IRS Issues Guidance on Automatic Rollover Rule (Employee Benefits Update)

By Dan Condon, Claire Holland and Kris Wardwell

IRS Issues Guidance on Automatic Rollover Rule

IRS Issues Final 401(k) Regulations

USERRA Health Continuation Coverage Period Extended for Military Service

IRS Issues Guidance on Automatic Rollover Rule

As discussed in our November 2004 Employee Benefits Update, beginning March 28, 2005 certain mandatory distributions to retirement plan participants must be automatically rolled over to an IRA unless the participant affirmatively elects otherwise. This new rule generally will apply to 401(k) plans and other tax-qualified plans, as well as 403(b) arrangements, which include an automatic cash-out provision for vested benefits not exceeding $5,000.¹ Recently, this new automatic rollover rule was explained in IRS guidance that is summarized briefly below.

Distributions Subject to the Rule. The automatic rollover requirement will apply to each distribution to a participant that:

• is eligible to be rolled over to an IRA under applicable tax law rules;
• is made without the participant’s consent;
• is made before the participant attains normal retirement age under the plan (or age 62, if later); and
• is more than $1,000.

Note that distributions to alternate payees (under qualified domestic relations orders ("QDROs")), surviving spouses, or other death beneficiaries are not subject to this requirement. In addition, the automatic rollover rule does not apply to the extent the distribution offsets an outstanding plan loan.²

Automatic Rollover Requirements. Before a plan makes a distribution subject to the automatic rollover rule, the plan administrator must notify the participant that, absent an affirmative election by the participant, the distribution will be paid to an IRA sponsored by the trustee or issuer identified in the notice. This information may be included in the notice that generally must be provided to participants entitled to receive distributions eligible for rollover (sometimes called the "rollover notice" or the "402(f) notice"). The notice may be sent electronically, subject to certain conditions that generally apply to electronic delivery of 402(f) notices. Alternatively, the notice may be mailed to the participant using the participant’s most recent mailing address in the records of the employer or the plan administrator.

If, after receiving the 402(f) notice, the participant fails to elect to receive the distribution directly or have it paid in a direct rollover to an IRA or other plan chosen by the participant, the distribution must be automatically paid in a direct rollover to an IRA selected by the plan administrator. In that case, the plan administrator may execute the necessary documents to establish an IRA on the participant’s behalf (with the IRA trustee or issuer providing the necessary IRA disclosure documents to the participant using the most recent address for the participant in the records of the plan administrator or employer).

Steps to Implement the Rule. In implementing the new automatic rollover rule, it will be necessary for the employer and plan fiduciaries to take a number of steps, which are described below.

• The plan must be amended to reflect the automatic rollover requirement by the end of the first plan year ending on or after March 28, 2005 (i.e., for calendar year plans, by December 31, 2005). The IRS guidance includes a sample amendment that may be used for this purpose.

• The plan administrator must establish procedures that will satisfy the requirements described above – e.g., procedures designed to provide the notice to participants receiving distributions subject to the rule. In addition, the plan administrator must establish an arrangement with the IRA trustee or issuer (selected by the plan administrator) that will sponsor the IRA to which the distribution will be rolled over. These procedures and this arrangement must be in place with regard to any distribution subject to the automatic rollover rule that is made on or after March 28, 2005. However, the IRS guidance indicates that if the procedures or arrangement are not in place on that date, the plan may delay making any distribution subject to the new rule until the procedures and arrangement are in place, so long as the distributions are made no later than December 31, 2005.

• In the case of plans subject to ERISA, the relevant plan fiduciaries should also take steps to satisfy the Department of Labor ("DOL") safe-harbor rule described in our November 2004 Employee Benefits Update - http://www.goodwinprocter.com/publications/EBU_11_2004.pdf - including the safe-harbor’s SPD requirements and standards applicable to the agreement with the rollover IRA sponsor.

Alternative of Limiting or Eliminating Mandatory Distributions. For plan sponsors that consider the additional requirements of the automatic rollover rule burdensome, the IRS guidance provides an alternative. The guidance notes that a plan may be amended to provide that distributions will be made to participants only with their consent, regardless of the amount involved. Similarly, a plan could be amended to provide for the mandatory cash-out of benefits only in cases where the vested account balance (under a defined contribution plan) or the present value of the vested accrued benefit (under a defined benefit plan) does not exceed $1,000. If a plan were amended in either of these ways, the automatic rollover rule would not be applicable to any distributions from the plan. However, before adopting such an amendment, the plan sponsor should consider whether, as a practical matter, it would lead to any increased administrative burdens related to a greater number of terminated participants with small benefit amounts retained in the plan.

The IRS has issued final regulations that apply to Section 401(k) cash or deferred arrangements and matching contributions under Section 401(m) of the Internal Revenue Code. These final regulations consolidate, clarify and - in some instances - modify the guidance that has been issued by the IRS over the past ten years. The final regulations apply for plan years beginning on or after January 1, 2006. A plan may adopt the final regulations for plan years that end after December 29, 2004, provided that the plan is administered in compliance with all provisions of the final regulations for the full plan year.

Highlighted below are some of the more significant clarifications and modifications included in the final regulations.

• Limitation on QNECs and QMACs. The regulations restrict the use of targeted qualified non-elective contributions ("QNECs") and qualified matching contributions ("QMACs"). Under this new rule, generally a QNEC or QMAC may not be taken into account for non-discrimination testing purposes (i.e., the ADP and ACP tests) to the extent that it exceeds 5% of a participant’s compensation, unless certain requirements are met. The rule is designed, in particular, to prohibit so-called "bottom-up" QNECs or QMACs that provide additional contributions at a high percentage of compensation to participants with the lowest compensation in order to boost the overall deferral rate of non-highly compensated employees ("NHCEs"). In the past, this approach enabled employers to pass the non-discrimination tests with a smaller total QNEC or QMAC than would be required if the contribution were allocated to a broad based group of NHCEs.

• Hardship Distributions. Funeral expenses and repair of damage to a participant’s principal residence are added by the final regulations to the "safe harbor" events for hardship distributions. In addition, in determining whether a participant has taken all available plan distributions and is therefore eligible for a hardship distribution, a participant in an ESOP must elect a plan distribution of any available ESOP dividend prior to being eligible for a hardship distribution.

• Automatic Enrollment. The final regulations clarify that plans that use the automatic enrollment rules (i.e., where an eligible employee has to affirmatively elect out of making 401(k) contributions) are not restricted to a 3% contribution amount. (The use of 3% contribution level in prior IRS guidance on automatic enrollment had led some to believe that 3% was a limit.)

• Pre-funding of Contributions. With certain limited exceptions, salary deferral and matching contributions may not be made prior to the time the relevant services are performed (or if earlier, the date that compensation subject to the deferral election would otherwise be paid).

• Gap Period Income. The final regulations adopt the previously proposed, but not mandatory, rule that the earnings related to excess contributions being distributed in order for a plan to meet the nondiscrimination tests must include the gap period income from the end of the plan year to seven days prior to the date of distribution.

• Military Service Contributions. The regulations include a new rule that additional elective contributions and matching contributions made in connection with an employee’s qualified military service are not included in the non-discrimination tests.

• Changes in Testing Method. The final regulations include an anti-abuse rule that prohibits repeated changes in testing procedures or plan provisions that have the effect of distorting the non-discrimination test results or significantly increasing the deferrals and matching contributions of highly compensated employees if a principal purpose of the change is to achieve that result.

The final regulations provide unified guidance that contains extensive and detailed rules. Plan sponsors are encouraged to review their plan documents and administrative procedures with their service providers and legal advisors to assure compliance by the beginning of the 2006 plan year. Most plans are likely to require some changes in plan documents and/or administration in order to comply with the final regulations. In addition, there are optional changes and clarifications that a plan sponsor may wish to implement.

Under USERRA, employees who enter qualifying military service can elect to continue their (and their dependents’) employer-provided health coverage. This USERRA continuation coverage is separate from the employee’s COBRA continuation coverage, though the two types of coverage can run concurrently. Prior to recent legislation, the maximum continuation coverage period under USERRA was 18 months.

The recently enacted Veterans Benefits Improvement Act of 2004 (the "Act"), which expands various rights and benefits under USERRA, increases the maximum USERRA continuation coverage period from 18 months to 24 months. Thus, for USERRA continuation coverage elections made on or after December 10, 2004, the maximum USERRA continuation coverage period is 24 months.

Plan sponsors should review their administrative forms, communications, and policies governing USERRA continuation coverage and make any necessary changes to reflect this extension. Although not required, one way to communicate USERRA continuation coverage rights is to include a description of such rights in the COBRA election notice provided to employees upon termination of employment. In this regard, revised model COBRA election notice – with an added paragraph at the end directing employees entering the military to contact the employer regarding possible USERRA coverage continuation rights – can be accessed at Goodwin Procter’s website. Plan administrators who do not wish to include a discussion of USERRA continuation coverage rights in their COBRA election notice can continue to use the model notice discussed in our July 2004 Employee Benefits Update - http://www.goodwinprocter.com/publications/EBU_07_04.pdf

The Act also mandates that employers provide a notice of USERRA rights, effective after the DOL issues a model notice. The model notice is expected later this year.

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