IRS Rules On Annuity Issues In Defined Contribution Plans

In a preface to the 2010 policy discussion about enhancing income security in defined contribution plans, the Internal Revenue Service ruled in PLR 200951039 on several issues under current law related to the use of annuity products in these plans.

Facts

The ruling request, which was pending since 2005, generally posited the following facts:

A qualified defined contribution plan holds a group annuity contract that is used to offer an annuity distribution option to participants. That distribution option is mirrored in the provisions of the plan. The contract makes available both fixed and variable (ultimately, mutual fund) investment options to which participants can allocate their accounts before and after distributions commence.

The annuity distribution option provides for an income payment stream for the participant’s life (or the joint life of the participant and a designated beneficiary) in two phases.

• Phase I is a series of periodic withdrawals for five years up to a designated maximum period, as the participant elects. The initial periodic payment is the product of the participant’s account value on the start date and certain payout options and actuarial factors selected (within specified ranges) by the participant. The amount of the payment thereafter is adjusted for the net performance of the investment options selected by the participant in relation to an assumed interest rate. The participant may, within limits, (i) allocate additional plan contributions or transfer other plan balances to the contract, (ii) surrender his or her interest in the contract in full, (iii) direct the insurance company to stop or restart payments, or (iv) change certain payout or actuarial options. On the participant’s death, the account value is available as a death benefit.

• At the end of Phase I, the contract provides for the commencement of Phase II. During this phase, life contingent annuity payments are made in a predetermined periodicity and amount (other than ongoing adjustments for actual investment performance) for the life of the participant and continue even if the account value is exhausted. The participant may no longer exercise the Phase I rights noted above. Payments are continued after the participant’s death in accordance with the form of the annuity and death benefit option elected by the participant (subject to Section 401(a)(9)).

For state insurance regulatory purposes, Phase I and Phase II payments are treated as a deferred annuity and as a payout annuity, respectively.

Rulings

Required Minimum Distributions: With respect to required minimum distributions under Section 401(a)(9), the IRS ruled:

During Phase I, RMDs are determined under the “account” rules of Treasury Regulation Section 1.401(a)(9)-5; but that During Phase II, the contract is “annuitized” because the payments become “fixed,” notwithstanding the ongoing adjustments for investment performance, and hence RMDs are determined under the “annuity” rules of Treasury Regulation Section 1.401(a)(6)-6.

The IRS, which had not previously addressed when a contract is “annuitized” for these purposes, relied on the definition of “amounts received as an annuity” under Treasury Regulation Section 1.72-2, the state law treatment of the contract, and the extent of participant control over the amount and timing of payments.

Election of a Life Annuity: Because the plan relied on the profit-sharing plan exception in Internal Revenue Code Section 401(a)(11)(B)(iii), spousal consent to a payment form other than a qualified joint and survivor annuity (“QJSA”) was not required unless and until a participant elects “benefits in the form of a life annuity.” The IRS observed that, under the contract, the participant elected the annuity distribution option at the start of Phase I and did not necessarily make a second election prior to Phase II.

Given that structure, the IRS characterized that initial election as an election to receive a future benefit in the form of a life annuity (Phase II payments), preceded by a distribution not in the form of a life annuity ( Phase I payments). Accordingly, the IRS ruled that Section 401(a)(11) applies at the time the participant elects the annuity distribution option, as distinguished from the election to receive Phase I payments or (as the taxpayer urged) Phase II payments.

Treasury Regulation Section 1.401(a)-20, Q&A-4 provides, however, that once a life annuity option is elected, the survivor annuity requirements of Section 401(a)(11) and Section 417 apply to all of the participant’s benefits unless there is a separate accounting of the account balance subject to the election.

To the extent such a separate accounting is provided, the practical import of the ruling is that the plan must satisfy the applicable written explanation, consent, election and withdrawal rules of Section 417, including waiver of the QJSA, only with respect to Phase II payments and within 180 days of the Section 417(f) “annuity starting date” (which the ruling does not address).

QJSA: Consistent with the structure of variable payout annuities generally, the contract determines Phase II payments, to the extent measured by the variable investment options under the contract (rather than the fixed option), on the basis of “annuity units” that vary in value with the performance of the investment option. The IRS agreed with the taxpayer that a QJSA could be based on a specified percentage of the annuity units used to calculate payments during the joint lives of the participant and the spouse, rather than of the dollar amount payable during that period.