Research Memorandum RE: Interpretation of IRC 415(b) Related to Reduced Early Retirement Benefits and Qualified Joint and Survivor Annuities FROM: Paul Zorn DATE: September 30, 2013 The following memorandum summarizes an interpretation of Internal Revenue Code (IRC) 415(b) that is published in the 2013 Enrolled Actuary s Gray Book. The interpretation relates how the 415(b) dollar limit is determined in situations involving early retirement benefits and qualified joint and survivor annuities. However, the author is not an attorney or a tax expert and so the following is not legal or tax advice or opinion. These issues should be discussed with legal counsel before action is taken. For defined benefit (DB) pension plans, IRC 415(b) limits the employer-provided benefits that can be paid to a covered participant each year. Generally, the limit is the lesser of (i) a specific dollar amount (e.g., $205,000 in 2013, indexed to inflation) or (ii) 100% of the participant s average compensation for the highest three consecutive years. Although private-sector plans are subject to both limits, governmental DB plans are exempt from the limit related to average compensation for the highest three consecutive years. 1 On an annual basis, the American Academy of Actuaries and the Conference of Consulting Actuaries sponsor an Enrolled Actuaries meeting. As a result of the meeting, the Gray Book is published to answer questions raised by actuaries regarding the Internal Revenue Code. The answers are based on summaries of oral responses from the U.S. Treasury Department and Internal Revenue Service (IRS) staff, but are not the result of a systematic or legal policy analysis. Consequently, as stated in the Gray Book, the responses do not necessarily represent the position of the Treasury or the IRS and cannot be relied upon by any taxpayer for that purpose. Nevertheless, the responses do represent the individual views of certain U.S. Treasury and IRS staff. 2013 Enrolled Actuaries Gray Book Question 6 Question 6 of the 2013 Gray Book addresses an issue related to IRC 415(b) regarding the dollar limit in situations where a reduced early retirement benefit is provided or where there is a reduction factor for a qualified joint and survivor annuity (QJSA). 2 Appendix A reproduces the question presented in the Gray Book, which is discussed below: Situation: A participant in a DB pension plan has an unadjusted benefit based on the plan s formula of $400,000 (before application of the 415(b) dollar limit), which is payable as a straight life annuity at the plan s normal retirement age (age 65). The participant takes early retirement at age 62 and elects a benefit payable in the form of a 75% qualified joint and survivor annuity (QJSA). The plan applies an 85% early reduction factor (to adjust the value of the benefit for early retirement) and a 90% factor for the QJSA (to adjust the value of the benefit for the likely longer payout period to the surviving spouse). The result is considered the plan formula benefit before application of the 415(b) limit. 1 IRC 415(b)(11). 2 Although not stated, it is implied that all of the benefits are employer-provided and that no portion of the benefit is provided through employee contributions. 9/30/2013 Gabriel Roeder Smith & Company Page 1
Question 6 of the 2013 Gray Book asks, given that 415(b) does not require the dollar limit to be reduced either for retirement between the ages of 62 and 65 or for the survivor portion of the QJSA, which of the following options is the correct way to apply the limit? Option 1: Under this option, the benefit that is based on the plan s formula ($400,000) would be reduced by the early reduction factor (85%) and the QJSA reduction factor (90%) to determine the benefit before application of the 415(b) dollar limit. The result would be $306,000 ($400,000 x 85% x 90%). This amount would then be tested against the 415(b) dollar limit ($205,000) and the benefit payable would be the lesser of $306,000 and $205,000 (i.e., $205,000). Option 2: Under this option, the accrued benefit would be the smaller of (i) the plan formula benefit before application of the 415(b) dollar limit ($400,000) or (ii) the 415 limit ($205,000). This smaller benefit would then be reduced by the early reduction factor (85%) and the QJSA factor (90%) to determine the benefit payable at early retirement in the selected optional form. The result would be $156,825 ($205,000 x 85% x 90%). This amount would be tested against the 415(b) dollar limit ($205,000) and the benefit payable would be the lesser of the two (i.e., $156,825). Answer: According to Question 6 of the 2013 Gray Book, the correct calculation is Option 2. As argued in Question 6, the early retirement reduction factor and the optional form factor apply to the accrued benefit (rather than the formula benefit), which must be limited to the 415(b) limit applicable at the plan's normal retirement age. American Academy of Actuaries Response to Similar Interpretations In a letter responding to a similar interpretation in 2012, the American Academy of Actuaries Pension Committee argued that this interpretation was contrary to statute, regulations, and the common understanding of practitioners, for the following reasons: Code 415(b)(2)(C) provides that the 415(b) dollar limit is reduced for benefits beginning before age 62 and appears only to give the Secretary authority to prescribe reductions in the dollar limit for early retirement commencement before age 62. Code 415(b)(2)(B) gives the Secretary authority to prescribe methods to convert optional forms of benefits for the purpose of comparing benefits under 415, but provides that no adjustments are made for a QJSA. The Academy s letter also argues that there is no evidence in the 2007 final regulations related to 415 that a deliberate change was made regarding these issues. Moreover, the final 415 regulations provide examples that contradict the interpretation: In Treas. Reg. 1.415(b)-1(d)(7), Examples 1 and 2 demonstrate that early retirement benefits are determined by reducing the accrued benefit under the plan formula rather than the dollar limit and make it clear that the reduction in the dollar limit before age 62 is reduced from age 62 rather than age 65. In Treas. Reg. 1.415(b)-1(c)(6), Example 4 strongly implies that the subsidy is ignored if the benefit is paid in the form of a 100% QJSA. The Academy s letter requests that since the IRS s position differs substantially from the widely held understanding of the practitioner community, it should be promulgated in a proposed regulation exposed for public comment, and applied only prospectively once such a regulation is finalized. 9/30/2013 Gabriel Roeder Smith & Company Page 2
Application to Governmental Plans To better understand the implications of the Gray Book response, GRS requested assistance from the Groom Law Group in order to determine whether governmental plans are exempted from applying this interpretation based on other sections of the IRC and regulations related to governmental plans. We collectively came to the conclusion that differences in how the IRC applies to public and private plans may affect whether the Gray Book interpretation applies to public plans. More specifically, Treas. Reg. 1.415(b)-1(a)(7)(iii) provides that for plans "not subject to the requirements of section 411" the "limitations described in this paragraph [i.e., 415(b)] are not required to be applied to the annual benefit accrued by a participant before the benefit is payable." In other words, for plans that are not subject to the rules related to the accrual of benefits under IRC 411, the 415(b) limitations are not applied to the accrued benefit, but rather to the benefit when it becomes payable. Gray Book Question 6 limits the accrued benefit to $205,000 and then applies the early retirement and QJSA reduction factors. However, since governmental plans are not subject to the limits on accrued benefits as a result of IRC 411(e)(1)(A), it seems reasonable for the early retirement and QJSA factors to be applied to the plan formula benefit when it becomes payable, and the payable benefit determined as provided in Option 1. Based on this, we drafted a Q&A on this topic and submitted it to the American Bar Association (ABA) for discussion with an IRS representative at the ABA annual meeting (see Appendix B for the full text of our Q&A). However, although we were told that the Q&A was viewed favorably, we did not receive a written response. We intend to attempt to resubmit this question through the Gray Book and ABA process with the hope of obtaining a positive written response. Implications The interpretation provided in Question 6 could significantly and unexpectedly limit the benefits that plans can pay to some participants. Although the Gray Book is not authoritative, it does reflect the views of certain U.S. Treasury and IRS staff. We recommend that public plans work with legal counsel to determine the applicability of the Question 6 interpretation to their specific situations. The American Academy of Actuaries letter is available at: http://www.actuary.org/files/publications/aaa-letter-on-irc-section-415b.pdf Circular 230 Notice Pursuant to regulations issued by the IRS, to the extent this communication (or any attachment) concerns tax matters, it is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding taxrelated penalties under the Internal Revenue Code or (ii) marketing or recommending to another party any tax-related matter addressed within. Each taxpayer should seek advice based on the individual s circumstances from an independent tax advisor. 9/30/2013 Gabriel Roeder Smith & Company Page 3
Appendix A 2013 Enrolled Actuaries Gray Book Question 6 Consider a DB plan participant with a benefit under the plan formula (before application of 415) of $400,000 payable as a straight life annuity at normal retirement (age 65). The participant plans to retire in 2013 at age 62, and to elect benefits payable in the form of a 75% QJSA. At age 62, the plan applies an early reduction factor of 85% and an optional form factor of 90% for the 75% QJSA form of payment. Given that 415(b) does not require the 415 dollar limit to be reduced either for retirement between age 62 and age 65 or for the survivor portion of a QJSA benefit, what is the correct way to apply the 415(b) limit to this benefit? Option 1: a) Plan formula benefit before application of 415 = $400,000 x 85% x 90% = $306,000 b) 2013 dollar limit under 415(b) = $205,000 c) Benefit payable (smaller of (a) or (b)) = $205,000 Option 2: a) Accrued benefit = smaller of plan formula benefit before application of 415 ($400,000) or 415 limit ($205,000) Plan benefit payable at early retirement in selected optional form = $205,000 x 85% x 90% = $156,825 b) 2013 dollar limit under 415(b) = $205,000 c) Benefit payable (smaller of (a) or (b)) = $156,825 RESPONSE Option 2 is the correct calculation. The early retirement reduction factor of 85% and the optional form factor of 90% apply to the accrued benefit, which must be limited to the 415(b) limit applicable to the plan's normal retirement age. 9/30/2013 Gabriel Roeder Smith & Company Page 4
Appendix B GRS Question for the American Bar Association Part A: Plan P is a non-contributory Code section 414(d) governmental defined benefit plan (which is not subject to Code section 411 pursuant to Code section 411(e)(1)(A)) and has a normal retirement age of age 62. A Plan P participant retires at age 62 in 2013 with a $268,000 annual benefit which includes an automatic 75% qualified joint and survivor annuity (QJSA) provided without reduction to the annual benefit. Can Plan P pay a benefit equal to the full $205,000 dollar limit without reduction for the QJSA? Part B: Assume the same facts as listed in Part A except that (1) Plan P has a normal retirement age of age 65 with an 85% early retirement reduction factor at age 62 and (2) the 75% QJSA is elected by the participant and the benefit is reduced by 90%. Both of the reductions provided by (1) and (2) are set forth in the terms of Plan P as established by the State legislature pursuant to its design process. How would the Plan P Code section 415(b) limit be calculated in this situation? Proposed Response: Part A: Yes. First, Code section 415(b)(2)(C) states that the dollar limit is reduced for benefits that begin before age 62. Under the facts of Part A above, the benefits do not begin before age 62, and in any event, Plan P does not actuarially reduce the benefit payable at age 62. Therefore, no early reduction factors are relevant to the determination of the Code section 415 limit. In addition, Code section 415(b)(2)(B) states that the dollar limit is not adjusted for benefits paid in the form of a QJSA. Likewise, Code section 415(b)(2)(B) states, "For purposes of this subparagraph... that portion of any joint and survivor annuity which constitutes a qualified joint and survivor annuity (as defined in section 417) shall not be taken into account." Here, the 75% QJSA is the automatic form and requires no adjustment under the terms of the plan. Therefore, no QJSA factor is relevant to the determination of the section 415 limit. Finally, Treas. Reg. section 1.415(b)-1(a)(7)(iii) states that, for a plan not subject to Code section 411, the adjustments to the 415 limit are not required to be applied to the annual benefit accrued by a participant before the benefit is payable. Part B: Code section 415(b)(2)(C) states that the dollar limit is reduced for benefits that begin before age 62. This legal requirement is illustrated in Treas. Reg. section 1.415(b)-1(d)(7), examples 1 and 2, which provide that the full dollar limit for a pre-age 62 distribution is reduced from age 62 not age 65 even though the plan does not provide unreduced benefits at age 62. In addition, Code section 415(b)(2)(B) states that the dollar limit is not adjusted for benefits paid in the form of a QJSA. This legal requirement is illustrated by Treas. Reg. section 1.415(b)-1(c)(6), example 4, which provides that the 415 limit is adjusted in the case of a lump sum that includes a subsidized QJSA. The regulation states, The special rule that disregards the value of the survivor portion of a QJSA... only applies to a benefit that is payable in the form of a [QJSA]. By implication, the subsidy is ignored if the benefit is paid in the form of a QJSA. This is consistent with Code section 415(b)(2)(B) that states, "For purposes of this subparagraph... that portion of any joint and survivor annuity which constitutes a qualified joint and survivor annuity (as defined in section 417) shall not be taken into account." Finally, Treas. Reg. section 1.415(b)-1(a)(7)(iii) provides that, for a plan not subject to Code section 411 (i.e., a governmental plan), the adjustments to the 415 limit are not applied to the annual benefit before the benefit is payable. This analysis can be illustrated as follows: (a) Plan formula benefit before application of 415(b) = $268,000 x 85% x 90% = $205,020 $205,020 (b) 2013 415(b) dollar limit $205,000 (c) Benefit payable (lesser of (a) or (b)) $205,000 9/30/2013 Gabriel Roeder Smith & Company Page 5