Employers Need to Act Soon to Implement New Guidance and Other Changes
Late last year, the IRS issued various notices and other guidance affecting tax-qualified retirement plans, including 401(k) plans, pension plans and ESOPs. This guidance implements many of the new requirements enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Although employers generally do not have to amend their plans for all of the EGTRRA changes, plan administration must change beginning January 1, 2002 (regardless of the plan year) in light of the various EGTRRA rules.
This On the Subject… highlights many of the changes and other issues that employers and administrators need to consider as soon as possible.
IRS Updates Model Rollover Notice
In Notice 2002-3, the IRS issued an updated model safe harbor rollover notice for retirement plan administrators to give to recipients of eligible rollover distributions. The new safe harbor notice reflects EGTRRA changes in the rollover and distribution rules.
Click here to review a model distribution notice for tax-qualified retirement plans.
Click here to review a model distribution notice for governmental section 457 plans.
Internal Revenue Code (Code) section 402(f) requires retirement plan administrators to provide a written explanation to recipients of eligible rollover distributions. This "402(f) notice" must explain the direct rollover rules, the mandatory income tax withholding on distributions not directly rolled over and the tax treatment of distributions not rolled over (including the special tax treatment available for certain lump sum distributions).
EGTRRA amended many of the rollover and distribution requirements effective for distributions made on or after January 1, 2002. In addition, EGTRRA requires that plans’ 402(f) notices be modified to address the new requirements. Some of the key EGTRRA changes include the ability to roll over certain after-tax contributions and expanded rollover opportunities to and from IRAs, governmental 457 plans and 403(b) tax-sheltered annuity plans. In addition, EGTRRA expanded the plans to which surviving spouses may roll over distributions.
The IRS-approved model safe harbor 402(f) notice addresses all of these changes to the Code’s rollover rules. Plan administrators must use the updated 402(f) notice for distributions on or after January 1, 2002. However, no penalty will be imposed for any failure to provide the updated notice with respect to any distribution made before April 14, 2002, provided the plan administrator makes a reasonable attempt to comply with EGTRRA’s expanded 402(f) notice requirement.
Plan administrators may customize the safe harbor 402(f) notice by omitting any portion that does not apply to their plans. For example, if a plan does not provide for distribution of employer stock or other employer securities, the paragraph entitled "Employer Stock or Securities" may be deleted. Plan administrators may also satisfy the section 402(f) notice requirement by providing explanations that differ from the safe harbor notice. However, any alternative explanation must contain the information required by section 402(f) and must be written in a manner designed to be easily understood.
New Transition Relief for Catch-Up Contributions
Many employers are considering implementing catch-up contributions for employees who are age 50 or older, beginning in 2002. However, the rules governing catch-up contributions are technical and, for some employers, difficult to apply. In particular, many employers are having trouble implementing the "universal availability" rule for catch-up contributions. Under this rule, an employer is required to offer catch-up contributions under all 401(k) plans maintained throughout the employer’s controlled group. Thus, if a parent corporation offers catch-up contributions in its 401(k) plan, any subsidiary corporation 401(k) plans must also offer catch-up contribution opportunities.
To ease the administrative burdens associated with implementing catch-up contributions, the IRS has issued two transition rules in IRS Notice 2002-4. First, 401(k) plans in a controlled group will be treated as complying with the universal availability requirement during 2002 so long as all 401(k) plans in the controlled group are amended to offer these contributions no later than October 1, 2002. Thus, even if the controlled group’s 401(k) plans are amended at various effective dates, the universal availability rule will be met as long as all applicable plans are amended for catch-up provisions by October 1, 2002.
Second, some employers maintain plans that cover employees working in Puerto Rico. If a plan covering Puerto Rican employees is trying to comply with the U.S. tax rules as well as the Puerto Rican tax rules and the employer wishes to offer catch-up contributions, the plan would not comply with Puerto Rican tax rules. Notice 2002-4 provides that, until further guidance is issued, a plan that offers catch-up contributions will not violate the universal availability rule solely because another plan maintained by the employer that is qualified under Puerto Rico tax law does not provide for catch-up contributions.
Unfortunately, the IRS Notice does not appear to solve this problem for employers that maintain a single plan that is dual qualified (i.e., qualified in both Puerto Rico and the United States). Therefore, employers with Puerto Rican plans should review their options carefully if they want to implement catch-up contributions.
In general, in light of the technical rules involved with implementing catch-up contributions, employers should consult with their third-party administrators to confirm that plan administrative systems comply with all of the requirements.
Distributions on Severance from Employment
EGTRRA amended Code section 401(k) so pre-tax elective deferrals may be distributed upon a "severance from employment" instead of a "separation from service." Notice 2002-4 includes rules clarifying the IRS interpretation of when 401(k) elective deferrals may be distributed in light of this new EGTRRA rule. Under the IRS interpretation, an employee does not have a severance from employment if, in connection with a change of employment, the employee’s new employer maintains the same section 401(k) plan with respect to the employee. For example, if a part of an employer’s business is sold and the purchaser assumes sponsorship of the seller’s 401(k) plan (including through a transfer of assets and liabilities, within the meaning of Code section 414(l)), the affected employees will not have incurred a severance from employment. This IRS interpretation follows one previously announced in rulings affecting non-401(k) pension plans.
Plans do not have to be amended to eliminate the separation from service standard for distributions (and, in some instances, such an elimination may not be desirable). However, if an employer wants to provide for distributions upon a severance from employment instead of a separation from service, the 401(k) plan must be amended to substitute severance from employment for separation from service. The amendment could apply prospectively or retroactively, as long as the effective date is provided for in the plan. Notice 2002-4 clarifies that a plan may also choose to apply the new severance from employment standard only to certain types of transactions or situations. However, if a plan is not amended to provide for distributions following a severance from employment, pre-tax elective contributions can only be distributed under the specific plan terms.
Elimination of Post-Hardship Contribution Limit
EGTRRA amended the 401(k) safe harbor financial hardship withdrawal requirements by allowing plans to suspend pre-tax elective deferrals for only six months following a financial hardship distribution instead of 12 months under the pre-EGTRRA rules. Many plans have already been amended to lower their 12-month suspension periods accordingly.
Under a related 401(k) regulatory safe harbor rule, the elective contribution limit (the section 402(g) dollar limit) in the year following the year of a hardship distribution is reduced by the amount of the elective deferrals made by the participant in the year in which the hardship distribution was made. This is referred to as the "post-hardship contribution limit." This rule does not logically apply once a plan is amended to reduce the hardship suspension period from 12 to six months. Therefore, the IRS in Notice 2002-4 indicated that the post-hardship contribution limit would be eliminated from the regulations effective beginning with hardship distributions taken in 2001.
Plans that are amended to lower the 12-month hardship suspension period to six months should also be reviewed to amend the post-hardship contribution limit.
Section 404(k) Dividend Deduction Guidance
The IRS issued Notice 2002-02 in which it clarified the rules on the new dividend deduction provisions of Code section 404(k). Under this rule, a deduction is allowed for dividends paid on employer securities held by an ESOP and with respect to which participants (or beneficiaries) are provided an election to have the dividend paid in cash (directly or through the plan) or reinvested in employer securities. Either way, the employer would still benefit from the dividends being deductible.
Notice 2002-02 provides many rules that clarify how the new dividend deduction rules apply. The notice provides a number of significant operational rules for ESOPs that wish to take advantage of the expanded deduction opportunities. Among the clarifications provided by the IRS is a rule that dividends paid or declared in 2001 and reinvested in 2002 could be deductible in 2002 so long as a calendar year ESOP is amended to allow for a distribution or reinvestment choice within the first 90 days of 2002. The IRS notice has a number of other technical rules and requirements; therefore, employers sponsoring ESOPs should review the notice carefully to take advantage of the new rules.
New Mortality Table for Defined Benefit Plans
In Revenue Ruling 2001-62, the IRS indicated that a new mortality table must be used by defined benefit plans for purposes of determining the lump sum present values of benefits under Code section 417 and for implementing the Code section 415 defined benefit plan limitations. The new table is based on the 1994 Group Annuity Reserve Table (94 GAR), using blended male/female rates. The new mortality table takes effect for distributions with annuity starting dates on or after December 31, 2002. However, plans are allowed to implement the new mortality table earlier. In the revenue ruling, the IRS provided model amendments that could be adopted to implement the new rules.
Plan administrators should consider (with actuarial assistance) the impact of changing to the new mortality table and whether it is advisable to implement the new rule earlier than the December 31, 2002 effective date. In particular, plans that merely incorporate the Code section 417(e) mortality table by reference to the statutory provision might not need any amendment unless they wish to adopt the new mortality table early. However, plans that reference the actual mortality table itself would need to be amended no later than the effective date of the guidance. Apart from plan amendment language, though, plan administrators should review actual administration to make sure the new mortality table is applied correctly and at the correct time.
Other Qualified Plan Issues
In addition to having to amend plans for this new IRS guidance, plan administrators and sponsors need to consider two other significant rules that apply this year:
New DOL Claims Procedure Regulations
The new U.S. Department of Labor (DOL) claims procedure regulations apply for claims filed on or after January 1, 2002. For most pension and 401(k) plans, the new rules are not significantly different from prior guidance. However, if plans provide for benefits upon disability (e.g., disability retirement benefits, accelerated vesting upon disability, etc.), then more stringent claims procedure rules might apply to disability determinations. In particular, if a pension or 401(k) plan administrator will make a determination of disability, the plan must comply with the new welfare plan claims rules for disability determinations, including, de novo review of appeals, consultation requirements for medical judgments, limits on appeal levels, accelerated time periods for deciding disability claims and more detailed disclosure requirements. On the other hand, if a pension or 401(k) plan relies on a determination of disability by a separate long-term disability plan administrator or some other independent third party (such as the Social Security Administration), then the special rules for disability claims would not apply.
New IRS Plan Loan Regulations
In 2000, the IRS finalized plan loan regulations addressing issues such as plan loan repayment periods, default and cure procedures, rules for suspensions of loan repayments and many other tax rules governing plan loans. Loans made on or after January 1, 2002, must comply with these regulations. Loan procedures and plan provisions should be reviewed for compliance with these new rules.