New Automatic Rollover Rules: An Update



The new automatic rollover requirements relating to cash-out distributions of retirement plan accounts will take effect on March 28, 2005. The Department of Labor (DOL) has previously issued regulations setting forth a fiduciary safe harbor for plan administrators that can apply to (1) the selection of an individual retirement account (IRA) custodian and (2) the investment of any amounts transferred to any rollover IRAs established with such custodian. Recently, the Internal Revenue Service (IRS) issued guidance regarding plan amendments and related matters that need to be addressed in order for the terms of a tax-qualified plan to allow for the making of automatic IRA rollover distributions. Plan administrators should take action now to ensure timely compliance with the new automatic rollover requirements under both the DOL regulations and IRS guidance.

Under most tax-qualified retirement plans, such as 401(k) plans, upon the termination of an employee's participation in the plan, the plan administrator must automatically distribute the participant’s vested account balance if it is $5,000 or less. If the participant does not make an affirmative election (e.g., to direct the administrator to make a direct transfer to another tax-qualified plan or an IRA), the entire account balance must be distributed to the participant. Under current law, 80% of the participant's account is distributed directly to the participant and 20% is remitted to the IRS as required withholding tax. Such a distribution is fully taxable as ordinary income of the participant and, if the participant is less than age 59-1/2, the distribution will also be subject to a 10% early withdrawal penalty.

Under the new rules, a plan administrator must roll over a participant's distribution to an IRA it establishes for the participant if the participant's account balance is greater than $1,000 but less than or equal to $5,000, provided that the participant does not make an affirmative election to receive a direct distribution or to have the amount paid in a direct transfer to another plan or an IRA. Pursuant to the final DOL regulations, a plan administrator will be deemed to have satisfied the fiduciary duties imposed on the administrator under the Employee Retirement Income Security Act of 1974 (ERISA) with respect to the selection of IRA providers and the investment of the funds held in the IRA if the plan administrator satisfies several conditions, including entering into a written agreement with the IRA custodian that specifically provides for the investment of the rollover funds only in certain stable value products (e.g., money market funds, interest-bearing savings accounts, and certifi cates of deposit) and for fees and expenses that are comparable to charges for other IRAs that are not automatic rollover IRAs.

The new guidance from the IRS indicates that plans must generally be amended before the end of the first plan year ending on or after March 28, 2005, to provide for automatic rollovers of mandatory distributions. For calendar year plans, the deadline is December 31, 2005. Moreover, the IRS guidance reiterates that the plan administrators must notify terminated participants in writing that, absent an affirmative election to the contrary, their mandatory distribution will be rolled over to an IRA as designated by the plan administrator. While the IRS has provided a model plan amendment, no sample participant notice has been issued at this time.

In light of the guidance described above, administrators of tax-qualified plans that provide for mandatory distributions should undertake the following actions as soon as possible to ensure compliance with the new automatic rollover requirements:

  • Evaluation and Selection of an IRA Custodian: As the fiduciary of a retirement plan, the plan administrator must engage in a deliberate process to evaluate prospective IRA providers and select the provider best suited to the needs of the plan. Written documentation, including a written agreement with the selected custodian and a copy of any written action and/or resolutions of any authorized fiduciary that set forth the necessary steps of the evaluation and selection process, should be maintained as evidence of the completion of this process.
  • Amendment of the Plan: Adoption of the sample amendment in the IRS guidance (or an amendment that is "materially similar") effective as of March 28, 2005, will constitute "good faith" compliance as required under the guidance to preserve the EGTRRA remedial amendment period for this provision.
  • Distribution of Summary of Material Modifications/Revised Summary Plan Description: Pursuant to the DOL regulations, a summary of material modifications or a revised summary plan description for the plan that describes the new rollover requirements must be prepared and distributed to plan participants.
  • Provision of Participant Notice: The plan administrator is required to provide a specified notice to each terminated participant. Such notice must indicate that, absent an affirmative election by the participant, the distribution will be rolled over to an IRA designated by the plan administrator. The notice must also identify the IRA custodian. The IRS has not yet provided a model notice to satisfy this requirement, although it is expected to do so soon.

Plan administrators should complete the process of evaluating and selecting an IRA provider as soon as possible. In its guidance, the IRS has indicated that a plan administrator will not fail to operate a plan in accordance with its terms if mandatory distributions are not made as of March 28 because arrangements relating to the automatic rollover of such distributions have not been completed, provided that such distributions must be made (or rollovers completed) on or before December 31, 2005. Although this provision appears to offer some relief from the March 28 compliance deadline, it is limited to the issue of operation of a plan in accordance with its terms. It is advisable in any case to complete arrangements with an IRA custodian as soon as possible so that regular plan administration may continue after March 28, i.e., terminated participants with small account balances may continue to be cashed out in the usual course without interruption.