At a recent meeting of the American Bar Association (“ABA”), a committee (“Committee”) sponsored by the ABA’s Tax Section proposed several changes to the Internal Revenue Code (“Code”). These changes are designed to simplify administration of tax-qualified retirement plans and IRAs and to curb perceived abuses associated with these retirement vehicles. The Committee anticipates that these proposed changes will be discussed on the Hill and with staff of the Internal Revenue Service (“IRS”) and the Department of the Treasury. Since these changes are being proposed by such a well-respected group, they deserve our attention. Discussed below are four of these proposed changes, which may be of interest to you for both personal and professional reasons.
- Required Distributions Upon Death of an IRA Owner
- Issue. According to the Committee, required minimum distribution provisions outlined in Code section 401(a)(9) are intended to prevent individuals from using retirement vehicles to accumulate funds for estate planning (i.e., wealth transfer) purposes. Nevertheless, the Committee notes that standard IRAs (which are subject to minimum distribution requirements) and Roth IRAs (which are exempt from minimum distribution requirements during the owner’s lifetime) are being heavily marketed as estate planning tools. For example, if the owner of a Roth IRA names his or her grandchildren as IRA beneficiaries, amounts held by the Roth IRA can accumulate tax-free for significant periods of time. The Committee also notes that, when individuals attain age 70 -1/2, they must perform complex calculations required by Code section 401(a)(9) in order to comply with minimum distribution requirements applicable to standard IRAs.
- Proposed Change. For post-death distributions from IRAs, the Committee recommends that all account balances be distributed by the later of:
- the end of the 5th calendar year following the calendar year of the participant’s (or spouse’s) death; or
- if the beneficiary is a child of the participant, the end of the year in which the beneficiary attains age 26.
- Observation. With respect to this proposed change, the Committee suggests that any grandfather rule balance the following:
- taxpayer expectations and planning;
- the need to limit complexity; and
- avoidance of incentives for taxpayers to rush into transactions prior to the effective date.
- In-Service Distributions from Defined Benefit Pension Plans
- Issue. Code section 401(a)(36) currently permits a tax-qualified defined benefit pension plan to provide for in-service distributions to employees who have reached age 62 (even though the plan has a later normal retirement age). The Committee believes that sponsors of tax-qualified defined benefit pension plans need a simple, reliable process that will allow older workers to receive a portion of their retirement benefits while gradually phasing out of the workforce.
- Proposed Change. The Committee recommends that Congress amend Code section 401(a)(36) to substitute age 55 for age 62 and that, aside from currently applicable nondiscrimination rules, there be no limits on employer discretion to design a phased retirement program.
- Observation. Many employers are, indeed, looking for a simple, reliable process that will facilitate phased retirement. Due to non-discrimination requirements and cost issues, however, employers have been reluctant to take advantage of Code section 401(a)(36) in its current form. It would be interesting to see whether changing the Code section 401(a)(36) age limit from age 62 to age 55 could generate more interest in this provision.
- Penalties Generated by Failure to Comply with Non-Qualified Deferred Compensation Requirements of Code section 409A
- Issue. Code section 409A provides that elections to defer compensation earned during a taxable year generally must be made no later than the close of the preceding year, and that the time and form ofdistribution from these plans must be specified at the time of initial deferral (with any changes subject to strict limitations). Penalties for noncompliance with Code section 409A are harsh. They include a 20% “additional tax” (in addition to acceleration of regular income tax) and a special interest penalty.
- Proposed Change. The Committee recommends that Code section 409A be modified to limit application of the 20% “additional tax” to the five highest-paid employees and to employees with income in excess of the Code section 401(a)(17) compensation limit ($245,000 for 2011).
- Observation. Code section 409A sanctions can be draconian. If adopted, this proposed change would be a small, first step toward mitigating these sanctions.
- Standardized Definition of Compensation for Tax-Qualified Retirement Plans
- Issue. The term “compensation” is defined in, or used in, numerous provisions governing the operation of tax-qualified retirement plans, including non-discrimination testing provisions of Code section 401(a)(4), determination of highly compensated employees under Code section 414(q), benefit limitations outlined in Code section 415, and top heavy provisions of Code section 416. On the other hand, a plan generally is free, subject to certain nondiscrimination requirements, to use any definition of “compensation” for purposes of computing contributions to, or benefits payable from, a tax-qualified retirement plan. The Committee believes that the varying definitions of compensation create complexity, which results in significant compliance challenges and costs.
- Proposed Change. The Committee recommends that W-2 Box 1 wages plus certain pre-tax elective deferrals (e.g., deferrals to a 401(k) Plan) be adopted as a standard definition of compensation for use in Code and regulatory provisions applicable to tax-qualified retirement plans. In addition, the Committee’s proposal would encourage, but not require, use of this statutory definition when defining “compensation” for purposes of computing contributions to, or benefits payable from, a tax-qualified retirement plan.
- Observation. In Compliance Trends & Tips published by the IRS, “failure to follow the plan document’s definition of compensation for determining contributions” was listed as one of the top failures reported to the IRS as part of its voluntary correction program. Consequently, whether or not the above-referenced Committee proposal becomes law, plan sponsors should take a moment to confirm that contributions to, and distributions from, their tax-qualified retirement plans are based on the definition of compensation actually contained in the plan document.
We will watch with interest as these proposed changes work their way through the relevant agencies and perhaps through Congress.
