On February 16, 2005, the Internal Revenue Service (IRS) issued a News Flash regarding plan amendments intended to comply with the new automatic rollover provisions. The new automatic rollover provisions require that, absent an affirmative election by a plan participant, mandatory cashout distributions from qualified plans between $1,000 and $5,000 must be transferred directly to an Individual Retirement Account (IRA) (described in greater detail in McDermott Will & Emery’s October 20, 2004 On the Subject: DOL Final Regulation Requires Amendment To Automatic Cash-Out Provisions, which can be found at: http://www.mwe.com/info/news/ots1004d.htm.) The News Flash addressed three major points, which are outlined below.
Rollover Amounts Must Be Included in the $1,000
The first point is the most unexpected and therefore controversial element of the News Flash. Here, the IRS clarifies its position that “amounts attributable to rollover contributions are included in determining whether a participant’s accrued benefit is $1,000 or less for purposes of the automatic rollover requirement…” This will complicate drafting and administration for those plans (like many 401(k) plans) that accept rollover contributions and then wish to disregard them in determining whether a mandatory distribution may be made.
Under the mandatory distribution rules, plans are allowed to force cashout distributions on participants whose accrued benefits do not exceed $5,000. For this purpose, a plan is allowed to disregard amounts attributable to rollover contributions. However, this ability to disregard rollover contributions does not apply in determining whether a participant’s accrued benefit is over $1,000 for automatic rollover purposes.
Consider the following example: Assume that a 401(k) plan ordinarily disregards rollover contributions in determining whether a plan participant may be involuntarily cashed out of his or her benefit upon termination of employment. Suppose the employer, like many others, does not want to arrange for automatic IRA rollovers for these involuntary cashouts due to the complexity of administering such rollovers and, therefore, lowers its cashout amount to $1,000. Under the IRS interpretation, even though the sponsor could disregard rollover contributions in deciding whether the account balance is $5,000 or less (for cashout purposes), it could not disregard rollover contributions in deciding whether the account balance is under $1,000 for purposes of avoiding automatic IRA rollover requirements. If the account balance, as so determined, is greater than $1,000, the plan sponsor must obtain the participant’s consent in order to make the distribution.
As a practical matter, this means that if the sponsor simply lowers the mandatory cashout threshold from $5,000 to $1,000, it would still have to allow automatic IRA rollovers or obtain consent for those accounts in excess of $1,000 due to rollover contributions. To properly draft around this problem, the sponsor will need to make sure that the only accounts that are automatically cashed out are those where the balance does not exceed $1,000 taking into account all contributions (including rollover contributions). Because this would mean that amounts between $1,001 and $5,000 could no longer be automatically cashed out, plan sponsors who wish to distribute participant account balances in this range in a lump sum must now obtain the participant’s consent before making a distribution. Of course, another alternative would simply be not to allow for any mandatory cashout distributions, in which case consent would be required for any distribution.
There is some question as to whether the IRS’s position on this issue is correct. The rules on automatic IRA rollovers refer to “eligible plans” which are defined by reference to the same tax Code sections that allow plans to disregard rollover contributions in valuing account balances. Nevertheless, the IRS seems to feel constrained to read the statute in a more limiting way. It is possible that the IRS could revisit the issue in the future, but until then, plan sponsors should consider the IRS view, as expressed in the News Flash, in amending their plans and changing plan administrative systems.
Prototype Plans Can be Amended
The News Flash also clarifies that prototype plans may permissibly be amended to reduce the mandatory cashout amount to any amount that is $1,000 or less without having the amendment cause the plan to lose its prototype status (and become an individually-designed plan). Therefore, employers maintaining prototype plans should expect to see communications from the prototype plan sponsors indicating either that the plan’s automatic cashout rule has been eliminated or that the plan will comply with the automatic IRA rollover requirements. Either way, the IRS will allow for the plan to maintain its prototype status without the need for a special IRS approval.
Amendments Must be Adopted by the End of the Plan Year Ending on or After March 28, 2005
Finally, the News Flash clarifies that, although plans must comply operationally with the automatic rollover requirements beginning with distributions made after March 28, 2005, plan amendments do not have to be adopted until the end of the first plan year ending on or after March 28, 2005 (December 31, 2005 for calendar year plans). Note that plans maintained on a non-calendar year basis will have to be amended prior to the end of this year. This is true even for those plans that intend to comply by reducing the mandatory cashout amount to $1,000 or eliminating their automatic cashout provisions entirely.