United States: Qualified Retirement Plans: November 2004 Developments

Automatic rollover to IRAs of mandatory cash out amounts worth more than $1,000 is required effective March 28, 2005. Plan sponsors are currently deciding whether to administer automatic rollovers or to reduce their mandatory cash out amount to $1,000 or less so the requirement can be avoided. If the decision is to reduce the mandatory cash out amount, an appropriate plan amendment should be adopted and participants should receive a Summary of Material Modifications or updated Summary Plan Description. A recent survey by Mercer Human Resources Consulting shows that many major providers of IRAs will offer an IRA vehicle for this purpose, but will, initially at least, only be offering them to their own retirement plan recordkeeping clients. This suggests that your most likely source of automatic rollover IRAs will be your plan's current recordkeeper if they are also in the IRA business. If not, you may need to consider reducing your mandatory cash out to a maximum of $1,000.

The Seventh Circuit Court of Appeals has issued another opinion in the Matz litigation on when a "partial plan termination" has occurred. The Matz case has been around for nine years and has even made an appearance at the U. S. Supreme Court. The Internal Revenue Code requires that plan participants who are terminated from a qualified plan due to a "partial plan termination" must be fully vested in their accrued benefits. For now, at least, in the Seventh Circuit, the rule is that there is a rebuttable presumption that a partial plan termination has occurred whenever there is a reduction of at least 20% in the total number of plan participants (not a 20% reduction in the total number of nonvested participants). Judge Posner.s opinion also advised that, within the range of 10% to 40% reductions, courts should consider all the facts and circumstances of the case in reaching its conclusion. His opinion suggests that reductions below the 10% level are not partial terminations and reductions over 40% are, conclusively, partial terminations. Matz v. Household International Tax Reduction Investment Plan, 7th Cir., No. 03-3244 (11/5/04).

IRS has proposed rules on Internal Revenue Code Section 403(b) plans. Code Section 403(b) plans may be offered only to employees of state public schools, employees of a Code Section 501(c)(3) organization, and certain religious ministers. Their contributions can only be made to insurance annuity contracts, custodial accounts invested only in mutual funds, or church retirement income accounts. A universal availability rule applies to salary deferral elections under Code Section 403(b) plans, but they are not subject to the average deferral percentage rules and minimum coverage rules that apply to Code Section 401(k) plans. These are the first new regulations addressing Code Section 403(b) plans in 40 years and, when eventually finalized, should provide comprehensive and up-to-date guidance.

An obvious trend in the proposed Code Section 403(b) regulations is to make the rules similar to the existing rules for Code Section 401(k) plans and Code Section 457(b) plans (deferred compensation arrangements for employees of tax-exempt organizations). The 401(k) rules for hardship elections and cash-or-deferred elections are specifically relied on in the proposed Code Section 403(b) regulations. The regulations are proposed to be effective for plan years beginning on or after January 1, 2006. (REG-155608-02)

IRS also announced that it is interested in commencing a determination letter process for Code Section 403(b) plans but will not do so until the proposed regulations are finalized.

IRS has proposed guidance on phased retirement arrangements. According to the IRS, the regulations once finalized will be "an important step to removing an unnecessary barrier to the implementation of programs that allow employers to retain the services of older workers who want to phase down their work in preparation for full retirement." Under the proposed rules, where the pension plan permits, employees who are at least age 59 ½ may receive a pro rata portion of their pension annuity to the extent they choose to reduce their work as part of a bona fide phased retirement program. (69 Fed. Reg. 65108, 11/10/04). Under the proposed rules:

• A qualifying phased retirement program would have to be in writing and adopted by the employer.

• The program must prohibit lump sum or rollover distributions.

• The program must allow participating retirees to continue accruing pension benefits on a full-time employee basis.

• It must allow participating retirees to receive the same benefits on full retirement as similarly situated employees who do not elect phased retirement.

• Highly compensated employees electing phased retirement would continue to be considered to be highly compensated employees even if their compensation during phased retirement falls below the applicable dollar amount.

• There would have to be periodic testing to determine that participating retirees are actually working reduced hours (as opposed to being full time employees).

The proposed regulations would apply for plan years beginning on or after the date the regulations are finalized.

Passing through to affected plan participants the legal, actuarial, and accounting costs associated with their Qualified Domestic Relations Orders ("QDROs") is an emerging trend. In our June 2003 EB Newsletter we reported on Labor Department Field Advisory Bulletin 2003-3, which said, for the first time, that plans could charge individual participants for (among other things) administration expenses relating to QDROs. The Wall Street Journal reported on November 9, 2004, that charging for QDRO expenses is an emerging trend. Fidelity Investments reported that 40 of the 200 plans for which it does QDRO administration now pass this charge through to participants. A typical range of charges appears to be $300 to $700, but the costs can be much higher where complex determinations are required.

Changes in the Working Families Tax Relief Act of 2004 ("WFTRA") to the Internal Revenue Code Section 152 definition of "dependent" are not intended to change the income exclusion for employer-provided accident or health coverage provided by Code Section 106. In Notice 2004-79 the IRS said it will correct a technical problem under Code section 106 regulations that would have caused employer-provided coverage for certain dependents to become taxable in 2005. WFTRA created the problem when it changed how "dependent" is defined in Code Section 152. The changes inadvertently took away the tax exclusion for employer-provided health coverage from dependents who are qualifying relatives (but not qualifying children) under the new definition, but who have income in excess of the gross income limitation included in that definition.

WFTRA's changes to the Code's definition of "dependent" are proving to be confusing to plan sponsors as their impact is being analyzed. Plan sponsors should review definitions of "dependent" used in their group health plans in light of the new definition of dependent effective for taxable years beginning on or after January 1, 2005. For example:

• Effective in 2005, if a plan requires, as a condition of coverage of a child of an employee/participant, that the employee/participant provide over 50% of the child's support, but does not require that the child reside with the employee/participant for more than one-half of the taxable year, the situation could arise (in cases other than divorce or separation) in which the child would qualify as a dependent under the plan but would not qualify as a dependent under Code Section 152.

• If a plan merely incorporates the Code Section 152 definition of "dependent" by reference, it may be necessary to negate the otherwise applicable gross income test for "qualifying relatives" in order to provide coverage for certain dependents with gross income that exceeds the dependency exemption amount ($3,200 in 2005).

It is premature to say that these "glitches" in the law are intentional and it is possible that they will be corrected administratively or legislatively. In the meanwhile, however, it is essential that group health plan sponsors be aware of them and take action where appropriate.

The 2005 limits for the adoption assistance exclusion and tax credit are announced. The maximum exclusion under Code Section 137 for qualified adoption expenses and adoption of a child with special needs will be $10,630 (up from $10,390 for 2004). The maximum credit under Code Section 23 for qualified adoption expenses and adoption of a child with special needs will also be $10,630. The amount that can be excluded from an employee's gross income begins to phase out for taxpayers with adjusted gross income ("AGI") of more than $159,450, and is completely phased out at AGI of $199,450.

Qualified transportation fringe benefit limits for 2005 are announced. For 2005, the limit for monthly exclusions from an employee's income to pay for parking will increase to $200 (up from $195 in 2004). The mass transit expense limit (and commuter highway vehicle expense limit) will be $105 (up from $100 in 2004).

The Flexible Spending Account ("FSA") "use it or lose it" rule is unlikely to be changed by Treasury regulation, according to a Treasury official. Roy Ramthun, U. S. Treasury senior advisor for health initiatives, recently advised that Treasury is reluctant to change the "use it or lose it rule," suggesting that Treasury lacks the authority to do so. Congress did not include the "use it or lose it" rule for the new Health Spending Accounts ("HSAs") and some legislators remain optimistic that the rule can be repealed for FSAs also.

Increased regulation of nonqualified deferred compensation arrangements is now the law. On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004, enacting significant changes to rules governing nonqualified deferred compensation. Initial guidance under the new law will apparently be issued on or before December 16, 2004. Our summary of the new rules was published on October 12, 2004, and is available at www.foley.com/employeebenefits.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.