DOL and IRS Rollover Guidance May Make Involuntary Cash Outs History

by Thomas M. Greene

Section 411(a)(11) of the Internal Revenue Code of 1986, as amended (the "Code"), permits tax-qualified retirement plan sponsors to distribute account balances or benefits with a value of $5,000 or less without the consent of the affected plan participants. This provision is referred to as the "involuntary cash out" limit or rule. The purpose of the involuntary cash out rule is to allow plan sponsors to eliminate small accounts and benefits and thereby reduce plan administration expenses. In order to further preserve assets for retirement, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), amended the Code to provide that involuntary cash outs of more than $1,000 must be rolled over to an individual retirement plan (i.e., individual retirement account (IRA) or an individual retirement annuity) if the affected participant does not elect to receive his or her benefit in another manner. The implementation of the EGTRRA change to the involuntary cash out rule was delayed until the U.S. Department of Labor (DOL) established a compliance "safe harbor" ("Safe Harbor") for the administration of this provision to shield plan administrators and other fiduciaries from liability under the Employee Retirement Income Security Act of 1974 (ERISA). This includes liability arising from the selection of an IRA provider or the selection of investment alternatives for the IRA. The DOL issued involuntary cash out Safe Harbor regulations on September 28, 2004. The regulations are effective for distributions made on or after March 28, 2005. On December 28, 2004, the Internal Revenue Service issued Notice 2005-5 which provides Code guidance on the EGTRRA changes to the involuntary cash out rule with respect to maintaining the tax-qualified status of a retirement plan. The purpose of this client alert is to provide an explanation of the more important aspects of the DOL Safe Harbor regulations and Notice 2005-5.

DOL Safe Harbor

The final regulations establishing the involuntary cash out Safe Harbor require a plan fiduciary to meet the following requirements:

The value of the benefit or the account balance being cashed out cannot exceed $5,000 (amounts rolled over into the plan from other qualified retirement plans or IRAs need not be included in determining whether the $5,000 threshold has been met).
• The benefit must be rolled over to a qualified IRA, the provider of which must be a federally regulated financial institution (i.e., a bank, credit union, an insurance company, or a mutual fund company registered under the Investment Company Act of 1940).
• The plan fiduciary and the IRA provider must enter into a written agreement providing that the funds will be invested in products that are intended to preserve principal and provide a reasonable rate of return, whether or not such rate of return is guaranteed, while maintaining adequate liquidity.
• The expenses charged by the IRA provider for maintaining the IRA cannot exceed the fees and expenses charged for comparable IRAs that are established for reasons other than the receipt of the involuntary cash out amounts.


• The participant must have the right to enforce the terms of the agreement between the fiduciary and the IRA provider.


• The participant is furnished with a summary plan description or summary of material modification that describes the plans automatic rollover provisions, the nature of the investment product in which rollover will be invested and the fees and expenses associated with the IRA.


• The plan identifies a contact person so the participant can get additional information or submit any questions.


• The plan fiduciary may not engage in a prohibited transaction in connection with the selection of the IRA provider or the investments. Notably, the DOL also published a prohibited transaction class exemption permitting banks or other financial institutions that maintain qualified requirement plans to receive involuntary cash out rollover amounts from the plans maintained for the benefit of their own employees, subject to certain specified conditions.

NOTE: Plan sponsors are required to provide each participant with a "Special Tax Notice" under Section 402(f) of the Code which explains the participant's rollover rights and the tax implications of either rolling his or her account balance over to an IRA or another qualified retirement plan or taking a direct distribution. If the account or benefit of a former employee is not more than $5,000 and the former employee fails to make an election within 30 days after receiving the 402(f) Notice, the plan administrator can cash out the former employee by making a direct distribution to the employee. Direct distributions to employees require plan sponsors to withhold 20% of the distribution to comply with federal tax withholding laws.

Plan sponsors should also be aware that the DOL Safe Harbor requirements and protections apply to the full amount of the participant's account balance if it is rolled over in accordance with the Safe Harbor. To that end, if a participant's account balance is more than $5,000 as a result of a prior rollover into the applicable plan sponsor's retirement plan, the Safe Harbor would apply to the full amount rolled out of the plan even though the plan sponsor need not take the previously contributed rollover amount into consideration for purposes of determining whether the participant's account exceeds the involuntary cash out amount.

IRS Notice 2005-5

Notice 2005-5 provides the following guidance to plan sponsors:

Amounts deducted from plan account balances to offset unpaid loan amounts are not subject to the rollover rules.
• The automatic rollover rules of Section 401(a)(31)(B) of the Code apply to governmental plans (i.e., Section 457 (b) and 403 (b) annuity plans), although governmental plans are not required to implement the new cash out rules with respect to involuntary cash out distributions made prior to the close of the first regular legislative session of the legislative body with the authority to amend the plan that begins on or after January 1, 2006.
• The automatic rollover rules also apply to church plans that do not elect to be covered by ERISA, although in the case of a non-electing church plan for which the authority to amend the plan rests with a church convention, the changes for involuntary cash out distributions are not required to be implemented prior to the date that is 60 days after the close of the earliest church convention that occurs on or after January 1, 2006.
• If a plan does not have adequate administrative procedures in place to process a cash out in accordance with the new rules (i.e., an agreement with a financial institution to establish IRAs), the plan will not be disqualified for failing to make such a distribution at that time provided that any delayed distributions are completed by December 31, 2005.
• Consistent with the DOL Safe Harbor, Notice 2005-5 allows plan sponsors/administrators to establish an IRA on behalf of a participant. The plan administrator can use the participant's last known mailing address, and there will be no violation of the IRA disclosure rule even if it is returned to the financial institution by the Post Office as undeliverable.
• Cash out distributions can be made to deemed IRAs which are otherwise part of the qualified retirement plan effecting
  the cash out.
• If a plan sponsor wishes to eliminate cash out distributions from its plan entirely, the elimination of such distributions will not be a violation of the anti-cutback rules of Code Section 411(d)(6).
• Plans that require a participant's consent to make a distribution of a benefit greater than $1,000 but not more than $5,000 do not have to comply with the spousal consent rules even if the plan is otherwise subject to the joint and survivor annuity and preretirment survivor annuity rules of the Code.
• Plan administrators are required to inform participants that their benefit or account will be rolled over into an individual retirement plan in the absence of an election to the contrary. This notice can be provided with or incorporated into the "Special Tax Notice" under Section 402(f) of the Code. Plan administrators will comply with their notice responsibilities under the Code even if the notice is returned by the Post Office as undeliverable by mailing the notices to the last known mailing address of the participant.
• Plans must adopt a "good faith compliance" amendment by the last day of the plan year ending on or after March 28, 2005 (December 31, 2005 for calendar year plans). If a plan adopts a disqualifying amendment, plan sponsors have until the end of the plan's EGTRRA remedial amendment period to adopt a corrective amendment. Notice 2005-5 provides a sample amendment which takes a minimalist approach and does not address any of the operational aspects of the DOL Safe Harbor.

NOTE: Previously, plan sponsors and financial institutions had expressed concern the USA Patriot Act would prohibit the establishment of IRA accounts by plan fiduciaries since it requires certain customer identification procedures be observed by the financial institution to track money. The federal regulators responsible for writing regulations on this subject have interpreted the applicable regulations as not requiring implementation of the customer identification programs and procedures until the former employee first contacts the financial institution to assert ownership and exercise control over the account.

Analysis

Both the DOL Safe Harbor and Notice 2005-5 provide some helpful guidance for plan sponsors and plan administrators on implementing the changes to involuntary cash outs. Whether or not the guidance can be implemented in operation remains subject to question though. The largest obstacle for plan administrators to overcome is reaching agreement with acceptable financial institutions to accept rollovers. Because these accounts are small and the fees will be limited, financial institutions seemingly do not have a great deal to gain from becoming a provider of individual retirement plans in this context. Volume may be a key to attracting financial institutions to take on this responsibility. If this becomes the case, sponsors of small plans may be ignored. This would be particularly ironic since small plans are more likely to have difficulty affording plan administrative expenses.

In light of the potential obstacles to administering this change in the law, plan sponsors should consider reducing a plan's involuntary cash amount to $1,000 to avoid these rules completely. Plan sponsors can eliminate the cost of maintaining the smaller accounts of terminated employees by passing on the cost of administering such accounts directly to the accounts. Under DOL Field Assistance Bulletin 2003-3 issued May 19, 2003, plan sponsors can treat active and terminated employees differently with respect to plan administration expenses and can pass on reasonable expenses to terminated employees even though active employees do not have to pay the same expenses.

Plan sponsors need to decide how they want to approach this problem over the next few weeks. The process should start with exploring whether a financial institution will take on this responsibility. If a plan sponsor cannot find someone to establish individual retirement plans in the next few months, implementation of these changes may not be possible and sponsors should contemplate reducing the cash out threshold to $1,000 and taking all the steps necessary for passing on the expenses of administering small accounts to the applicable terminated employees. Initially, it did not appear financial institutions were quick to jump at this opportunity. We now understand, however, that at least one major retirement plan and IRA vendor has offered this service to its retirement plan customers. We will apprise you of future developments in this area as they arise.

If you have any questions concerning the topics discussed in this alert or any other employee benefits topic, please contact your Mintz Levin employee benefits attorney or your primary contact with the Firm who can direct you to the right person.

Copyright © 2005 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

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