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Issues Surround Cashing Out Or Rolling Over Small Account Balances Of Terminated Participants. |
As a way to better manage the cost of administering a plan, employers frequently ask about the options for allocating plan expenses to participants. These discussions may focus on several related issues including whether charging such accounts to former employees can legally rid the plan of these accounts or encourage former employees with larger accounts to agree to take distributions.
Additionally, removing small accounts of former employees from a plan may arise when a participant eligible to receive a distribution cannot be found or the participant has been found but just doesn’t respond to a distribution notice. Where the account is too small (under $1,000) to force out as an automatic IRA rollover, the employer really has few options in removing those accounts. So what can be done to rid the plan of small accounts under $1,000?
One approach is to impose an annual per capita fee of, say $25 for example, to each account of all terminated participants with a vested balance that is still held by the plan as a recordkeeping expense. Such a charge will of course need to be permitted under the terms of the plan document. In 2003, the Department of Labor released guidance in a field assistance bulletin allowing this type of charge, as discussed in more detail below.
This DOL guidance was discussed by the Internal Revenue Service. There the IRS addressed a qualified defined contribution plan that permitted participants to elect withdrawal of their vested account any time after a termination of employment up until the plan’s normal retirement age. The plan provided that certain administrative expenses – such as investment management fees – would be allocated pro rata (based on each account’s assets as a percent of all plan assets) to the individual accounts of all participants and beneficiaries based on the value of their account balances in the plan. The plan also provided that any account’s share of the expenses that were not paid by the employer would be charged against the account. This employer paid plan costs only for active employees. Thus, the cost associated with the accounts of former employees or their beneficiaries was charged directly to those accounts. The Service ruled that the charges represented proper and reasonable plan expenses under ERISA.
The legal question was whether such a charge made only to the accounts of terminated participants represented an impermissible “significant detriment” to those participants who did not consent to a distribution and violated IRC §411(d)(11). That section prohibits the distribution of a terminated participant’s account without the consent of the participant when the benefit exceeds $5,000. The question here was, did the imposition of such a charge to only the terminated participants or beneficiaries impose a significant detriment to the participant who did not consent to a distribution so that the significant detriment rule was violated. That is, was the participant being improperly coerced to make the distribution election now rather than leave the funds in the plan?
Treasury Regulations permit a pro rata allocation of proper plan expenses to all plan accounts. The Service ruled that the proposed allocation only to terminated employees’ accounts does not impose a detriment so significant that it was inconsistent with the deferral rights mandated by IRC § 411(a)(11) because similar fees would be imposed in the marketplace for a comparable investment outside the plan.
The IRS holds that not every method of allocating plan expenses is reasonable, and a method that is not reasonable could result in a significant detriment. For example, allocating the expenses of only active employees pro rata to all accounts (current employees and former employees), while also allocating the expenses of former employees only to their accounts, would not be reasonable since former employees would be bearing more than an equitable portion of the plan’s expenses. Accordingly, such an allocation of expenses is a significant detriment.
Certain sanctions equal (per capita) allocation of charges to each account in the case of fixed administrative expenses, such as recordkeeping, legal, auditing, and annual reporting, claims processing, and similar administrative expenses. However, where fees are determined pro rata based on account balances, such as investment management fees, IRS guidance indicates that a per capita allocation method would be arbitrary. With respect to investment advice expenses, the IRS sanctions either pro rata or per capita, and whether or not based on actual utilization.
The IRS notes the following as specific examples of the types of expenses that can be charged directly to a participant's account, provided the expense is reasonable: (1) hardship withdrawals, (2) calculation of benefits payable under different distribution options, (3) benefit distributions, (4) accounts of separated participants (may be charged for a portion of the plan's administrative expenses), and (5) QDRO expenses.
Finally, the allocation of plan expenses must also comply with the nondiscrimination. The method of allocating plan expenses is a plan right or feature described under the appropriate regulations. For example, if, in anticipation of the divorce of a plan participant who is a highly compensated employee, the plan’s method of allocating expenses is changed so that the expense of a determination of whether an order constitutes a qualified domestic relations order under § 414(p) ceases to be allocated solely to the account of the participant for whom the expense is incurred, but instead is allocated pro rata to all accounts, the timing of such change may cause the plan to fail to satisfy the IRS requirements with respect to the nondiscriminatory availability of benefits, rights and features and with respect to the timing of plan amendments.
The bottom line summary is that a plan may impose reasonable expenses to only former employees as long as the requirements discussed above are followed. |
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Plan Sponsors To Be Required To Make New Disclosures To Participants. |
Last year, the Department of Labor issued proposed regulations on disclosures of fees between service providers and plans. Now it has released proposed regulations on participant disclosures.
On July 22, the DOL issued proposed regulations intended to make it easier for 401(k) plan participants to make “informed decisions about the management of their individual accounts and the investment of their retirement savings,” according to the preamble. According to the news release for these proposals, the regulations would provide participants with fee and expense information regarding the investment options available under their 401(k) plans. The DOL plans to finalize the proposal this fall, effective for plan years beginning on or after January 1, 2009.
The proposal requires disclosure of “plan-related information” and “investment-related information. Plan-related information falls into three categories – general plan information, administrative expense information, and individual expense information.
The proposal describes general plan information as how participants and beneficiaries may give investment instructions, any specified limitations on such instructions, including any restrictions on transfer to or from a designated investment alternative, the exercise of voting, tender and similar rights appurtenant to an investment as well as any restrictions on such rights; the specific designated investment alternatives offered under the plan; and any designated investment managers to whom participants and beneficiaries may give investment directions. This information is required to be furnished to an individual on or before the date he or she becomes eligible to be a participant or beneficiary under the plan and at least annually thereafter. In addition, participants and beneficiaries would be furnished a description of any material changes to this information no later than 30 days after the date the changes are adopted.
For administrative expenses, the proposal requires that on or before the date the individual becomes a participant or beneficiary, he or she must be furnished with an explanation of any fees and expenses for plan administrative services, such as legal, accounting or recordkeeping, that may be charged against the individual accounts of participants or beneficiaries and the basis on which such charges will be allocated to each individual account, such as pro rata or per capita. These disclosures would continue on an annual basis. This information could be included in the plan’s Summary Plan Description. In addition to these general disclosures, participants and beneficiaries must be furnished with statements of the dollar amounts actually charged during the preceding quarter to their accounts for administrative services, with general descriptions of the services to which the charges relate. These disclosures must occur at least quarterly and should enable plan participants to distinguish the administrative services from other charges and service costs that may be assessed against their plan accounts. The DOL does not believe that it is necessary, or even useful, for these administrative charges to be broken out and listed on a service-by-service basis.
Finally, individual expenses are those expenses that are assessed on an individual-by-individual, rather than plan-wide, basis. Such expenses could relate to a qualified domestic relations order, plan distribution, participant loan, or investment advice services. The disclosure rules for these expenses are the same as those for administrative expenses.
Turning to investment-related information, the proposal mandates that participants and beneficiaries must be furnished certain basic information with respect to each designated investment alternative offered under the plan on or before the date of eligibility and at least annually thereafter. This information must include the name and category (such as a money market mutual fund, index fund, or balanced fund) and a website address where participants can get supplemental information regarding the investment alternative, including principal strategies, risks, performance, and costs. Other required disclosures include specified performance data to each investment alternative and the fees and expenses related to the purchase, holding, and sale of the investment alternative.
The “centerpiece” of the proposal is a requirement that the plan provide investment-related information in a comparative chart or similar format that will permit “straightforward comparison” of the plan’s investment alternatives. The proposal provides a model chart to comply with this requirement but allows plan fiduciaries the flexibility to design their own charts or other comparative formats. These materials must also include a statement that more current information about an investment is available at the website for the investment.
The proposal preamble explains that many of the required disclosures are already required for plans that have elected to comply with the requirements of ERISA § 404(c). Compliance with those disclosure requirements is voluntary, however, and does not extend to participants and beneficiaries in all participant-directed individual account plans. The DOL now believes that all participants and beneficiaries in these plans “should have access to basic plan and investment information.” This proposal is intended to establish uniform, basic disclosures for all such participants and beneficiaries, regardless of whether they participate in a section 404(c) plan. In addition, the proposal would require presentation of the investment-related information “in a form that encourages and facilitates a comparative review among investment options.”
According to DOL data listed in the preamble, there are an estimated 437,000 participant-directed individual account plans, covering an estimated 65 million participants, and holding almost $2.3 trillion in assets. According to DOL analysis, a one percentage point difference in fees can result in an 18 percent difference in savings, using a 10% rate of return over 20 years. The DOL estimates that the present value of the cost to implement this regulation over 10 years would be $759 million. On the other hand, it expects the present value of the resulting benefits over that same period would be $6.9 billion. Two-thirds of the projected benefit would come from the time participants would save by not have to search for the information that must be disclosed under the proposal. The DOL expects that the remaining third will come from price competition that would result from better disclosure. |
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Caution Is Required When Moving Money From A Qualified Plan. |
A recently issued Tax Court decision (Leon and Tilley, TC Summary Opinion 2008-86) illustrates the costly tax consequences that result when a participant receives a taxable distribution from a 401(k) plan, rather than rolling the distribution over to an IRA or another plan. The end result can be an even greater financial disaster when the distribution includes the unpaid balance of a loan to the participant. Despite the fact that most tax advisors would recommend a direct rollover, far too many participants fail to heed this common sense advice, causing severe damage to their retirement savings and to their wallet when the tax bill comes due. If an employee has an outstanding loan balance and wants to avoid current tax by making a rollover or direct transfer, the employee would have to repay the loan balance before the expiration of the grace period.
In this case, Karen Tilley, a participant, borrowed almost $41,000 from her employer’s 401(k) plan in order to buy a home. The loan terms required semimonthly payroll deductions over a 10-year term. In October 2003, Ms. Tilley terminated her employment, which triggered a plan acceleration clause making the outstanding loan balance immediately due and payable as of the date of her termination. The plan also had a 90-day grace period for the required payment, meaning that the plan administrator would only treat the loan in default if any scheduled repayment was not made during their grace period. Unfortunately, Ms. Tilley made no further payments on the loan and the plan administrator treated the loan as in default in early 2004, after the expiration of the grace period.
In March 2004, the plan administrator informed Ms. Tilley that she had a deemed distribution from the plan of about $31,000, representing the unpaid loan balance. She was also informed that this amount was fully taxable. In April 2004, the plan administrator sent her a check for about $61,500, which represented the entire cash balance of her plan account, less federal tax withholding of approximately $15,400. Instead of rolling this amount into an IRA she had established, Ms. Tilley deposited the entire distribution check into her checking account.
Ms. Tilley subsequently received a Form 1099-R reporting that she had received a taxable distribution of slightly more than $108,000 in 2004, representing the cash balance of her plan account plus the deemed distribution of the outstanding loan balance. At this point, Ms. Tilley compounded her error by failing to include this distribution on her 2004 federal income tax return. Not surprisingly, the IRS caught up with her and determined that the entire distribution was includible in her income and was also subject to the 10% penalty on early distributions under IRC § 72(t) because she was under age 59 1/2.
In her Tax Court case, Ms. Tilley argued that she had intended to roll the distribution into her IRA but that the plan administrator had erred by sending her a check. She stated that she was now willing to roll the funds into her IRA. She also argued that the deemed distribution of the loan balance occurred in 2003 because the loan became due and payable upon the termination of her employment.
The Tax Court rejected both arguments. After the passage of 4 years, the Court would not grant her a waiver of the requirement to roll over a distribution within 60 days of the distribution date. She received the distribution and used the funds that were distributed, which negated any contention that error was that of the plan administrator. Current treasury regulations stating that the deemed distribution of a loan occurs after the expiration of a grace period were not in effect in 2004. Nevertheless, the Court determined that the more reasonable interpretation of the plan documents was that the acceleration clause simply controlled the amount due to the plan at the time of the participant’s termination and did not negate the effect of the 90-day grace period. Finally, the Court agreed that Ms. Tilley received a distribution that was subject to the 10% penalty.
The Court also imposed a 20% negligence penalty on Ms. Tilley and her husband because it concluded that they did not have “reasonable cause” to believe that her distribution was not taxable. Thus, the taxable effect of the distribution, plus the penalty for failure to properly report the distribution, caused a truly dismal tax result for the Tilleys. |
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Controversial “401(k) Debit Card” May Spur Further Regulation. |
Two Democratic Senators, Schumer of New York and Kohl of Wisconsin, have introduced legislation to restrict loans from 401(k) plans and to ban the use of debit cards to access 401(k) plan accounts. They announced this effort at a hearing of the Senate Special Committee on Aging, which is chaired by Senator Kohl. The hearing was named: “Saving Smartly For Retirement: Are Americans Being Encouraged To Break Open The Piggy Bank?” In addition to the debit card ban, the proposed legislation would also limit the number of loans a participant could take from a plan. According to Senator Schumer, similar proposals to use credit cards to create loans from 401(k) accounts a decade ago were abandoned when he introduced legislation to ban their use. This time, the Senators wish to make the ban the law.
Although a plan loan has a superficial appeal, because the participant is borrowing “from himself” instead of paying interest to a lender, many economic studies indicate that these loans actually cost the participant money. This is partly due to the lost earnings that occur when the funds are removed from the plan because the interest paid is less than the investment earnings on funds not borrowed. In addition, the participant must use after-tax dollars to pay back the loan. Those funds are taxed again when the participant finally receives a distribution from the plan, meaning that the loan repayments suffer double taxation. According to Senator Schumer, approximately $10,000 in retirement income is lost for every $1,000 that a participant takes as a loan from a 401(k) plan.
In a statement related to the hearing, the Pension Rights Center noted that in 2006, 87.5% of all 401(k) plans permitted participant loans, and 84% permit loans for any reason. The Center viewed that as part of “the very real problem that all too many workers are withdrawing their 401(k) money for non-retirement purposes.” It decried this trend in an era when 401(k) savings will be the primary, if not sole, source of retirement income other than Social Security. The Center for American Progress added a report noting that from 1989 to 2004, loans from defined contribution plans have risen almost 400%, to $31 billion when adjusted for inflation. |
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Note: Occasionally, articles we feel would be of interest to our E-newsletter readers will be presented that previously appeared in other compilations of writings by Greg Matthews who is the Editor for the 401(k) Advisor, a monthly newsletter from Aspen Law & Business. The newsletter may be ordered at www.aspenpublishers.com or by calling 1-800-638-8437. |
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IRS CIRCULAR 230 DISCLOSURE: To ensure
compliance with the requirements imposed on us by IRS
Circular 230 (31 C.F.R. 10.33 - 10.37, et. seq.), we
inform you that to the extent this communication, including
attachments, mentions any federal tax matter it is not
intended or written and cannot be used, for the purpose
of avoiding Federal Tax penalties. In addition, this
communication may not be used by anyone in promoting,
marketing or recommending the transaction or matter
addressed herein. Anyone other than the recipient who
reads this communication should seek the advice based
on their particular circumstances from an independent
tax advisor. |
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