

Defined Benefit Plans

How Defined Benefit Plans Work

Determining the Benefit Amount

Who Uses Defined Benefit Plans

Benefit Limits

Eligible Combined Plans

Benefit Limits and Vesting—Defined Benefit Portion

Benefit Limits and Vesting—Defined Contribution Portion

Other Benefit and Contribution Requirements

Cash-Balance Pension Plans

Defined Contribution Plans

Money Purchase Pension Plans

Profit-Sharing Plans

Savings or Thrift Plans

Employee Stock Ownership Plans (ESOPs)

Target Benefit Plans

Contribution Limits for Defined Contribution Plans

Defined Benefit vs. Defined Contribution

Fully Insured Plans–Section 412(e)(3) Plans

Section 412(e)(3) Plans Defined

Advantages

Disadvantages

IRS Response to "Abuses" in Fully Insured Plans

Section 401(k) Plans

The Appeal of 401(k) Plans

Salary Deferral and Catch-up Limits

Roth Deferrals

How 401(k) Plans Work

Nondiscrimination Rules

Individual 401(k) Plan

Advantages

Establishing and Maintaining an Individual 401(k)

Drawbacks

Keogh Plans

Summary of the Different Qualified Retirement Plans

Defined Benefit Plan

Defined Contribution Plan

Money Purchase Pension Plan

Profit Sharing Plan

Employee Stock Ownership Plan (ESOP)

Target Benefit Plan

Section 412(e)(3) Plan

Section 401(k) Plan

Individual 401(k) Plan

Keogh Plan

Simplified Employee Pension (SEP) Plan

SIMPLE Retirement Plan

Life Insurance and Qualified Retirement Plans

Where Life Insurance Fits

The Incidental Tests

Transfers of Policies from Qualified Plans

Taxation of Qualified Plan Distributions

Annuity Payments

Lump-Sum Distributions

Employer Securities

10% Federal Income Tax on Early Distributions

Phased Retirement Distributions

Required Minimum Distributions

The Age 70½ Requirement

Required Beginning Date

50% Excise Tax

Uniform Lifetime Table-Reg. Sec. 1.409(a)(9)-9

First Year Distribution

Second Year Distribution