7. H.R. 1961

Portability of Pension Plan Benefits

Background

There is no precise definition of portability of pension benefits, and the term is often used to refer to a broad range of concepts. In general terms, portability refers to the ability to maintain pension benefits following a change in employment. In order to evaluate any pension portability proposal, it is helpful to understand what is meant by portability, and what aspect of portability any particular proposal means to address.

The most discussed concepts of portability generally fall into three categories: (1) portability of benefits, which generally refers to vesting; (2) portability of service (also sometimes called portability of credited service or portability of service history), which refers to the ability to count years of service under a plan of a prior employer in determining benefits under a plan of a new employer; and (3) portability of assets (also sometimes called portability of current or present value), which refers to the ability to maintain a distribution of benefits in another retirement arrangement.

In addition, issues of coverage (i.e., what employees are covered under private pension plans) and preservation of benefits (i.e., whether an individual saves a distribution of retirement benefits or spends the distribution for preretirement purposes) often arise in discussions on portability. H.R. 1961 (described below) generally relates to portability of assets and coverage issues.

In general

Present Law

Under present law, the pension system that provides the greatest degree of portability is the social security system. The social security system provides almost universal coverage for all workers, and benefits are based on all covered employment. Outside the social security system (i.e., in the private pension system), present law requires portability of service in limited circumstances. There are a number of provisions of present law which facilitate portability of assets, the most significant being the ability to roll over distributions to an individual retirement arrangement (IRA). In addition, the withdrawal restrictions applicable to tax-qualified retirement plans, as well as the rules regarding taxation of benefits, are generally designed to provide incentives to individuals to save pension benefits for retirement purposes, and not spend them for preretire

ment uses.

Under a plan of deferred compensation that meets the qualification standards of the Internal Revenue Code (a qualified plan), an

(24)

employer is allowed a deduction for contributions (within limits) to a trust to provide employee benefits. Similar rules apply to plans funded with annuity contracts. A qualified plan may be a pension, profit-sharing, or stock bonus plan.

An employer's deductions and an employee's benefits under a qualified plan may be limited by reference to the employee's compensation. The Code also imposes overall limits on benefits or contributions that may be provided under qualified plans.

Under a qualified plan, employees do not include benefits in gross income until the benefits are distributed even though the plan is funded and the benefits are nonforfeitable. Tax deferral is provided under qualified plans from the time contributions are made until the time benefits are received. The employer is entitled to a current deduction (within limits) for contributions to a qualified plan even though an employee's income inclusion is deferred. In addition, employees may make after-tax contributions to a qualified plan and defer taxation on the earnings on such contributions until distribution from the plan. An employee may also make elective deferrals to a qualified plan on a salary reduction basis. Elective deferrals are excludable from gross income when made, and are not taxed until distributed from the plan.

Benefits or contributions under a qualified plan are subject to standards designed to prohibit discrimination in favor of highly compensated employees. In addition, qualified plans are required to meet minimum standards relating to coverage (what employees participate in the plan), vesting (the time at which an employee's benefit becomes nonforfeitable), and benefit accrual (the rate at which an employee earns a benefit). Also, minimum funding standards apply to the rate at which employer contributions are required to be made to ensure the solvency of pension plans.

A simplified employee pension (SEP) is another type of tax-favored retirement arrangement under which the employer contributes directly to an IRA established for the employee. A contribution must be made for each employee who is at least age 21, has performed service during at least three of the immediately preceding five years, and received at least $300 of compensation from the employer. Contributions must bear a uniform relationship to compensation. Under the Tax Reform Act of 1986, employers with less than 25 employees may establish SEPS on a salary reduction basis. Like qualified plans, contributions to SEPs are excludable from income and earnings accumulate on a tax-deferred basis.

Portability of assets

In general

There are a number of provisions in present law that facilitate portability of assets. Present law encourages portability by permitting assets to be rolled over or to be transferred from one tax-favored retirement arrangement to another, and by providing incentives to individuals to save amounts received from retirement plans for retirement purposes.

IRA rollovers

An individual may generally roll over a distribution received from a qualified plan to an IRA if (1) the distribution is a total distribution of the individual's entire interest in the plan, or (2) the distribution is a qualified partial distribution. To the extent a distribution is rolled over into an IRA, it is not includible in income and is not subject to the 10-percent additional income tax on early distributions (see below). Of course, when such amounts are subsequently distributed from the IRA, they are includible in income and subject to the 10-percent additional income tax unless an exception to the tax applies. Only employer contributions (and income on employer or employee contributions) can be rolled over to an IRA. Distributions of employee contributions cannot be rolled

over.

A total distribution may be rolled over to an IRA if it is made (1) because of the death of the individual; (2) after the individual has attained age 59-1/2; (3) because of termination of employment (other than in the case of a self-employed person); or (4) in the case of self-employed persons only, after the individual becomes permanently disabled. In the case of these distributions, a distribution is a total distribution only if it includes the individual's complete share in all of the employer's pension plans, or profit-sharing plans, or stock bonus plans. That is, for this purpose, all plans of the same type are treated as a single plan.

A total distribution may also be rolled over if it is made because of a termination of a plan. In order to qualify as a partial distribution, a distribution must be at least 50 percent of the individual's interest in the plan and meet certain other requirements.

Tax-free rollovers and transfers between IRAS are permitted, although certain restrictions may apply.

Rollovers and transfers to another qualified plan

Distributions from qualified retirement plans can generally be rolled over to another qualified plan or transferred to another qualified plan on the same basis that distributions can be rolled over to an IRA, except that partial distributions may only be rolled over to an IRA. Present law does not require that plans permit transfers or rollovers from another qualified plan. Plan provisions permitting such transactions are likely to be most prevalent in the case of related companies or where there has been a merger or acquisition.

Incentives to retain funds for retirement purposes

In some cases, present law restricts the ability of employees to obtain a distribution from a qualified retirement plan prior to termination of employment. In the case of pension plans, i.e., defined benefit plans and money purchase pension plans, distributions cannot be made prior to termination of employment. Elective contributions to qualified cash or deferred arrangements (sec. 401(k) plans) cannot be distributed prior to termination of employment, attainment of age 59-1/2, death, disability, or financial hardship. Contributions to profit-sharing and stock bonus plans generally can be distributed within two years of when they were contributed.

Employee contributions generally may be withdrawn at any time. A plan may impose stricter restrictions on plan distributions than those imposed by the qualification rules.

The qualification rules generally require that a distribution be available upon the attainment of normal retirement age. Whether an employee who terminates employment prior to normal retirement age has the right to obtain a current distribution of the value of his or her benefit depends on the terms of the plan. Defined contribution plans generally permit a distribution of the employee's account balance upon termination of employment. In defined benefit plans, there are not separate accounts for each individual and, as a result, distributions often are not available until retirement age. Some defined benefit plans prefer not to make lump-sum distributions, because doing so can affect the funded status of the plan.

If the present value of the employee's benefit does not exceed $3,500, the benefit may be distributed upon termination of employment to the individual, without the individual's consent. Many plans, including both defined contribution plans and defined benefit plans, will cash out benefits of less than $3,500 because the employer will want to avoid the administrative burdens of keeping track of small benefits for former employees.

If the present value of the individual's benefit exceeds $3,500, then the benefit cannot be distributed prior to the later of normal retirement age or age 62, unless the participant consents to the distribution. Thus, participants with larger benefits have the option of deferring a plan distribution until retirement age.

Taxation of distributions

A number of rules regarding taxation of distributions are designed to encourage individuals to save distributions for retirement purposes rather than use them for current consumption.

For example, the Tax Reform Act of 1986 (the 1986 Act) added a 10-percent additional income tax on all early distributions from qualified retirement plans, including IRAs. Prior to the 1986 Act, a similar 10-percent tax applied to early distributions from IRAs and early distributions to certain "key employees," such as five-percent owners, from a qualified plan.

The tax is an additional income tax, so it only applies to the portion of a distribution includible in income. Thus, the tax does not apply to distributions of employee contributions or to the portion of a distribution that is rolled over to another qualified plan or an IRA.

In addition, the additional tax does not apply to distributions (1) after attainment of age 59-1/2; (2) due to the death of the individual; (3) due to the disability of the individual; (4) used to pay medical expenses that would be deductible if the individual itemized deductions (not applicable to IRAs); (5) that are part of a series of substantially equal periodic payments made for the life or life expectancy of the individual (or the joint lives or joint life expectancies of the individual and his or her spouse); (6) made in the case of an employee who separated from service after attainment of age 55 (not applicable to IRAs); (7) from an employee stock ownership

plan; or (8) made pursuant to a qualified domestic relations order (not applicable to IRAs).

Other changes in the 1986 Act were also designed to reduce the incentive to take distributions prior to retirement. Under the law prior to the 1986 Act, an individual who received a lump-sum distribution could elect to apply 10-year income averaging to the distribution, which treated the distribution as if it had been received over a 10-year period. In addition, under prior law, the portion of a lump-sum distribution attributable to contributions prior to January 1, 1974, could qualify for treatment as long-term capital gains. The 1986 Act phased out long-term capital gain treatment over six years and replaced 10-year forward averaging with five-year forward averaging. In addition, averaging may be elected only after the individual has attained age 59-1/2, and only one such election may be made.

In general

Explanation of the Bill

H.R. 196114 modifies the rules relating to distributions from qualified plans (sec. 401(a)), qualified annuity plans (sec. 403(a)), tax-sheltered annuity contracts (sec. 403(b)), and IRAs (sec. 408). Generally, the bill provides that (1) in certain circumstances, direct transfers to IRAs are required in lieu of distributions; (2) the Treasury Department may permit the distribution of employee contributions to be rolled over; (3) distributions from IRAs must be made with the consent of the IRA owner; (4) certain spousal rights to survivor benefits are required for IRAs and tax-sheltered annuity contracts; (5) certain nontax provisions are made applicable to pension plans consisting of one or more IRAs; and (6) the rules relating to salary reduction SEPS are modified.

Transfers

In general, the bill requires that single-sum distributions to employees or their spouses from qualified plans, qualified annuity plans, and tax-sheltered annuity contracts (qualified retirement plans) be made in the form of a direct trustee-to-trustee transfer to an IRA. This requirement does not apply, however, if (1) the present value of the employee's accrued benefit exceeds $3,500, (2) a different form of benefit is elected, and (3) commencement of payment of the benefit is not deferred. This requirement also generally does not apply to governmental plans, church plans, certain frozen plans, and certain plans to which employers do not contribute.

The bill also requires that an individual be permitted to transfer IRA assets to another IRA or to a qualified retirement plan that accepts such transfers.

14 H.R. 1961 was reported, with amendments, by the House Committee on Education and Labor on June 7, 1988 (H.Rpt. 100-676, Part 1). The bill was referred jointly to the Committee on Education and Labor and the Committee on Ways and Means.

H.R. 1961, as reported, has the same provisions as 8. 2848 (Senator Quayle).