Blogging Employee Benefits

February 12, 2006

Restricted Employees – Use of Rollover to IRA for Security

Filed under: IRS, Nondiscrimination — Fuguerre @ 12:29 am

A segregated, reserved portion of an Individual Retirement Account will satisfy conditions relating to payment of a lump sum distribution to a restricted employee, according to a recent IRS private letter ruling. [PLR 200606051]

To prevent potential discrimination that could occur upon early termination of a defined benefit pension plan, one of the rules under the IRC §401(a)(4) nondiscrimination requirement limits the benefits payable to the 25 highest paid highly compensated employees. [Reg.§1.401(a)(4)-5(b)(1)] A lump sum distribution may be made in excess of those limits, provided adequate provision is made for repayment of restricted amounts in the event of plan termination while the restrictions remain applicable. [Rev. Rul. 92-76]

Can a restricted employee’s lump sum distribution provide its own security under these rules, while retaining favorable tax status for the retirement savings through a rollover to an IRA? The recent PLR blesses one approach –

  • Distribution of the value of the restricted employee’s entire accrued benefit from the defined benefit plan will be eligible for rollover to an IRA. Under the PLR’s arrangement, the restricted employee plans to take a lump sum distribution of the entire value of the accrued benefit under the defined benefit plan, despite the Reg.§1.401(a)(4)-5(b)(3) restriction on benefits, and roll over that entire amount into an IRA via a direct trustee-to-trustee transfer. As previously noted in Rev. Rul. 92-76, an otherwise eligible lump sum distribution that includes such restricted benefits remains characterized as a lump sum distribution, although a portion of the distribution may need to be returned to the plan, hence remains eligible for rollover despite the inclusion of the restricted benefits. Amounts withdrawn from the employee’s defined contribution account and deposited with the IRA via a trustee-to-trustee transfer in accordance with terms described below are similarly eligible for rollover treatment.
  • The IRA repayment agreement satisfies the nondiscrimination conditions of Reg.§1.401(a)(4)-5(b) and the security rules of Rev. Rul. 92-76. Under the PLR arrangement, the restricted employee and the employer will enter a repayment agreement to secure repayment of the restricted amount to the pension plan in the event such repayment is ever required. The employee will secure that repayment obligation by:
    • Segregation of the IRA into two separate accounts –
      1. “Restricted assets,” initially having a value equal to 125% of the restricted amount; and
      2. “Unrestricted assets” equal to any remaining IRA assets, if any;
    • Assignment by the restricted employee to the pension plan of rights in the IRA restricted assets; and
    • Agreement that the IRA bank will hold the IRA restricted assets for the benefit of the pension plan during the period of restriction.

    If (as would usually be likely) the initial IRA assets do not have an initial value of at least 125% of the restricted amount, a sufficient amount would be rolled over by a trustee-to-trustee transfer from the restricted employee’s account balance under a defined contribution plan. Subsequently, if the IRA restricted assets fall below 110% of the restricted amount, then any IRA unrestricted assets would be reclassified as restricted assets or another rollover from the defined contribution plan would be made, sufficient to raise the IRA restricted assets back to 125% of the restricted amount; else an escrow account would be established. The repayment obligation would terminate and the security released at any time that repayment is no longer required under Reg.§1.401(a)(4)-5(b) and the related rules.

  • Assignment of rights to the restricted assets will not violate IRA nonforfeitability rules. Since potential return of the IRA restricted assets to the defined benefit pension plan derives from the plan’s rights under Reg.§1.401(a)(4)-5(b), rather than from claim by the IRA trustee or the individual’s employer, the assignment of rights under the arrangement will not violate IRC §408(a)(4).
  • The rules applicable to use of IRA amounts as security for a loan do not apply. Since the contingent obligation to return certain restricted amounts to the plan is not a loan, the deemed distribution rules of IRC §408(e)(4) do not apply.
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