Regardless of their age, employees who are fortunate enough to be covered by a noncontributory qualified defined benefit (usually pension) plan would be well advised to check and see how and when they or their spouses or other beneficiaries will be entitled to a benefit. Here’s an overview of the essential rules.
When payments may commence. Distributions from a pension plan typically are made in the form of an annuity. In a pension plan (i.e., qualified defined benefit plan or money purchase plan), distributions to an employee generally are allowed only after the employee has either: (1) retired, or (2) reached “normal retirement age” (typically age 65, but could be earlier, such as age 62 under certain conditions). (Reg. § 1.401(a)-1(b)(1)(i))
Note: Many plans provide for reduced distributions to employees who separate from service before reaching normal retirement age, and who meet an age requirement, or age and service requirements. For example, a plan with a normal retirement age of 65 may allow reduced distributions to employees who retire at age 62, or to employees who retire after attaining age 55 and have completed 10 years of service.
An employee who has a vested interest in a pension plan but leaves before retirement typically will have to wait to receive his annuity benefit until he attains the plan’s normal (e.g., age 65) or early (e.g., age 62) retirement age to begin to collect a benefit. However, some plans will make a lump-sum payment to departing employees instead of making them wait until a certain age to collect benefits. The lump-sum distribution can be rolled over tax free to an eligible retirement plan (including an IRA).
If the plan allows lump-sum distributions, the lump sum must be equal to the present value (PV) of the future annuity to which the participant is entitled. To calculate the PV of an annuity, the plan must apply a Code-prescribed interest rate and mortality table. (Code Sec. 417(e)(3))
Note: An annuity’s PV is inversely related to the interest rate used to convert the annuity to its PV: the higher the interest rate, the smaller the lump-sum and vice versa. Thus, in today’s low-interest-rate environment, a lump-sum distribution should yield a bigger payout than would be available in higher-rate times. And by investing the lump-sum himself (e.g., within an IRA), a departing employee may be able to achieve better results than he would by waiting for an annuity to commence at normal retirement age.
Qualified pre-retirement survivor annuity (QPSA). Plans must provide a QPSA payable to the participant’s surviving spouse if the vested participant dies before the annuity starting date and has a surviving spouse. (Code Sec. 401(a)(11)(A)(ii)) A QPSA is a form of death benefit paid as a life annuity (a series of payments, usually monthly, for life) to the surviving spouse (or a former spouse, child or dependent who must be treated as a surviving spouse under a qualified domestic relations order, or QDRO) of a participant who: (a) was vested in his or her retirement plan benefits; (b) died before retirement; and (c) was married to the surviving spouse (for at least one year if the plan so provides), or to a former spouse named in a QDRO.
Qualified joint and survivor annuity (QJSA). This refers to retirement benefits that are paid as a life annuity (a series of payments, usually monthly, for life) to the participant and a survivor annuity over the life of the participant’s surviving spouse (or a former spouse, child or dependent who must be treated as a surviving spouse under a QDRO) following the participant’s death. The monthly survivor benefit must be at least 50% of the joint benefit. (Code Sec. 417(b))
Note: The term “qualified survivor annuity” refers to both a QJSA and a QPSA.
Qualified optional survivor annuity (QOSA). Plans subject to the above qualified survivor annuity requirements must offer participants an election to have benefits paid in the form of a QOSA. Specifically, a plan participant may elect (with spousal consent, if married) to waive the QJSA form of benefit or the QPSA form of benefit, or both. (Code Sec. 417(a)(1)(A)(i), Code Sec. 417(a)(2)) And if the participant elects to waive a QJSA or QPSA, then he must be allowed to timely elect a QOSA. (Code Sec. 417(a)(1)(A)(ii))
A QOSA is an annuity for the life of the participant’s spouse that is equal to a specified percentage of the amount of the annuity that is: (1) payable during the joint lives of the participant and the spouse, and (2) the actuarial equivalent of a single life annuity for the life of the participant (or a distribution option having the effect of such an annuity). (Code Sec. 417(g)(1))
If the QJSA for a married participant provides a survivor annuity for the life of the participant’s spouse that is:
- Less than 75% of the amount of the annuity that is payable during the joint lives of the participant and his spouse, then the QOSA must provide a spouse survivor annuity percentage of 75%, or
- Greater than or equal to 75% of the amount of the annuity that is payable during the joint lives of the participant and his spouse, then the QOSA must provide a spouse survivor annuity percentage of 50%. (Code Sec. 417(g)(2); Notice 2008-30, 8, 2008-12 IRB 638)
Illustration. A defined benefit plan’s QJSA provides that a survivor’s benefit is 50%. Thus, the survivor annuity provided under the QOSA must be 75% of the amount of the annuity which is payable during the joint lives of the participant and the spouse.
Which plans must provide survivor annuities? The survivor annuity requirements of Code Sec. 401(a)(11) and Code Sec. 417 apply to all defined benefit (e.g., pension) plans and all other plans subject to the funding standards of Code Sec. 412 (i.e., money purchase pension plans, including target benefit plans). However, a special exception applies for certain money purchase plans that are part of employee stock ownership plans (ESOPs).
The survivor annuity requirements do not apply to defined contribution plans (other than money purchase and target benefit plans) where all of the following requirements are met:
- Under the plan, the participant’s nonforfeitable accrued benefit is payable in full, on the participant’s death, to the surviving spouse (unless the participant elects with spousal consent that the benefit be paid instead to a designated beneficiary);
- A life annuity option cannot be elected, or the participant does not elect to receive benefits in the form of a life annuity; and
- The plan is not a transferee or offset plan with respect to the participant. (Code Sec. 401(a)(11), Reg. § 1.401(a)-20, Q&A 3)
Requirements (2) and (3) are applied on a participant-by-participant basis. As a result, a profit-sharing or stock bonus plan, for example, could be subject to the survivor annuity requirements of Code Sec. 401(a)(11) and Code Sec. 417 for some participants but not others.
Single-life annuity. In general, if a participant is unmarried, payments from a defined benefit plan are made in the form of a single-life annuity. A married participant also can choose a single-life annuity if the participant’s spouse consents.
Payments to same sex-spouses or domestic partners. Under section 3 of the Defense of Marriage Act of 1996 (DOMA), before it was found to be unconstitutional by the Supreme Court’s Windsor decision in 2013, a qualified plan could not define the term “spouse” for its QJSA to include a same-sex spouse or domestic partner. Subsequent to the Windsor decision, Rev Rul 2013-17, 2013-38 IRB 20, held that for Federal tax purposes, the terms “ spouse,” “ husband and wife,” “ husband,” and “ wife” include an individual married to a person of the same sex if the individuals are lawfully married under state law, and the term “ marriage” includes such a marriage between individuals of the same sex. Also, for Federal tax purposes, IRS adopted a general rule recognizing a marriage of same-sex individuals that was validly entered into in a state whose laws authorize the marriage of two individuals of the same sex even if the married couple is domiciled in a state that does not recognize the validity of same-sex marriages.
Under Notice 2014-19, 2014-17 IRB 979, any retirement plan qualification rule that applies because a participant is married must be applied with respect to a participant who is married to an individual of the same sex. For example, a participant in a plan subject to the Code Sec. 401(a)(11) rules who is married to a same-sex spouse cannot waive a QJSA without obtaining spousal consent under Code Sec. 417.
Lump-sum payouts. A plan may provide that, if the PV of a QJSA or a QPSA is $5,000 or less, the entire present value of the benefit will be immediately distributed to the participant. (Code Sec. 417(e)(1)) However, if the present value of the benefit is more than $5,000, a lump-sum distribution can only be made with the participant’s (and spouse’s, if applicable) written consent. (Code Sec. 417(e)(2))