American Bar Association Proposals To Simplify Pension Tax Laws

As my previous blog installment explained, major simplification of federal tax laws is universally desired but unlikely in the near future due to political gridlock. Piecemeal simplification of pension laws and regulations appears more feasible. In October, the American Bar Association Tax Section submitted recommendations to Congress that would simplify selected tax laws affecting pension and benefit plans. The ABA recommendations deserve attention because past ABA proposals of this type have convinced Congress to eliminate some very unwieldy pension laws, such as the impossibly complex “combined plan” limit of Code section 415(e). (I worked on the ABA committee that urged Congress to eliminate Code section 415(e).)

The ABA proposes a variety of changes, most significantly:

•  Simplification of the age 70 1/2 required minimum distribution rules to

–  exempt taxpayers whose tax qualified plan benefits are $250,000 or less and whose IRAs have combined values under $250,000, and

–  require post-death distributions within five years after the death of the individual and spouse or, if the beneficiary is a child of the decedent or his or her spouse, the beneficiary’s attainment of age 26.

These changes deserve Congressional approval, because they would allow more flexibility in the timing of distributions from smaller retirement accounts and would streamline post-death distribution rules.

•  Liberalization of pension rules to allow employees to receive pension benefits while continuing to work as early as age 55, rather than the current minimum age 62.

Although this proposal would simplify distribution rules for pension plans, I question the choice of age 55. It adds potential confusion because it does not coordinate with laws prohibiting in service withdrawals from 401(k) and 403(b) plans before age 59 1/2.

Political Gridlock and Pension Law

The Presidential campaigns rarely mention pension issues, but pension law is shaped by politics. What do current political trends mean for the future of pension law? A recent book by two prominent congressional scholars tells us that the political gridlock in Washington is Even Worse Than It Looks. The authors, Thomas E. Mann and Norman J. Ornstein, explain that the causes for this include:

•  Political parties that are polarized and “vehemently oppositional”;  

•  The “checks and balances” in the U.S. constitutional system, which present “more structural impediments to action than any other major democracy”;

•  Redistricting that allows politicians to run in “safe” districts, not requiring them to respond to diverse political views;

•  Splintered media sources that narrow their ideology to viewers’ preferences, promoting extremism rather than centrism; and

•  Campaign finance laws that allow huge sums of money to buy negative, polarizing ads.

What does this portend for tax simplification proposals that would affect pension laws? It suggests that no comprehensive changes are imminent. In some ways, this is good. It delays the possible disruption that could be caused by major “simplification” of the kind proposed by the Bush administration, which would consolidate various retirement plans (457, 403(b), 401(k)) into a single form called an Employer Retirement Savings Plan. The American Society of Pension Professionals and Actuaries has stated that such reforms would “not be simplification” and “would disrupt saving, and force state and local government and nonprofits to modify their retirement savings plans and procedures.” Gridlock would also forestall proposals to reduce retirement plan tax benefits in order to raise revenue, such as the “20/20” proposal of the National Commission on Fiscal Responsibility and Reform that would limit annual contributions to the lesser of $20,000 or 20% of compensation.

The good news is that vast complexities of pension law could be simplified by administrative action and piecemeal legislation. Progress on simplifying pension law is possible despite a political situation that may remain Even Worse Than It Looks.

Correction of IRS Model 402(f) Notice is Long Overdue

 

It has been three years since the IRS issued its version of the “402(f)” notice that retirement plans must provide before paying a distribution that is eligible for rollover to an IRA. (IRS Notice 2009-68.) Buried in the IRS notice is a description of rollover rules for after-tax money that does not follow Internal Revenue Code section 402(c)(2). The IRS should correct this notice, as it presents unjustified complications for individuals who wish to make a direct IRA rollover of taxable retirement plan money and also receive a distribution of after-tax retirement plan money.

 

Detailed analysis of this error in the IRS notice appears in correspondence to the IRS from interested parties such as the American Benefits Council. See http://www.americanbenefitscouncil.org/documents/followup_letter_re_402c2.pdf

 

The IRS position is particularly illogical because it can be avoided through an indirect rollover. According to the IRS position, a portion of a plan’s after-tax distribution is taxable when paid to a recipient who also makes a direct rollover of a taxable distribution from the plan to an IRA. However, the IRS concedes that the after-tax distribution is not taxable if the recipient takes the extra step of first receiving the entire distribution (including after-tax and pre-tax money and paying 20% withholding tax) and then rolling the taxable money to an IRA within 60 days. It is illogical for the IRS to adopt a policy that gives an indirect rollover more favorable tax treatment than a direct rollover. It is also contrary to the plain wording of Internal Revenue Code section 402(c)(2). The IRS owes the pension community a long overdue correction of this error. A three year delay in taking corrective action is too long, particularly for retirement plan sponsors who struggle to satisfy the many complex deadlines the IRS applies to their tax law compliance.

Having Your Pension and Working Too—A Strict IRS Ruling Contrasts with New Laws for Federal Employees

A new law (the 2012 Highway Investment Act) allows a phased retirement program for federal employees. In contrast, an IRS private letter ruling severely restricts pension plans from paying benefits to retirees who return to work before age 62. This difference in laws governing federal pensions and other pension plans is illogical.

The new law allows federal employees to work part time at 20% to 80% of their full-time schedule, receive pay and pension credit for that working percentage, and also receive a pension for the other (nonworking) percentage of their full-time schedule. No termination of employment is required to start this combination of work and pension.   

In contrast, tax laws prohibit all other “pension plans” (money purchase pension plans and defined benefit pension plans) from providing benefits to an employee who is under age 62 and has not retired or separated from employment (unless the employee has reached the plan’s “normal retirement age”). Internal Revenue Code section 401(a)(36), Treas. Reg. sections 1.401(a)-1(a)(2) and 1.401-1(b)(1)(i). Because the meaning of key terms such as “retired” and “separated from employment” is open to varying interpretations, the practical impact of these laws has been uncertain. Just how long must an employee be absent from work to make a pension payment permissible before age 62? Under what circumstances may the employee return to work without jeopardizing the tax qualified status of the pension plan?

The IRS letter ruling (201147038) states that an absence from employment for a week or less is not a bona fide separation or retirement. The ruling refers to Treasury Regulations interpreting Code section 409A to define “retirement” and “separation.” (The ruling notes that “although section 409A and its regulations address a nonqualified plan arrangement the definitions regarding termination and separation from service are consistent with” the definitions for purposes of pension plan qualification.) The 409A regulations apply very strict rules. For example, the 409A regulations generally require that the employer and employee reasonably anticipate that after the date of termination the employee will either perform no further services, or services at a level of no more than 20 percent of the average services performed over the immediately preceding 36 month period. The regulations also list other relevant factors, such as whether the employee continues to be eligible for other employee benefit programs, whether the employee is permitted and available to perform service for others in the same line of business and whether a change in business circumstances, such as termination of the employee’s replacement, causes the employee to return to employment.

The result is:  Plans that pay pensions to retirees under age 62 who are rehired after a short absence face possible disqualification if the IRS determines that the retirement was a sham, because the retiree returns to work at more than 20% of his prior work schedule. In contrast, the new law allows federal employees (including IRS employees) to switch to 20% to 80% part-time work and receive federal pensions before age 62 without terminating their employment.

These differences in laws for federal employee pensions and other pensions make no sense.

Pension COLA Reductions—Contract Breach or Justified Flexibility?

Is it legal to reduce pension cost-of living adjustments (COLAs) being paid to retirees? This question is a major issue, because of the value of COLAs for retirees and their high expense for pension plans. Recent reductions in retiree COLAs for several state and local government pension plans have brought legal challenges. The following paragraphs briefly examine how legal protections for COLAs differ in private sector and public sector pension plans. Recent cases offer less protection to public pension COLAs than previous cases, yet public pension COLAs still exist. In contrast, private plan COLAs have are rare, perhaps due to legal restrictions. Is a COLA that may be reduced better than none?

(a) Broad Level of Protection: Past State Court Decisions Protect Governmental Pension COLAs for Past and Future Accruals. Because state laws vary, there is no single “general rule” for public sector pension COLAs. However, some past state court decisions give public sector COLAs surprisingly broad protections. At least one decision prohibits COLA reductions for past and future pension accruals for active employees, e.g., Calabro v. City of Omaha, 247 Neb. 955, 531 N.W.2d 541 (1995). Another decision prohibits COLA reductions for employees who have worked for a “legally significant period of time” Nash v. Boise City Fire Department, 104 Idaho 803, 663 P. 2d 1105 (1983). These decisions protect COLAs not only for current retirees but also for benefits earned in the future by active employees, so that COLAs may only be cut back for newly hired employees or employees who have worked for less than a “legally significant period of time.” These decisions seem almost naïve in the simplicity with which they create potentially huge future COLA liabilities for state and local pension plans.

(b) Medium Level of Protection:  ERISA Protects Private Sector Pension COLAs for Past Accruals. Unlike the COLA rules for public sector plans that were created by state courts, laws affecting private sector COLAs have been studied, written and revised over time by Congress, the IRS and the U.S. Department of Labor as well as federal courts. The resulting laws, which are more exacting than state court decisions, prohibit reductions in COLAs for past benefit accruals (with limited exceptions for very poorly funded plans). This approach allows reductions in COLAs for benefits earned in the future but not the past. Hickey v. Chicago Truck Drivers, 980 F. 2d 465 (7th Cir. 1992). The laws for private sector pensions also address the question:  May a pension plan avoid this prohibition on COLA reductions by adopting a temporary or “ad hoc” COLA, or does that make the benefit too unreliable because it may be renewed (or not) at the discretion of the plan sponsor? Treasury regulations adopted in 2005 allow only limited use of “ad hoc” COLAs, by prohibiting a COLA (or other benefit) reduction if it is part of “a pattern of repeated plan amendments providing for similar benefits in similar situations for substantially consecutive, limited periods of time.” (Treas. Reg. section 1.411(d)-4 Q&A-1(c)(1).) In simpler (but less precise) words, a private sector pension plan may adopt a temporary COLA once or twice, but the COLA becomes a protected, permanent pension benefit after it is renewed several times.

(c) Low Level of Protection: Recent State Court Decisions Allow Public Pension COLA Reductions for Retirees. Recent state court decisions uphold COLA reductions for public sector pensions, reasoning that (1) the governing pension documents do not state that COLAs are protected contractual rights, and (2) the COLAs are not a protected benefit because they have been repeatedly adopted in varying forms over time. Justus v. Colorado (District Court for Denver City and County, 2011) and Swanson v. Minnesota, (Ramsey County District Court, 2011). Could these decisions approving “ad hoc” COLAs create a precedent that undermines the broader security of public sector pension benefits (a concern that tax regulations governing private sector pensions attempt to address with more detailed regulation)? Or do these decisions allow benefit flexibility that is necessary to continue to pay benefits from underfunded public pension plans (applying less stringent rules than apply to private sector pensions)? Which approach serves the interests of pension plan sponsors and participants more fairly and effectively? One thing is certain: future pension law developments will offer more examples of the trade-off between pension viability, flexibility and security.

Supreme Court Justice Roberts’ 1935 Opinion on Pension and Health Care Reform

“Those who cannot remember the past are condemned to repeat it.”

–George Santayana 

This quote came to mind recently while I read Supreme Power by Jeff Shesol. This fascinating book recounts the legal standoff between Franklin Roosevelt and the Supreme Court over the constitutionality of FDR’s “New Deal” legislation. In a key decision, the Supreme Court struck down the Railroad Retirement Act as unconstitutional on May 6, 1935. The author’s explanation of this decision (Railroad Retirement Board v. Alton) initially peaked my interest because it involved pension legislation that, similar to ERISA, was intended to safeguard pensioners in dying industries. The laws mandated employer and employee contributions to pensions for retirees of failing railroads. But the interesting parallels to current legal issues did not end there. The name of the Supreme Court Justice who wrote the 1935 opinion was Roberts (although the 1935 Justice was named Owen Roberts, not John Roberts). Even more striking, the 1935 opinion discussed not only employer‑provided pensions but also employer‑provided medical benefits. Justice Roberts opined that the federal government could not force the railroads to provide pensions because this was not within the federal powers to regulate interstate commerce. As the book explains, Justice Roberts reasoned that if Congress could mandate employer‑provided pensions, then “there was no limit to the field of so-called regulation”: Congress could order employers to provide employees “a hundred other matters” including, “say, free medical care for employees.”  (Emphasis added, Supreme Power, page 118.)

As this illustrates, current legal controversies surrounding employer‑provided pension and medical benefits have occurred in the past. And they will undoubtedly continue into the future (perhaps even with other Justices named Roberts).