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Benefits Under PPA ’06 Expand to Include Beneficiaries

The IRS has begun to follow through on the Pension Protection Act of 2006 to revise the rules for retirement plans to allow for distributions to beneficiaries on account of hardship.

October 2007
from The Tax Adviser

Under the old rules, hardship distributions from qualified cash or deferred arrangements, such as Sec. 401(k) or governmental Sec. 403(b) plans, could not be made before the occurrence of specific events. The hardship distribution rules mandated that (1) these distributions be made on account of an “immediate and heavy financial need” of the participant or the participant’s spouse or dependent and (2) the distribution be necessary to satisfy their financial need.

Hardship Distributions

In an effort to use the safe-harbor standards provided in the regulations, and to ensure that allowable distributable events met the permitted criterion of being an “immediate and heavy financial” need, plans often permitted distributions of elective contributions to a participant or a participant’s spouse or dependents only for expenses described in Regs. Sec. 1.401
(k)-1(d)(3)(iii)(B).

For example, plan sponsors and administrators would build into the terms of their plan documents language that limited participant distributions to those events listed specifically in the relevant regulations. Although whether a condition will satisfy the requirement of being “an immediate and heavy financial need” remains essentially determinable on the basis of the relevant facts and circumstances in a particular case, certain costs are deemed to per se satisfy this requirement.

These costs include but are not limited to:

  1. Costs for medical care that would otherwise be deductible under Sec. 213(d) (without regard to whether the cost exceeds 7.5 percent of taxpayers’ adjusted gross income);
  2. Costs directly related to the purchase of a principal residence;
  3. Costs of tuition, related education fees, and room and board expenses for up to 12 months of postsecondary education for the employee or the employee’s spouse, children and dependents (for tax years after January 1, 2005);
  4. Costs necessary to prevent the employee’s eviction from his or her principal residence or foreclosure on the mortgage on that residence;
  5. Costs for burial and funeral expenses for the employee’s deceased parent, spouse, child or dependent; and
  6. Costs for repairing damage to the employee’s principal residence that would qualify for the casualty deduction under Sec. 165.

Allowing for these specific events in a plan document creates a safe-harbor list of events that are per se acceptable to the IRS in satisfying the immediate and heavy financial need standard. For example, the need to pay funeral expenses would constitute an immediate and heavy financial need, while the need to purchase a boat or a television would not. In addition, because plan administrators are generally required to determine for themselves whether these requirements have been satisfied, consideration of other sources of plan funds (i.e., borrowing against account balances allowed under the plan) or nonplan fund sources must be considered if known (though employers may generally rely on written representations of the employee as to the availability of other sources of funds).

PPA ’06

Under the new rules, as described in Notice 2007-7, plans permitting hardship distributions of elective contributions using the safe-harbor costs listed in the regulation may expand the class of individuals having the ability to receive hardship distributions to include a primary death beneficiary under the plan. This distinction is important; the rules as they existed did not provide primary death beneficiaries (i.e., people with a beneficial interest in an account on the death of the employee participant) with the ability to receive hardship distributions as provided by the safe-harbor event descriptions under the regulations. Notice 2007-7 elevates a person’s beneficial interest, in that he or she may receive benefits on the death of the plan participant, to the same level as a participant’s direct, spousal, or family relationship interest (at least for purposes of taking advantage of the hardship distribution regulations). Note, however, that for this purpose, a “primary beneficiary under the plan” is an individual who is named as a beneficiary under the plan and has an unconditional right to all or a portion of the participant’s account balance under the plan on the participant’s death.

Plans adopting these expanded hardship classifications must still meet all other requirements applicable to hardship distributions — namely, the requirement that the distribution be necessary to meet the financial need. In addition, the same expansion to the class of individuals is applicable to Sec. 403(b) plans, and these other requirements also continue to apply.

Unforeseeable Financial Emergency

In addition to its implications for Sec. 401(k) and 403(b) plans, Notice 2007-7 provides guidance on certain distributions made from Sec. 457(b) or Sec. 409A arrangements (or deferred compensation arrangements for executives). Under the new rules, these types of plans may treat participants’ beneficiaries the same as they treat participants’ spouses or dependents in determining whether the participant has incurred an unforeseeable financial emergency as described in the regulations.

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Kirk Sinclair, J.D., Holtz Rubenstein Reminick LLP, Melville, NY, is a contributor of The Tax Adviser. His views as expressed in this article do not necessarily reflect the views of the AICPA or The Tax Adviser.