IRS Provides Further Guidance on Mandatory Rollover Rules

Beginning March 28th, qualified retirement plans cannot cash out benefits worth more than $1,000 unless the participant affirmatively elects to receive cash. These new mandatory IRA rollover requirements were described in detail in our Benefits Alert published on November 19, 2004. The IRS has now provided guidance on how plans need to implement the new rules in Notice 2005-5 that was issued in January, and in a "News Flash" issued last week.

Deadline for Amending Plans/Operational Compliance

The IRS is requiring that all qualified retirement plans be amended to comply with the new requirements by the last day of the first plan year ending after March 28th. For a calendar year plan, the deadline is therefore December 31, 2005. A plan operating on a July 1 plan year would have to be amended by June 30, 2005. The IRS News Flash makes it clear that this amendment deadline applies no matter what approach the particular plan uses to come into compliance. However, all plans are required to begin operating in compliance with the mandatory rollover rules on March 28th, whether or not the actual plan amendments have been adopted yet.

Ways to Come Into Compliance

Based on the IRS guidance, plans have at least the following three options for coming into compliance with the new restrictions on involuntary cash-outs and the mandatory rollover rules:

• Eliminate involuntary cash-outs over $1,000 (or all involuntary cash-outs). Although most plans currently provide that benefits less than $5,000 will be cashed out, plans are not required to do involuntary cash-outs. The IRS guidance makes it clear that an amendment reducing the cash-out level from $5,000 to $1,000 (or eliminating cash-outs entirely) will not affect the plan's qualified status. If you decide to adopt this approach, you will need to revise your employee communications to reflect the lower limit and make sure your plan's trustee or recordkeeper begins using the lower limit.
• Implement the IRA rollover requirement beginning March 28th. If you decide to continue doing involuntary cash-outs of amounts greater than $1,000, you will need to choose (and enter into a written agreement with) a default IRA service provider, select a default IRA investment, and prepare revised employee communications (a revised SPD or an SMM, and a revised special tax notice) for distributions that are made on or after March 28th. The IRS has said informally that they intend to publish a revised special tax notice reflecting the new rules, but it is not clear how soon it will be released.
• Suspend involuntary cash-outs on March 28th and decide later on your approach to compliance. IRS Notice 2005-5 permits a plan that is not able to come into administrative compliance with the new rules by March 28th to stop making involuntary cash-outs above $1,000 (or all involuntary cash-outs) and decide later how the plan will ultimately comply. This suspension will not cause the plan to fail to be administered in accordance with its terms between March 28th and the plan's amendment deadline. If you do this, you will still be able to choose either of the above options for coming into compliance, but you will have more time to locate an IRA provider and set up your procedures (or determine that no provider is available).

Rollovers Must Be Included in Determining the $1,000 Limit.

Beginning in 2002, plans that accepted rollover contributions could provide that the rollover account would be disregarded in determining whether the participant's benefit was less than $5,000 and therefore subject to involuntary cash-out. For example, a new participant who made a $10,000 rollover into the plan and then quit after making only $500 of 401(k) contributions could be treated as having a benefit under $5,000 (even though the total benefit was $10,500) and thus could be forced out of the plan. In contrast, the IRS is now taking the position that a rollover account has to be included in applying the $1,000 limit that determines whether the new mandatory IRA rollover rule applies. Thus, beginning March 28th, the participant in this example cannot be paid out in cash involuntarily.

If the plan in this example decides to implement the IRA rollover requirement for benefits between $1,000 and $5,000 and this participant fails to elect a cash distribution, the benefit can still be treated as being less than $5,000 (and therefore able to be forced out) even though the mandatory rollover to the IRA would include the participant's rollover account for a total rollover of $10,500. If the plan decides instead to drop the cash-out limit to $1,000, the amendment will also need to assure that the rollover account is included in calculating that limit, and this participant's benefit would have to stay in the plan until he or she voluntarily elects the distribution (or reaches some other required payment date).

Defined Benefit Plans Are Also Subject to the New Rules.

Most of the discussion about the new mandatory IRA rollover rules has focused on 401(k) plans and other defined contribution plans. However, it is also common for defined benefit plans to cash out small pensions with a present value of $5,000 or less. The new limits on involuntary cash-outs, and the deadline for plan amendments, apply equally to such payments from defined benefit plans (including cash balance and other hybrid plans). As a result, most defined benefit plans will need to either locate a rollover IRA provider or reduce their cash-out limit from $5,000 to $1,000.

Watch Out for Other Consequences of Reducing the Cash-Out Limit.

If you choose to bring a plan into compliance by reducing the cash-out limit to $1,000, that change can have other consequences for plan administration that need to be considered. For benefits between $1,000 and $5,000, the plan can (but is not required to) make available any other distribution options that are offered by the plan (installments, annuities, etc.). There are obvious disadvantages to opening up the possibility that the plan would have to pay small amounts over an extended period. On the other hand, continuing to limit such participants to electing lump sums only could mean that you will have an additional category of participants to track and administer differently. A plan that is subject to the qualified joint and survivor annuity rules will also need to decide whether to make the annuity options available to, and impose the spouse consent requirements on, benefits between $1,000 and $5,000. Whatever decision is made on these issues, it will be important to assure that the plan's administrative procedures and distribution notices are modified appropriately.