The seemingly obscure issue of when a payment from an annuity contract purchased under a Defined Contribution plan is considered to be a "payment from an annuity" is actually one of the most pressing tax issues that needs to be resolved in the area of DC annuitization. Resolution of this issue determines when spousal consent rules apply and notices given. What makes it so important to have a clear set of spousal rights rules is that the timing of the application some of the actuarial rules used in determining the level of benefit under certain kinds of products can be affected and, more universally, the actual administration of the spousal consent rules can be challenging in the best of worlds.
At issue, again, in the latest PLR from the IRS is how the spousal consent rules apply to a "hybrid" annuity of the sort which is being widely designed in the 401(k) marketplace. These hybrid products guarantee lifetime income while also maintaining a participant account account balance under which the participant remains invested in equities. These types of products tend to have complex designs, but they basically permit participants to withdraw amounts from their account balances throughout their lifetime and provide "longevity insurance" payments at a guaranteed level once the account balances reach zero or the participant reaches a certain age.
Simply put, the IRS was asked if electing and beginning a flow of withdrawals from an account balance at actuarially determined levels, where the actual "insurance" does not kick in for a number of years, constitutes "payment as an annuity" (I won’t go into here the Sect 417 differences between "payments as an annuity" and "payments NOT as an annuity").
The IRS first answered that question late in 2009 in PLR 200951039. It ruled that the that the initial election from this sort of product was legally two different elections: it was first an election to take “payments as an annuity” at that later date, when "insurance payments" arising from the longevity insurance kicked in, which then triggers application of the 417 rules. Secondly, for any payment prior to that "longevity insurance" payment start date, it was an election to take “payments not as an annuity.”
In the new PLR, 201048044, the IRS apparently shifted from this initial position. A vendor introduced a new product for the 401(k) marketplace which is (from a strictly legal view) strikingly similar in key respects to the product described in In the prior PLR. The taxpayer asked for guidance on whether the initial payments under the scenario described above would be considered "payment as annuity."
Surprisingly, and in contradiction to its earlier ruling, the IRS answered that it would be.The new PLR ruled that the initial distribution election characterizes ALL periodic payments from the contract as “payments as annuity,” beginning with the first payment. This is so even though all the payments are withdrawals from an account balance, reducing that account balance.
Lets look at the details to see why this appears to be a shift in the IRS position.
In the new PLR, the product is a specially designed “”Guaranteed Lifetime Withdrawal Benefit,” or GLWB with a number of unique design elements, held by a plan. The product in the prior PLR was a unique version of variable annuitization, distributed from a plan. The two products, however, share common design elements which are determinative of how to apply the "payment as an annuity" rules:
-Participant DC account balances are deposited in equity based, insurance pooled separate accounts, which balances will vary with investment performance.
-The participants elect to begin taking a monthly payment at time of retirement. Positive investment performance serves to increase the monthly benefit over time, investment losses serve to decrease the benefit. Under both products, there is a guarantee base under which the benefit will never go below, in spite of investment losses.
-Payments reduce the account balance.
-The amount of the monthly withdrawals are actuarially determined. Under the product in the prior PLR, the monthly payment is calculated based on life expectancy. In the product in the new PLR, the base payment is calculated using an average calculation from a pool of insurers.
-The death benefit while there is an account balance equals the account balance.
-The participant can withdraw all or any portion of the account balance at any time. Under the product in the prior PLR, this right ceases at the earlier of a stated age or when the account balance reaches zero. Under the product in the new PLR, that right ceases at the time the account balance becomes zero.
-The insurance company continues to pay the elected monthly benefit for the rest of the participant’s life, even after the account balance reaches zero (thought he monthly benefit is ultimately reduced by early withdrawals). This is the true income guarantee.
Of the two different positions taken by the IRS, one position is not inherently better than the other. They both have their strengths and their weaknesses (which I will not go into here). Whether one is better suited than the other is so much dependent on the specific product design and the administration and system capabilities of the insurer. This new PLR is actually more consistent with the tax treatment of similar types of payments of "non-qualified" annuities (that is, annuities not sold in relation to qualified plans).
The problem is that the differences in these two rulings are difficult to reconcile, and muddies the waters for designing DC annuitization programs. There are a number of important differences between the products described in the two PLRs, but none of them appear to impact the determination of when payments should be characterized as "payment as an annuity." If there is a critical, minute fact difference upon which the the new rule was based, it would be helpful for the IRS to highlight it so we can use it in our design efforts I suspect, however, that the difference lies in process: the request for this new PLR was put in much different terms than the first, and the PLR was issued out of a different IRS group than the first.
In any event, we now have contradictory rulings. While the IRS has firmed up the position that payments from these sorts of hybrid products are (at some time or another) "payments as an annuity" subject to 417, it left us with confusion as to when that status actually occurs. An opportunity to settle the issue has been missed. Instead, we are left with a new, self-constructed bump in the road for DC annuities- without any particular policy consideration serving as its basis.