Summer 2010 RPF

Summer 2010 RPF

Retirement Plan Forum

  Common Purpose. Uncommon Commitment.

SUMMER 2010
Retirement Plan Forum

A Quarterly Newsletter for Retirement Plan Sponsors

 


Retirement Plan Forum

In this Issue:

Exception to the Early Withdrawal Penalty
Deadline for Depositing Deferrals
HEART Act Clarifications
Passing the Test
Plan Automation: One, Two, Three
Recent Developments


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Exception to the Early Withdrawal Penalty

Qualified plan distributions paid to participants who are younger than age 59½ are generally subject to a 10% excise tax. There are several exceptions to the age-59½ rule, however, most notably the exception for distributions paid to terminated participants age 55 or older.

Under Code Section 72(t)(2)(A)(v), payments made to qualified plan participants who have separated from service with their employer during or after the year they reach age 55 are exempt from the 10% early withdrawal penalty. Here are some practical examples:

Example 1: Participant severs employment after age 55
John terminates employment on March 15, 2010, and elects to receive a lump-sum distribution of his 401(k) balance. He is age 57. John’s distribution will not be subject to a 10% excise tax because he separated from service after attaining age 55.

Example 2: Participant severs employment before age 55; requests distribution after age 55
Henry separates from service in 2007 at age 52. He reaches age 55 on February 28, 2010, and calls his employer to request a distribution. Henry asks if the 10% early distribution penalty applies now that he is 55 years old and is disappointed to learn that it does. Why? Because the 10% penalty is waived only for those participants who separate from service in the year they attain age 55 or thereafter. The fact that Henry did not receive the actual distribution until after age 55 is irrelevant unless he waits until after age 59½.

Example 3: Participant severs employment at age 55
Rebecca leaves her job on March 19, 2010, but will not be 55 years old until December 8, 2010. She withdraws her entire 401(k) balance on October 26, 2010. She had not yet attained age 55 at the time of severance nor at the time of the distribution. Will the 10% penalty apply?

No. The IRS clarified (Notice 87-13 Q&A 20) that distributions paid to a qualified plan participant who severs service during or after the year in which he/she reaches age 55 are exempt from the 10% early withdrawal penalty.

Example 4: Participant severs employment after age 55 and directly rolls over account to individual retirement account (IRA).
Bret retires at age 56 and directly rolls over his entire 401(k) balance into a traditional IRA to avoid the 20% mandatory federal income-tax withholding. Bret will have to wait until he reaches age 59½ to withdraw funds from the IRA without penalty because the rule waiving the 10% penalty after separation of service at age 55 or after applies only to qualified plans and not to IRAs.

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Deadline for Depositing Deferrals

Almost two years after issuing proposed regulations, the Department of Labor (DOL) has finalized regulations that establish a safe harbor period for the timely deposit of deferrals (and loan repayments) for small plans. The final regulations (effective January 14, 2010) are essentially the same as the proposed regulations with a few minor clarifications.

The general rule is that employee deferrals must become plan assets on the earliest date on which they can reasonably be segregated from the employer's general assets. That rule has not changed — but it has been clarified.

The New Rules

As in the proposed regulations, the final regulations create a safe harbor period for depositing deferrals to a pension or welfare benefit plan with fewer than 100 participants (determined at the beginning of the plan year). To satisfy this safe harbor, contributions must be deposited into the plan no later than the seventh business day following the day on which such amounts would otherwise have been payable to participants in cash.

The final regulations also include a safe harbor for loan repayments that are deposited into the plan by no later than the seventh business day following the day they are received by the employer.

Contributions will be considered deposited when placed in a plan account. The contributed amounts do not have to be allocated to specific participant accounts or investments by the seventh day.

Example: Acme Enterprises sponsors a 401(k) plan with 30 participants. The company has one payroll period and uses an outside payroll processing service to pay employee wages and process deductions. Acme receives information from the payroll service within one business day after paychecks have been issued. Acme checks the information for accuracy within three business days, and forwards the withheld employee contributions to the plan. An amount equal to the total withheld employee contributions is deposited with the plan trust on the fifth business day following the date employees receive their paychecks.

Under the safe harbor, when participant contributions are deposited in the plan by the seventh business day following a pay date, the contributions are deemed to be contributed to the plan on the earliest possible date on which such contributions can reasonably be segregated from the general assets of the company.

If an employer complies with the seven-day period, fine. However, if the employer fails to deposit deferrals or loan repayments by the end of the safe harbor period, losses and interest on the late deposits must be calculated from the actual date on which the contributions and/or repayments could reasonably have been segregated from the employer’s general assets and not from the end of the safe harbor period. In the former example, penalties for noncompliance would apply starting five business days from when deferrals were withheld from employee paychecks, since that is the normal time frame for Acme Enterprises to deposit contributions to the plan trust.

Clarifications in the Final Regs

Here are some highlights of the clarifications included in the final regulations.

SIMPLE IRAs and SARSEPs. SIMPLE IRAs and SARSEPs are also subject to the final regulations because they are cash-or-deferred arrangements. However, SIMPLE IRAs have a 30-calendar–day deadline (instead of a seven-business-day deadline) to make deposits in both ERISA and the IRC.

Deposit-by-deposit basis. The safe harbor is available on a deposit-by-deposit basis. Thus, if one payroll misses the safe harbor deadline, all other payrolls during the year may still use the safe harbor.

Safe harbor is optional. Using the safe harbor rule is optional, not mandatory. Nor is the safe harbor the only way for employers to meet their obligation to deposit deferrals or loan repayments on the earliest date on which they can reasonably be segregated from the employer’s general assets.

Large plans not included. The DOL does not believe it has the information it needs to extend the safe harbor (or a variation of it) to large plans at this time. Thus, large plans are still subject to the “as soon as administratively feasible rule” (which may or may not be within the seven-day parameter set by the safe harbor for small plans). The amount of time an employer actually uses to send in deferrals each payday establishes a benchmark that is used to determine if a payment is late.

Example: An employer with a large plan regularly deposits deferrals into the plan’s trust by the fourth business day after employees would have received their pay as cash. If the employer deposits the deferrals in eight business days instead, interest due to the plan (because of the late payment) would be calculated from the fourth business day.

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HEART Act Clarifications

The IRS recently provided guidance (IRS Notice 2010-15) on the Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART Act), which affects qualified plan rules for individuals called into qualified military service (QMS). The guidance clarifies certain HEART provisions and reinforces others.

The HEART Act created a new tax code section (IRC Section 401(a)(37)). It provides that survivors of a plan participant who dies on QMS will be entitled to any additional benefits — other than benefit accruals relating to the participant’s period of qualified military service — that would have been provided had the participant resumed employment and then terminated on account of death. Benefits include service credit, ancillary life insurance benefits, and other survivor benefits that are contingent upon a participant’s death and vesting.

Vesting Service

HEART requires that participants killed on QMS be treated as having returned to employment the day before their death and that vesting be provided accordingly; just as if the individual had died while he or she was employed.  In almost all defined contribution (DC) plans, this will result in 100% vesting. However, that may not be the case in defined benefit (DB) plans, which often do not fully vest upon death.  Although credit will be given as if the employee had died while employed for the purpose of vesting percentages, the plan is not required to include the participant’s period of QMS when determining the amount of death benefits for either a DB or a DC plan. However, the plan may opt to do so.

If a participant is not entitled to reemployment rights under USERRA, then the survivor benefits under the HEART Act do not apply.

The Notice also clarifies that the plan does not have to provide 100% vesting for service members who become disabled on QMS, although it may choose to do so.

Differential Wage Payments

Under the HEART Act, differential pay is considered compensation. Any individual receiving differential wage payments will be treated as an employee of the employer making the payment. Thus, if an employee on QMS is already a plan participant, his or her differential wage payments are considered compensation for qualified plan purposes, such as employer allocations and elective deferrals. (Note: Differential pay was an option on the final 415 regulations plan amendment and, thus, has already been either included or excluded in the plan's definition of compensation.)

Contributions resulting from differential wage payments may be included in nondiscrimination testing. However, this is not permitted — nor desired — if the amounts will cause the testing to fail. If these amounts are included in testing, they must be included for all employees receiving differential wage payments.

Qualified Reservist Distributions

The qualified reservist distribution (QRD) was created by the Pension Protection Act of 2006 (PPA) and made permanent by the HEART Act. It is a distribution from an IRA or of deferrals from a 401(k) or 403(b) plan to a member of a military reserve unit that was ordered or called to active duty for a period in excess of 179 days (or for an indefinite period). The QRD must be made between the date of the order or call to active duty and the date the active duty period ends. There is no 10% penalty on QRDs for participants under age 59½.

A QRD or any portion of a QRD may be repaid up until two years after the day the active duty period ends. Whether the QRD is from a 401(k), 403(b), or IRA, repayment may only be made to an IRA as after-tax amounts. Thus, there is no deduction for the repayment (unless it is made within the normal 60-day period allowed for rollovers). Since this is a rollover, it has no impact on the annual IRA contribution limit.

Deemed Severance Distribution

For distribution purposes, an individual called into active duty is deemed to be severed from employment after 30 days of active duty and may request a distribution of deferrals after that 30-day period. Deferrals are suspended for six months after such a distribution. Deemed severance distributions are eligible rollover distributions subject to the 20% mandatory income-tax withholding. A plan is not required to allow deemed severance distributions. If an individual has a real severance from employment and then returns to the job within six months of taking a distribution of deferrals, he or she can begin making elective deferrals immediately.

If an individual on active duty is eligible for both a deemed severance distribution and a QRD (after 179 days on active duty), the distribution will be treated as a QRD. Thus, there will be no six-month suspension of deferrals or 10% premature distribution penalty.

Remedial Amendment Period

Plans must be amended for the HEART Act by the last day of the first plan year beginning on or after January 1, 2010. (The deadline for amending governmental plans is January 1, 2012.)

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Passing the Test

SITUATION: Our 401(k) plan failed the actual deferral percentage (ADP) nondiscrimination test for the 2009 calendar year. To correct the failure, we chose to return the excess contributions made by highly compensated employees to those employees (plus plan income attributable to those contributions), rather than make additional qualified nonelective or matching contributions for nonhighly compensated employees. Some of the highly compensated employees were unhappy to have their contributions reduced. 

QUESTION: What can we do to avoid test failure again this year and keep our highly compensated employees happy?

ANSWER: A cost-effective way to help ensure your plan will pass nondiscrimination testing is to increase plan participation by lower paid employees.

DISCUSSION: The ADP test compares the average rate at which highly compensated employees defer salary with the average deferral rate for nonhighly compensated employees. The difference between the highly paid and the lower paid employees must be within certain defined limits. If it isn’t, you must correct the excess contributions made by the highly compensated employees — as you did.

To avoid failing the test again this year, look at adding automatic enrollment and automatic contribution escalation features to your plan. Both of these features are proven to increase plan participation by lower paid employees.

Alternatively, or in addition to adding these plan features, you may want to ramp up your employee education efforts to reach lower paid and nonparticipating employees. Some approaches to consider: a targeted, personalized campaign of e-mails and/or paycheck stuffers stressing the benefits of participating in your plan, mandatory enrollment/education seminars on company time, posters in areas/departments with high concentrations of lower paid employees, and small prize incentives for attending retirement education/enrollment seminars or enrolling.

Studies show that offering matching contributions usually increases plan participation. If you don’t currently offer a match or you discontinued your match during the recent economic downturn, consider offering one or bringing your company match back. Lower paid employees are often the ones most influenced by matching dollars. Those who participate frequently contribute up to the employer matching percentage. Consequently, changing your match structure from 50% on the first 4% of pay to 25% on the first 8% of pay could increase participant contributions without increasing your monetary outlay.

Another way to avoid failing the nondiscrimination tests in future years is to adopt a safe harbor plan design. If all safe harbor requirements are met, a plan doesn’t have to conduct annual nondiscrimination testing.

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Plan Automation: One, Two, Three

About a fifth of employees who are eligible to participate in an employer-sponsored retirement savings plan don’t contribute. Nor are many of these employees saving for retirement outside of their employers’ plans. Workers who don’t participate in an employer-sponsored plan are much less likely then those who do to have total savings and investments of at least $50,000 (56% versus 13%).* And among those employees who do participate, a relatively small fraction regularly rebalance their accounts — one reason so many participant accounts were hit hard by the 2008 stock market crash.

What can plan sponsors do to increase plan participation and help participants increase their plan account balances? Automate their plans.

Automatic Enrollment. With automatic enrollment, when an employee becomes eligible to participate in the plan, a set percentage of the employee’s compensation is withheld (often 3%) and deposited in a 401(k) plan account for the employee. Some employers apply automatic enrollment only to new employees, but you could choose to automatically enroll all of your eligible employees. All employees must be given the option to decline participation.

Automatic Contribution Escalation. Along with automatic enrollment, consider automatic contribution escalation. You can increase the automatic deferral percentage over time as long as the increases are made in accordance with a specified schedule. You must notify employees of the amount of the deferral increases and when increases will occur. Employees must be given the option to opt out of increases.

Automatic Rebalancing. You may have several options for offering participants automatic rebalancing: Make automatic rebalancing an optional feature of your plan and encourage participants to use it; offer managed accounts; or choose a default investment option for your plan, such as a life-cycle or target-date fund, that automatically rebalances.

* 2010 Retirement Confidence Survey, Employee Benefit Research Institute, www.ebri.org

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Recent Developments

Retirement Assets Make a Recovery

Retirement plan assets made a comeback in 2009, recovering nearly all of the recession-driven losses of the previous year, according to Retirement Market Insights 2010, a new report by Spectrem Group. Total U.S. retirement assets — including both defined contribution and defined benefit plans — rose 18% to $9.3 trillion, up from $7.9 trillion in 2008. Assets in 401(k) and other defined contribution plans rose 19% to $4.5 trillion, from $3.8 trillion in 2008. 401(k) assets alone, which account for 71% of all defined contribution assets, grew 20% to $2.3 trillion in 2009, up from $1.9 trillion in 2008. The recovery may not be enough to dispel unease among plan participants. The report also noted that the number of participants seeking advice on how to investment their retirement money has more than doubled since 2008.

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This newsletter and the material contained in it is not intended as legal or tax advice. Please consult the appropriate professional with any specific questions you have.

CUNA Mutual Group is a leading provider of financial services to credit unions, their members, and valued customers worldwide. As we celebrate 75 years of market commitment in 2010, CUNA Mutual’s vision is unwavering: to be a trusted business partner who delivers service excellence with customer-focused products and market-driven innovation.

For questions or comments contact the Retirement Service Center at 800.999.8786, option 1, or email us.

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