The ERISA consultants at the Learning Center Resource Desk, which is available through Columbia Threadneedle Investments, regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans.
A recent call with an advisor in California is representative of a common inquiry related to distributions from defined benefit plans. The advisor asked:
“My client, a senior partner with an engineering firm, called and was upset because the administrator of his firm’s cash balance plan told him he can’t take a lump distribution, even though the plan document specifically permits lump sums. How can this be? I thought the plan sponsor had to follow the plan document.”
Highlights of Discussion
Unfortunately for your client, in certain circumstances defined benefit (including cash balance) plans cannot make lump sum distributions to highly compensated employees (HCEs), despite the option being available under the terms of the plan. This restriction, sometimes known as the “High 25” or “claw-back” rule, affects the top 25 highest paid HCEs. The rule is intended to ensure that large lump sum distributions made to the top HCEs don’t jeopardize the funding status of the plan and its ability to make benefit payments to other participants.
Treas. Reg. 1.401(a)(4)-5(b)(3)(ii) states that a plan cannot make certain benefit payments (including a lump sum payment) to an HCE (a restricted employee) who is in the top 25 of employees in terms of compensation unless one of the following conditions is satisfied:
- after taking into account the payment to the restricted employee of all benefits payable to or on behalf of that restricted employee under the plan, the value of plan assets must equal or exceed 110% of the value of current liabilities;
- the value of the benefits payable to or on behalf of the restricted employee must be less than 1% of the value of current liabilities before distribution; or
- the value of the benefits payable to the restricted employee must not exceed $5,000 [the amount described in section 411(a)(11)(A) of the Internal Revenue Code (IRC) related to restrictions on certain mandatory distributions].
IRS Revenue Ruling 92-76 prescribes three workarounds, permitting a lump sum if the client does not wish to take an annuity payment. A lump sum is permitted if:
- the distribution is placed in an escrow account;
- a surety bond is obtained for the distributed amount; or
- a letter of credit is secured that allows the plan to recoup all or a portion of the distribution in the event of future funding shortfall.
These rules are complex and expert counsel is necessary to ensure compliance.
When discussing benefit restriction rules for defined benefit plans with your clients, do not forget the well-entrenched benefit restrictions that may apply for the High 25 HCEs in the plan.
The Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC (RLC), a third-party industry consultant that is not affiliated with Columbia Threadneedle. Any information provided is for informational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Threadneedle does not provide tax or legal advice. Consumers consult with their tax advisor or attorney regarding their specific situation.
Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Columbia Threadneedle.
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