Originally published November 2004

Contents

  1. IRS and SSA Announce Dollar Limits and Thresholds for 2005
  2. President Signs Tax Bill with Significant Non-qualified Deferred Compensation Changes/Immediate Action Required
  3. Withholding Requirements Increased for Supplemental Wage Payments in Excess of $1 Million
  4. New Legislation Excludes Incentive Stock Option and Employee Stock Purchase Plan Income from Social Security Wages
  5. Modified Definition of Dependent Potentially Affects Benefit Plans
  6. Automatic Rollover Rules Go Into Effect March 28, 2005
  7. Guidance Issued on Locating Missing Plan Participants under Terminating Defined Contribution Plans

1. IRS and SSA Announce Dollar Limits and Thresholds for 2005

The Internal Revenue Service has announced cost-of-living adjustments to the dollar limits on contributions made to, and benefits under, tax-favored retirement plans, and other thresholds for 2005.

Many of the pension plan limitations will change for 2005 because the increase in the cost-of-living index met the statutory minimum necessary to trigger an adjustment. Other limits or threshold amounts increase as required by statute.

The dollar limits and thresholds applicable for years beginning in 2005 are as follows:

Retirement Plans

The annual limit on 401(k) contributions, 403(b) elective salary reduction contributions, and deferrals under 457(b) plans is increased to $14,000 (from $13,000).

The annual dollar limit for catch-up contributions made to an applicable 401(k) plan or 403(b) arrangement for individuals age 50 or over is increased to $4,000 (from $3,000).

The dollar limit on annual benefits payable from a defined benefit plan is increased to $170,000 (from $165,000).

The annual limit on contributions and forfeitures that can be allocated to a participant’s account under a defined contribution plan is increased to $42,000 (from $41,000).

The annual limit on compensation that may be taken into account in determining contributions or benefits (and for certain testing purposes) is increased to $210,000 (from $205,000).

The dollar amount used to determine highly compensated employee (HCE) status is increased to $95,000 (from $90,000). This means that an employee will be an HCE for a plan year beginning in 2006 if he or she has compensation in excess of $95,000 for the 2005 plan year. (HCE status for plan years beginning in 2005 will be based on whether the employee has compensation in excess of $90,000 during the 2004 plan year.)

Social Security Taxable Wage Base

In addition to these limits, the Social Security Administration has announced that the Social Security taxable wage base will increase to $90,000 for calendar year 2005 (up from $87,900 for calendar year 2004).

2. President Signs Tax Bill with Significant Non-qualified Deferred Compensation Changes/Immediate Action Required

On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004. This new law contains a number of major changes applicable to non-qualified deferred compensation arrangements, as discussed in detail in a previous article (please click on ‘Next Page’ link at bottom of page to read this). The new law requires the IRS to issue guidance by December 21, 2004; however, as discussed in the Client Alert, it is very important for employers to review their non-qualified deferred compensation arrangements immediately, as the IRS guidance might not be issued in time to assist employers in providing information about the changes to participants who wish to elect to defer compensation otherwise payable in 2005.

3. Withholding Requirements Increased for Supplemental Wage Payments in Excess of $1 Million

The American Jobs Creation Act of 2004 also contains new withholding requirements for certain supplemental wage payments (e.g., bonuses, commissions). Currently, supplemental wage payments are subject to withholding at a flat rate of 25 percent. Effective for payments made after December 31, 2004, supplemental wage payments in excess of one million dollars in a year will be subject to withholding at the highest income tax rate (i.e., 35 percent for 2005).

4. New Legislation Excludes Incentive Stock Option and Employee Stock Purchase Plan Income from Social Security Wages

Although historically employers had not included income resulting from incentive stock options or section 423 employee stock purchase plans in an employee’s wages for FICA and FUTA purposes, in November 2001 the IRS issued proposed regulations that would have required the withholding of FICA and FUTA taxes in those circumstances. While these proposed regulations never went into effect, there has remained a lack of clarity in this area. The American Jobs Creation Act of 2004 puts an end to this confusion and specifically excludes from FICA and FUTA wages any income which results from (i) a transfer of stock to an individual under an incentive stock option or under a section 423 employee stock purchase plan, or (ii) the sale (including a disqualifying disposition) of that stock.

5. Modified Definition of Dependent Potentially Affects Benefit Plans

The newly enacted Working Families Tax Relief Act of 2004 modifies the definition of "dependent" effective for taxable years beginning in 2005 and later. This modification has a potential impact on employee benefit plans that use this definition of dependent. Most significantly, the modified definition of dependent imposes an income limitation of $3,100 (adjusted after 2004) with respect to an individual who does not qualify under the new rules as a child dependent. It is expected that the IRS will issue guidance before year end that will eliminate this income limitation from the new rules as they apply to most employee benefit provisions.

However, even under the anticipated IRS guidance, it is likely that the $3,100 income limit for dependents who do not qualify as a child dependent will apply for purposes of dependent care plans.1 While employer groups have asked the IRS, at a minimum, to postpone the effective date of the new rules applicable to dependent care plans for at least one year, it is not clear at this time whether the IRS will do so. If the IRS does not provide relief, an employee who elects salary reduction under a dependent care flexible spending arrangement for 2005 to pay for expenses of an adult (or a child who does not meet the new rules) who has income of over $3,100 will not be eligible for any reimbursement with respect to such expenses and will forfeit (under the "use it or lose it" rule applicable to flexible spending arrangements) any amount that cannot otherwise be used for expenses relating to qualifying dependents.2 Accordingly, employers should advise employees who are eligible to participate in a dependent care arrangement of the new income limitation for adult dependents (and for children who do not meet the new ru2les for child dependents).

There are also a number of minor changes in the definition of dependent that will apply for purposes of employee benefit plan provisions. Whether any of these detailed, technical changes are relevant to an employer’s plans will depend on the type of benefit provided and the specific terms of the relevant plan. Ultimately, it will be necessary to review all plan documents and contracts to determine what technical amendments or administrative changes will be necessary to accommodate the new statutory definition.

6. Automatic Rollover Rules Go Into Effect March 28, 2005

Beginning March 28, 2005, tax-favored retirement plans containing cash-out provisions will have to comply with automatic rollover rules. These rules require that cash-outs in excess of $1,000 but not more than $5,000 be automatically rolled over to an individual retirement account or individual retirement annuity (i.e., an "IRA") if the participant does not direct otherwise (for example, if the participant does not complete a benefit election form). The rules permit (but do not require) plans to provide that the same automatic rollover standards will apply to cash-out amounts of $1,000 or less. These automatic rollover rules will be applicable to Section 401(a) tax-qualified plans (e.g., 401(k) plans, profit sharing plans, money purchase plans, ESOPs, defined benefit plans) and Section 403(b) arrangements, as well as governmental Section 457(b) plans.

Most of the plans affected by these new automatic rollover rules are subject to the fiduciary duty requirements of ERISA. In the case of an ERISA plan, the plan administrator or other relevant fiduciary will have to comply with ERISA’s fiduciary duties (e.g., prudence) in selecting the IRA and the relevant investment vehicle that will receive automatic rollovers from the plan. The Department of Labor has issued a final regulation that provides a safe harbor for complying with these ERISA fiduciary requirements in the context of automatic rollovers. Under the DOL regulation, an automatic rollover from an ERISA plan to an IRA will qualify for the safe harbor if (i) the cash-out amount does not exceed $5,000, (ii) specified standards are satisfied regarding the selection of the IRA provider, the investments for the rollover amounts, and the fees and expenses charged to the IRA, (iii) certain disclosures are made to participants, and (iv) the selection of the IRA and the investment of the rolled over funds do not result in a "prohibited transaction" under ERISA. If these conditions are satisfied, the plan fiduciary will have no responsibility to monitor the IRA after the rollover is effected. The following paragraphs summarize some of the highlights of these conditions.

Determining the Cash-out Amount

In determining whether the participant’s distribution is within the cash-out amount for purposes of the DOL regulation, the generally applicable rules for cash-outs will govern. For example, in plans that exclude previously rolled-over amounts in determining the cash-out amount, these previously rolled over amounts will also be subject to the automatic rollover rules if the remaining distribution is a cash-out distribution. After-tax contributions are taken into account in determining the participant’s cash-out amount.

Selection of the IRA Provider

Automatic rollovers must be made to an IRA. The plan administrator or other relevant plan fiduciary may select one IRA provider or multiple IRA providers. In making the selection, the relevant plan fiduciary must enter into a written agreement that contains the following provisions:

  • The rolled-over funds will be invested in an investment product designed to preserve principal and provide a reasonable rate of return (whether or not guaranteed), consistent with liquidity. Typically, these investments would include money market funds, interest bearing savings accounts, certificates of deposit, and certain stable value products.
  • The investment product selected for the rolled-over funds will seek to maintain, over the term of the investment, the dollar value that is equal to the amount invested in the product by the IRA.
  • The investment product selected for the rolled-over funds will be offered by an FDIC insured bank or savings association, a federally insured credit union, an insurance company that is protected by a state guaranty association, or a mutual fund.
  • All fees and expenses related to the IRA (e.g., establishment charges, maintenance fees, investment expenses, termination costs, and surrender charges) will not exceed the fees and expenses charged by the IRA provider for comparable rollover IRAs.
  • The participant whose distribution is automatically rolled over to the IRA will have the right to enforce the terms of the contractual agreement establishing the IRA, with regard to his rolled-over funds, against the IRA provider.

Disclosure to Participants

Participants must be notified that they can transfer the automatic rollover to another IRA provider. In addition, the automatic rollover procedures must be described in a summary plan description or summary of material modifications that is distributed to the participant at a time before the automatic rollover occurs. The SPD or SMM must contain all of the following:

  • a description of the automatic rollover;
  • an explanation that the automatic rollover will be invested in an investment product designed to preserve principal and provide a reasonable rate of return and liquidity;
  • a statement indicating whether the participant’s account pays all fees and expenses or the extent to which such fees and expenses are shared with the plan or plan sponsor; and
  • to the extent not otherwise provided in the SPD or SMM, the plan contact (including name, address, phone number) for information about the automatic rollover, the IRA provider, and the IRA’s fees and expenses.

Prohibited Transaction Issues

The plan fiduciary’s selection of the IRA provider and the applicable investment for rolled-over funds must not violate ERISA’s prohibited transaction rules. For example, in general, the plan fiduciary and the sponsoring employer (or their affiliates) may not receive any payment or other benefit as a result of the selection of the IRA or the investment vehicle. However, the DOL has issued a prohibited transaction exemption that will permit a fiduciary of a plan maintained by a financial institution (or its affiliate) i) to establish IRAs for automatic rollovers at the financial institution (or its affiliate), (ii) to select a proprietary product for the IRA’s initial investment, and (iii) to receive certain fees in connection with the IRA’s establishment, maintenance, and initial investment. This exemption is subject to a number of conditions, including the requirement that fees and expenses (other than establishment fees) attributable to investment in proprietary products may be charged only against the income earned by the IRA.

Implementation

The IRS is expected to issue its own regulations governing automatic rollovers some time before the effective date of March 28, 2005. It is expected those regulations will address, among other things, changes to the tax notice that is required to be provided to recipients of eligible rollover distributions (often called the "402(f) notice" or the "rollover notice"), required plan amendments, and the effect of outstanding loans on the determination of the cash-out amount.

At this time, plan fiduciaries should be taking a number of steps to prepare for the automatic rollover rules.3 For example, relevant plan fiduciaries should begin the process of selecting a financial institution to receive the plan’s automatic cash-outs. Further, plan administrators should review their participant communications related to distributions (SPDs, benefit forms, etc.) and make any necessary changes for the disclosures required by the DOL regulation. It may also be appropriate to consider alerting participants to some of the practical aspects of having funds rolled over automatically. For example, beneficiary designations filed with the plan will not be effective with respect to the IRA (unless the IRA provider agrees otherwise).

7. Guidance Issued on Locating Missing Plan Participants under Terminating Defined Contribution Plans

The DOL has issued new guidance that addresses the steps a plan administrator (or other responsible plan fiduciary) of a terminating defined contribution plan should take in order to locate missing participants and how a plan administrator should proceed if the results of a participant search are unsuccessful.4 The new DOL guidance provides a plan administrator with definitive steps that will assist it in meeting its ERISA fiduciary duties. (A plan administrator should keep written records of the steps it has taken in order to demonstrate compliance with ERISA fiduciary standards.)

Search Methods to Locate Missing Plan Participants

If a plan is not able to contact a plan participant (or beneficiary entitled to receive a distribution) by using routine methods of notice delivery (e.g., first class mail or electronic delivery), a plan administrator must take the following four steps to locate the missing plan participant:

  • Use certified mail.
  • Make sure that employer and third party administrator records are reviewed to determine if any other employer plans (e.g., a group health plan) have more up-todate records for the plan participant.
  • Identify and contact any designated plan beneficiaries (e.g., spouse, children) to obtain updated information concerning the location of the missing plan participant.
  • Use the letter forwarding service of either the IRS or the Social Security Administration (SSA). As part of this process, the plan administrator will have to provide a letter to the participant. This letter must include contact information to claim the benefit. It is also suggested that a deadline for a response be included, as neither the IRS nor SSA will notify the plan administrator as to whether the participant was located.

Expenses of locating a missing plan participant may be charged to the participant’s account, provided that the expense is reasonable and the method of expense allocation is consistent with the plan documents and ERISA.

If a participant is not located using the four steps discussed above, a plan administrator should consider use of Internet search tools, commercial locator services, and credit reporting agencies to locate a missing participant. Depending on the circumstances, it may be prudent for a plan administrator to use one or more of these other options. If the cost of using a service is to be charged to the participant’s account, the size of the account balance in relation to the cost of the service should be considered.

Options if Efforts to Locate a Plan Participant are not Successful

If a plan administrator follows the above-outlined DOL guidance and is still unable to locate a plan participant, the plan will nonetheless be required to process distributions in order to complete the plan termination under IRS rules. Accordingly, the DOL has provided guidance for plan fiduciaries regarding the methods of making those distributions consistent with ERISA fiduciary standards.

  • IRA Rollover. In the view of the DOL, an automatic rollover to an IRA is the preferred distribution option. The rollover is more likely than the other options listed by the DOL to preserve assets for retirement, particularly because the automatic rollover to an IRA defers any income tax or withholding on the distribution. If a plan administrator follows the safe harbor conditions discussed above in choosing the IRA to be utilized for the rollover, the DOL has indicated in this new guidance that, as an enforcement matter, the plan administrator should be treated as satisfying its fiduciary obligations in connection with the distribution. Notably the DOL guidance indicates that in the context of distributions on behalf of a missing plan participant in a terminating defined contribution plan, a plan administrator may follow the safe harbor for selection of an IRA even if the distribution is in excess of the $5,000 maximum that applies to cash-out distributions.
  • Alternatives to IRA. If a plan administrator is unable to locate an IRA provider that will accept a rollover distribution on behalf of a missing plan participant, the fiduciary may consider two alternatives:
    • Bank Account. Establishment of an interest-bearing federally insured bank account in the name of the missing participant. The participant must have the unconditional right to withdraw funds from the account. In selecting a bank and accepting an initial interest rate (which may or may not have a guarantee period) a plan administrator must consider all relevant information, including associated bank charges.
    • Escheat to State Unclaimed Property Funds. Transfer the missing participant’s account balance to the state unclaimed property funds in the state of the participant’s last known address or work location. According to the DOL, some states maintain searchable data bases for their escheat funds and/or may provide a nominal interest rate. These factors should be considered in determining which of the two alternatives a plan administrator chooses to use.

It should be noted that both of these alternatives will result in the transferred amounts being subject to income tax, and potential additional tax for premature distributions. Mandatory tax withholding is required. In addition, accrued interest will also be subject to tax.5

DOL Guidance Does Not Apply to All Defined Contribution Plans

This DOL guidance does not apply to account balances exceeding $5,000 if any member of the plan sponsor’s controlled group maintains another defined contribution plan to which account balances from the terminating plan could be transferred. In that case, the account balances of missing plan participants must be transferred to such other defined contribution plan. In addition, the guidance states that it assumes that the terminating plan does not provide an annuity option. The DOL guidance is set forth in Field Assistance Bulletin 2004-2 which can be found at http://www.dol.gov/ebsa/regs/fab_2004-2.html.

Footnotes

1 In order to be a child dependent under a dependent care plan, the new rules add a requirement that the child must have the same principal place of abode as the employee for over one-half the year. This is in addition to the relationship test and age limitations.

2 Note that, for permanently and totally disabled adults, certain income earned at sheltered workshops is excluded for this purpose.

3 Note that plans may implement the rules at any time before March 28, 2005, but are not required to do so.

4 Terminating defined benefit pension plans subject to PBGC rules are not covered by this guidance; administrators of those plans must follow the rules set forth in applicable PBGC regulations.

5 The DOL guidance specifically disapproves of the "100% income tax withholding" approach that has been used by some plans in the past. Under that approach, the plan applies 100% income tax withholding to the benefit, effectively transferring the amounts to the IRS on the assumption that it will result in a credit to the participant’s income tax liability.

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