Year-End Housekeeping Issues for Retirement Plans

Jeffrey R. Capwell and James E. Hickmon

McGuireWoods LLP

Charlotte, NC

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Southern Employee Benefits Conference - 36^th Annual Educational Conference

Legal and Legislative Committee Update

September 14, 2005

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I. QUALIFIED RETIREMENT PLANS

A. Automatic Rollover Procedures. Section 401(a)(31)(B) of the Internal Revenue Code of 1986 (the “Code”) requires that involuntary distributions of more than $1,000 but less than $5,000 be directly rolled over to an IRA if the participant does not make an affirmative election to receive the distribution or to have it transferred in a direct rollover to an eligible retirement plan. The new requirement took effect on March 28, 2005. The IRS issued transition relief which allows plans to delay processing mandatory distributions until the plan implements procedures to comply with the new rules, provided that mandatory distributions are made by December 31, 2005. See Notice 2005-5.

Action Items:

· Plans that intend to retain mandatory distribution provisions will need to implement automatic rollover procedures in the next few months.

· Some plans may wish to avoid the compliance burdens of the automatic rollover rules by eliminating mandatory distributions altogether, or by reducing cash-out amounts to $1000 or less.

· Whichever alternative is selected, a plan amendment reflecting the manner in which the plan was operating since March 28, 2005 must be adopted by the end of the first plan year ending after March 28, 2005. For calendar year plans, the amendment must be adopted by December 31, 2005.

B. Revamped Determination Letter Application Program Now Open. After years of study, the IRS issued a completely redesigned determination letter program for qualified retirement plans. See Rev. Proc. 2005-66. The new program establishes a five-year application cycle for individually designed plans and a six-year cycle for pre-approved plans. For individually designed plans, there are five different cycles, the first of which closes on January 31, 2007. Which cycle applies to a plan depends upon the last digit of the taxpayer identification number (TIN) of the employer that maintains the plan. Special rules determine which TIN should be used for plans maintained by a controlled group of corporations, multiemployer and multiple employer plans, governmental plans, plans affected by a merger, acquisition, change in plan sponsor or a plan spin-off. The initial submission cycles will consider amendments required by EGTRAA and certain other recent law changes.

Action Items:

· Sponsors of individually designed plans should determine which cycle will apply to their plans. TINs that end in 1 or 6 are subject to the first cycle (“Cycle A”) which closes on January 31, 2007.

· Sponsors of individually designed plans should also confirm that their plans timely adopted “good faith” amendments for EGTRAA, which will be a condition to receipt of a favorable determination letter for EGTRAA. See Rev. Proc. 2005-66, Part I, Section 2.07.

· For adopters of pre-approved plans, the initial deadline for sponsors and practitioners maintaining such plans to submit applications for opinion and advisory letters is January 31, 2006. At the end of each review cycle, the IRS will issue a deadline by which adopting employers must adopt the newly approved plans (expected to be at least a two year window).

C. New 401(k) Plan Regulations Will Take Effect in 2006. Final regulations affecting 401(k) plans take effect for plan years beginning on or after January 1, 2006 (with certain exceptions for collectively bargained plans). Important changes and clarifications in the new regulations include restrictions on the use of “targeted“ QNECs and QMACs to satisfy the ADP and ACP tests; an expanded list of safe harbor hardship events; prohibitions on pre-funding elective deferrals and matching contributions to accelerate deductions and broader automatic enrollment provisions.

Action Items:

· Although the regulations permit some provisions to be incorporated by reference, plan amendments may be necessary in some circumstances. For example, plan documents will require binding election of various nondiscrimination testing methods. A safe harbor plan may no longer incorporate a “fall back” option to use the ADP test only in those years in which it fails to meet the safe harbor requirements.

· Optional plan amendments will be required for plans wishing to utilize the optional nondiscrimination methods and liberalized hardship distribution rules.

· Prior regulations did not provide specific rules for salary deferral elections. The final regulations require a plan to provide employees with an effective opportunity to make (or change) a cash or deferred election at least once each plan year. This may require a plan amendment in some cases.

D. Roth 401(k) Contributions Permitted Beginning in 2006. Section 401(k) plans may permit participants to make Roth after-tax contributions beginning in 2006. Proposed IRS regulations allow such contributions only if the plan is amended to permit participants to designate between Roth and pre-tax distributions; the plan accounts separately for the Roth contributions; Roth contributions are taken into account for nondiscrimination testing purposes in the same manner as pre-tax contributions; Roth distributions remain subject to the same distribution restrictions as pre-tax contributions under Code Sections 401(a)(9)(A) and (B); and the plan provides that any rollover distribution of Roth contributions may only be made to a qualified plan that accepts and maintains Roth accounts or to a Roth IRA. A number of administrative issues will need to be clarified in final regulations, such as guidance on the taxation of designated Roth contributions, including the application of the 10% excise tax for premature distributions, defaulted loans of Roth contribution account balances, and hardship withdrawals.

Action Items:

· The primary impediment to implementation of Roth contributions will likely be whether the plan’s recordkeeper is fully capable of meeting the various administrative requirements associated with these contributions. Changes may also be needed to the sponsor’s payroll system to accommodate both pre-tax and after-tax contribution deductions.

· Summary plan descriptions, employee notices and election forms will need to be revised if the Roth feature is added to the plan. Consideration should be given to identifying the various factors that participants may want to take into account in selecting between pre-tax and after-tax Roth contributions.

E. Proposed Overhaul of Section 415 Regulations. In May the IRS published a completely revised set of regulations under Section 415. Although the proposed regulations generally will not become effective until 2007, certain changes are effective now. First, there is an exception to the general rule that amounts received following termination of employment cannot be considered compensation for purposes of Section 415. Under the exception, amounts paid within 2 ½ months following termination can be included in compensation so long as (1) the amounts would have been paid if the employee had not terminated employment, or (2) the amounts represent bona fide sick, vacation or other leave that would have been available if the employee had not terminated employment. Second, the general rule described above also does not apply to payments made to an employee who is absent to perform qualified military service. The new guidance regarding payments during military leave will allow plans to take differential pay and other supplemental compensation into account in computing benefits, and to allow employees on such leave to continue to defer such amounts under 401(k) plans.

F. Requirements for Adopting a Reforming Amendment to Avoid Retroactive Effect of the Heinz Decision. In Central Laborers’ Pension Fund v. Heinz, the U.S. Supreme Court held that the anti-cutback rule was violated by a plan which expanded the definition of disqualifying post-retirement employment and triggered the suspension of early retirees’ already accrued benefits. In response, the IRS issued guidance to allow employers to retroactively reform plan provisions which are now prohibited under the Heinz decision. See Rev. Proc. 2005-23.

Under the guidance, a plan must adopt a reforming amendment retroactively to June 7, 2004 and comply operationally with the reforming amendment. The plan must provide for retroactive payment of benefits no later than January 1, 2006. In addition, affected participants must be provided with written notice of their option to elect commencement of benefits as of the first date the reforming amendment is effective or the date the participant was first eligible for benefits. This notice must be sent on or before January 1, 2006.

II. SECTION 403(b) PLANS

A. New Rule Changes on the Horizon. A proposed overhaul of the IRS regulations governing Section 403(b) plans was issued late last year. Originally scheduled to take effect for plan years beginning on or after January 1, 2006, IRS officials recently indicated that the new rules generally will not take effect before January 1, 2007. One of the most significant changes is a requirement all Section 403(b) plans be in writing, and comply both in form and operation with applicable rules. In addition, the new rules will require Section 403(b) plans to comply with the full range of nondiscrimination rules applicable qualified plans, except for employee salary reduction contributions which will remain subject to the “universal availability” rule. Other changes include clarification of a plan sponsor’s ability to terminate or freeze an arrangement, guidance on the ordering of Section 403(b) and Section 414(v) catch-up contributions, the extent the Section 414(p) QDRO rules apply to Section 403(b) plans, and participant rollover notice requirements.

III. SECTION 457(b) PLANS

A. Amendments for Eligible Governmental Section 457(b) Plans. Eligible Section 457(b) governmental plans may use model amendments contained in Revenue Procedure 2004-56 to comply with plan changes required by EGTRRA and the regulations issued under Code Section 457. The compliance deadline for such plans is December 31, 2005. See Rev. Proc 2004-56. The amendments include provisions for annual elective deferral and catch-up contribution limitations, the special Section 457 catch-up contribution limits, model participant loan provisions, and plan rollover and plan to plan transfer provisions.

B. Ability to Correct Certain Non-Conforming Section 457(b) Plans. Section 457(b) plans established before June 14, 2004 and that no longer conform to the requirements of Code Section 457(e)(1)(A) because they are maintained by a labor organization instead of an eligible governmental employer may brought into compliance by December 31, 2005 if certain requirements are met. See Announcement 2004-52. First, payroll contributions must have ceased after December 31, 2004. Second, either an eligible governmental employer must adopt the plan, or the accounts of the employees under the plan are transferred (not rolled over) into an eligible governmental plan

IV. NONQUALIFIED RETIREMENT PLANS

A. More Definitive Section 409A Guidance Expected Soon. A number of special transition rules for bringing plans into compliance with the new Code Section 409A requirements are scheduled to expire on December 31, 2005. See Notice 2005-1. For example, plans with non-grandfathered benefits that do not comply with the new rules must be amended to comply in form with the new rules by December 31, 2005. However, it appears likely that the deadline for this transition rule and possibly for other transition rules will be extended when more definitive guidance is issued. The release of such guidance appears imminent.

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