Daily Tax Update - January 3, 2005

Internal Revenue Service Issues Guidance Relating to Automatic Rollover of Cash-Out Distributions
On December 28, 2004, the Internal Revenue Service (the "IRS") issued Notice 2005-5 relating to automatic rollovers of mandatory cash-out distributions from retirement plans to individual retirement accounts ("IRAs"). Under the Economic Growth and Tax Relief Reconciliation Act of 2001, if a plan provides for mandatory cash-out distributions of amounts equal to or less than $5,000, then any amount that is greater than $1,000 must be paid in a direct rollover to an IRA if the distributee fails to make an affirmative election to have the amount paid in a direct rollover to an eligible retirement plan. Notice 2005-5 provides many answers to questions regarding the new automatic rollover rule. The provisions of Notice 2005-5 become effective to rollovers of mandatory distributions made on or after March 28, 2005, which is the effective date of the complementary DOL regulations implementing a fiduciary safe harbor related to automatic rollovers.

  • Pursuant to Notice 2005-5, a mandatory distribution that is subject to the automatic rollover rule is a distribution that (1) has a value equal to or less than $5,000 and greater than $1,000, (2) is made without the participant’s consent and (3) is made to a participant before he attains the later of age 62 or normal retirement age. Therefore, any distribution of amounts equal to or less than $,1000 or amounts that are cashed out when a participate attains normal retirement age (provided that the definition of normal retirement age under the plan is age 62 or later) would not be subject to the automatic rollover rules.

  • Notice 2005-5 states several other important rules: Any distribution to a surviving spouse or alternate payee is not a mandatory distribution for purposes of the automatic rollover rules. In addition, the automatic rollover rules apply to governmental 401(a), 403(b) and 457(b) plans that have mandatory cash-out provisions even though these plans may not be subject to the provisions of Code section 411. However, these governmental plans will not be treated as failing to satisfy the requirements of the automatic rollover rules if the automatic rollover provisions are not applied to mandatory distributions from such plans that are 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. Non-electing church plans are also subject to the automatic rollover rules, but non-electing church plans, maintained for which the authority to amend the plan is held by a church convention, will not be treated as failing to satisfy the automatic rollover requirements if the provisions are not applied to mandatory distributions from such plans that are made prior to the date that is 60 days after the close of the earliest church convention that occurs on or after January 1, 2006.

  • Non-governmental 403(b) plans are also subject to the automatic rollover provisions, but must comply with the rules for distributions made on or after March 28, 2005. Non-governmental 457(b) plans (e.g., those sponsored by tax-exempt entities) are not subject to the automatic rollover requirements.

  • Notice 2005-5 provides that plans are permitted to exclude the value of a participant’s rollover contributions when determining the present value of a participant’s account for purposes of determining whether a mandatory cash-out distribution can be made. However, the automatic rollover rule will apply to the entire amount in the participant’s account. Therefore, to the extent a participant has $5,000 or less in deferrals made under a 401(k) plan, but over $5,000 in rollover contributions, a plan can still force out the entire amount, but must roll over all of the account balance to an IRA in accordance with the automatic rollover rules.

  • What should you do now as plan sponsor of a plan that provides for mandatory cash-outs? A plan must adopt a good faith amendment reflecting the automatic rollover requirements by the end of the first plan year ending on or after March 28, 2005. This means that calendar year plans will have to adopt an amendment by December 31, 2005. Notice 2005-5 includes a sample "good faith" plan amendment that individual plan sponsors and sponsors (or volume submitter practitioners) of pre-approved plans can adopt or use in drafting individualized plan amendments. In addition to adopting a conforming amendment, plan sponsors should identify IRA providers and issuers to whom mandatory cash-out distributions will be rolled over. These IRA providers and issuers may be hard to find. Note that providers or issuers must provide a participant with a disclosure statement that clearly states the participant’s right to revoke the IRA within a seven-day period of revocation.

  • Plan sponsors should also revise their summary plan descriptions or issue a summary of material modification explaining the automatic rollover rules. Lastly, a plan sponsor will need to revise its 402(f) notice to contain an updated explanation of the automatic rollover procedures. The IRS has not released an updated model 402(f) notice (the latest model is contained in Notice 2002-3), but it is expected that it will release a revised notice sometime in early 2005.

  • If the rules outlined above sound like too much of an administrative headache, the IRS does point out in Notice 2005-5 that a plan can eliminate mandatory distributions for amounts over $1,000 without violating the anti-cutback provisions under the Code.

  • Any questions about this summary can be directed to Anne Moran (amoran@steptoe.com), Don Wellington (dwellington@steptoe.com), Shaun Terrill (sterrill@steptoe.com) or Ellen Kohn (ekohn@steptoe.com).

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