Rollover portability rules
Generally, a rollover is the movement of a tax-free distribution of cash or other assets from one retirement plan, such as a 401(k), to another retirement plan or account, such as a traditional individual retirement account (IRA). This “contribution” to the second retirement account is called a “rollover” contribution.
Thanks to ongoing tax law and regulatory changes, rollovers have become quite complex.
Before assets from a qualified plan (or a governmental 457 or a 403(b) plan) can be rolled over, a distributable event must occur. Distributable events include, but are not limited to, termination of employment, death, in-service distribution, plan termination, or disability. In addition, the eligible rollover distribution rules apply:
- If assets are sent to the receiving plan or account by direct rollover, no tax withholding occurs.
- If the distribution is eligible to be rolled over but is paid directly to the participant, there is a 20% mandatory federal tax withholding (that plan sponsors must send to the IRS) and the participant has 60 days from the day the funds were received to roll them into an IRA (or other eligible retirement plan). Note that the participant also may contribute an amount equal to the withheld tax to the rollover IRA (or other eligible retirement plan) within 60 days.
Distributions not eligible for rollover
An “eligible rollover distribution” from a qualified plan, such as a 401(k), is any distribution of all or any part of the participant’s balance except:
- Any of a series of substantially equal distributions paid at least once a year over
- The lifetime or life expectancy of the participant,
- The joint lives or life expectancies of the participant and his/her beneficiary, or
- A period of 10 years or more;
- A required minimum distribution or hardship distribution;
- A corrective distribution or participant loan that is a deemed distribution;
- Dividends paid on employer securities; or
- The cost of life insurance coverage acquired with plan assets.
A surviving spouse beneficiary may roll the deceased participant’s funds to his/her own IRA. If the surviving spouse is working and his/her plan accepts rollovers, the surviving spouse could also choose to roll it to his/her own plan. However, the surviving spouse may not become a participant in the deceased spouse’s plan.
A nonspouse beneficiary may roll the deceased participant’s funds into an inherited IRA. The required minimum distribution (RMD) rules for beneficiaries apply to amounts rolled into an inherited IRA.
Any time after-tax amounts are distributed, special care should be taken to determine if they are eligible for rollover. This does not refer to Roth contributions. Here are some examples of what can and cannot be done:
- After-tax amounts from a qualified plan may be directly rolled to an IRA by direct transfer but not by the 60-day participant rollover method.
- A direct rollover of after-tax amounts from a qualified plan may be made only to a defined contribution plan or an IRA, not to a defined benefit plan.
- After-tax amounts rolled from a qualified plan to an IRA may not be rolled back to a qualified plan.
Traditional IRA rollovers
A traditional IRA may be rolled into a qualified plan, such as a 401(k), if the qualified plan accepts IRA rollovers. Once the rollover has been made, the traditional IRA funds lose their IRA characteristics and are treated as rollover funds in a qualified plan. Thus, they have creditor protection, are available for participant loans, and may be invested in insurance. The required minimum distribution rules of the plan also apply.
SIMPLE IRA rollovers
Once a participant in a SIMPLE IRA plan has satisfied the rule requiring two years of participation, he/she may roll the funds to any plan eligible to receive a rollover. Note: A SIMPLE IRA may not receive rollovers from any plan other than another SIMPLE IRA.
Qualified rollover contributions
This relatively new term describes a rollover to a Roth IRA. It could be a rollover from a 401(k) designated Roth account or a conversion (e.g., from non-Roth sources in a 401(k)).
The once-a-year rule
When a participant moves funds from one IRA to another IRA, a one-year waiting period between rollovers applies. The 12-month wait begins when the funds are distributed from the first IRA and applies to both the IRA from which the distribution is made and the funds that are actually rolled over. If a rollover is made from a qualified plan to an IRA, however, there is no 12-month wait because there has been no IRA-to-IRA rollover.
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Beneficiary distribution options in 2011
Qualified retirement plan documents, such as 401(k) plans, have default provisions to cover various beneficiary scenarios, including the possibility that a participant failed to designate a beneficiary prior to death or that a deceased participant’s beneficiary form may be invalid or missing.
Other thorny issues can arise, such as a beneficiary predeceasing the participant or a life changing event (e.g., a divorce and/or remarriage) occurring after a beneficiary designation form was filed.
Administrators are encouraged to review the plan’s beneficiary designation forms on a regular basis (at least once every five years) to confirm that each participant has a current form on file. Also, participants should be educated about the importance of reviewing their beneficiary forms every five years (or sooner, if there is a reason). Failure to do so could result in distributions that do not conform to participants’ wishes or fulfill their estate plans.
Marital status should be addressed as part of the participant’s beneficiary designation since there are laws that protect a spouse as the primary beneficiary of a married participant. Detailed procedures must be followed to permit a bona fide waiver, i.e., consent must be in writing and be witnessed by a notary public or plan representative. Note that some states currently allow same-sex marriages. However, federal laws, protections, and requirements do not apply to such marriages.
A spouse beneficiary may generally roll over qualified plan funds into his or her own IRA or qualified plan (if the receiving qualified plan accepts rollovers). Alternatively, the spouse may leave the funds in the participant’s plan until the end of the year in which the decedent would have attained age 70½. If the decedent was under age 70½ and the beneficiary is over age 70½, this could be advantageous.
A spouse may establish a life expectancy payout based on his or her own life expectancy. The spouse’s age is used to determine the distribution factor from the IRS single life expectancy table in the year distributions begin and each subsequent year. A spouse may name a beneficiary and, when the spouse dies, payments can continue over the spouse’s remaining life expectancy at that point (reduced by one each year). The spouse’s beneficiary may not use his or her own life expectancy.
Some surviving spouses prefer to roll over the funds to their own IRAs so that their beneficiaries can use their own life expectancies to “stretch” out payments when the IRA owner dies.
A nonspouse beneficiary may directly roll over qualified plan funds into an “inherited IRA.” If a life expectancy payout is elected, the age of the nonspouse beneficiary is used to determine the distribution factor from the IRS single life expectancy table. (The distribution factor is then reduced by one in years following the initial distribution year.)
Conversion to an inherited Roth IRA
Effective in 2008, a spouse or nonspouse beneficiary may now convert qualified plan funds to an inherited Roth IRA, provided the individual can pay the taxes in the year of conversion. An in-plan rollover to a designated Roth may only be made by a spouse beneficiary.
RMDs in the year of death
If the participant was receiving required minimum distributions (RMDs), the decedent’s RMD for the year of death must still be paid. The beneficiary may then begin receiving life expectancy distributions based on his or her life expectancy the following year. A nonspouse beneficiary who is a person (as opposed to a charity or similar entity without a life expectancy) may use his or her life expectancy to calculate the minimum payout using the IRS single life expectancy table. (The life expectancy factor is reduced by one for each year thereafter when calculating subsequent payments.)
A beneficiary generally must decide how to take a distribution by September 30 of the year after the year of the participant’s death. The options are to:
- Take the entire benefit in a lump sum,
- Establish a life expectancy payout arrangement commencing no later than the last day of the calendar year following the participant’s death,
- Disclaim his or her beneficiary rights, or
- Receive payment (either periodically or in a lump sum) of the entire benefit by the last day of the fifth year following the year of the participant’s death.
Note: This option is usually only applicable if the decedent died before reaching their required beginning date for taking required minimum distributions (RMDs). Also note that because RMDs were waived for 2009, the five-year rule is extended by one year for the beneficiaries of participants who died between 2004 and 2009.
While these rules are the norm, plans can be drafted to provide that distributions to beneficiaries, including spouses, must be made by the end of the calendar year containing the fifth anniversary of the participant’s death.
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Suspend Deferrals After a Hardship Distribution
SITUATION: Our 401(k) plan allows hardship distributions. We use the tax law’s safe harbor method of determining eligible hardships. We recently received a request for a hardship distribution and want to make sure we comply with all of the requirements.
QUESTION: Is there anything we should take particular care with?
ANSWER: In addition to confirming that the distribution meets one of the six “immediate and heavy financial needs” under the safe harbor method rules, make sure you have suspended elective deferrals by the participant receiving the distribution for six months.
DISCUSSION: Failure to suspend deferrals after a distribution is a common compliance error. Hardship distributions can be made only to satisfy an “immediate and heavy financial need of an employee.” To qualify, the employee must have obtained all other currently available distributions and loans from the plan and be prohibited from making elective deferrals to the plan for at least six months following the distribution.
The safe harbor method permits hardship distributions to: (1) pay certain medical expenses incurred by the participant, participant’s spouse, or dependents; (2) purchase a principal residence; (3) cover post-secondary educational expenses for the participant, the participant’s spouse, children, or dependents; (4) prevent eviction from or foreclosure on a principal residence; (5) pay the burial or funeral expenses of a spouse, parents, children, or dependents; and (6) pay expenses for the repair of damage to the participant’s principal residence that would qualify for the income-tax casualty loss deduction.
While many compliance errors can be corrected under the IRS’s Employee Plans Compliance Resolution System (EPCRS), the system doesn’t specify a correction for failing to suspend employee deferrals following a hardship distribution. However, in a phone forum, the IRS pointed out the EPCRS’s general rule that a plan sponsor’s correction approach must restore the plan and the affected participant(s) to the same position they would have been in had the failure not occurred.
The IRS outlined two possible correction methods. A plan may return the improper elective deferrals, adjusted for earnings, to the participant. This option complies with the EPCRS general rule. Alternatively, the plan could suspend elective deferrals for a six-month period going forward. However, this correction wouldn’t restore the participant to the same position if employer matching contributions for the going-forward period differed from those for the suspension period or if the employee quit employment before the end of the six-month period.
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Safe Harbor 401(k) Plan — Right for Your Organization?
A safe harbor design allows a 401(k) plan to avoid annual nondiscrimination testing on pretax salary deferrals and employer matching contributions. Highly compensated employees can contribute the maximum annual amount allowed by law to the plan. The following questions and answers may help if you’re considering a safe harbor 401(k) plan.
What happens if a 401(k) plan fails the annual nondiscrimination testing? Typically, a 401(k) plan that fails nondiscrimination testing must refund contributions to highly paid employees or recharacterize them as after-tax contributions if the plan allows.
How do we qualify for the safe harbor? You must choose either to make a nonelective contribution of at least 3% of compensation on behalf of each nonhighly compensated employee who is eligible to participate in your plan or use a qualifying matching formula. The basic matching formula is 100% of the first 3% of compensation deferred, plus 50% of deferrals between 3% and 5% of compensation. If your company is already making — or plans to make — contributions at these levels, you may want to consider using a safe harbor design even if your plan generally passes the nondiscrimination tests. It could help avoid problems in the future.
What other requirements apply? You must provide a notice of rights and obligations under the safe harbor plan to all eligible employees between 30 and 90 days before the start of each plan year. Employees who will become eligible during the year must be given reasonable advance notice. In addition:
- All safe harbor contributions are immediately 100% vested.
- You can’t set conditions on the receipt of safe harbor contributions — for example, that plan participants be employed on the last day of the plan year or work at least 1,000 hours during the plan year. (However, the plan can have minimum age and service requirements that employees must meet before they are eligible for plan participation.)
- Safe harbor contributions generally can’t be available for in-service withdrawal before age 59½.
- Plan documents must state whether safe harbor or non-safe harbor testing will be used.
Can safe harbor matching contributions be stopped during the year? You can reduce or stop safe harbor matching contributions during a plan year if you give your participants at least 30 days notice so they can change their elective deferrals if they want. But you’ll have to perform annual nondiscrimination testing for the entire plan year.
Are the safe harbor rules the same for a plan with a qualified automatic contribution arrangement (QACA)? Not all of them. The QACA safe harbor matching contribution formula is a 100% match on the first 1% of compensation deferred and a 50% match on deferrals between 1% and 6%. Also, participants may be required to have two years of service before becoming vested in QACA contributions. And, the minimum employee deferral percentage must start at not less than 3% and increase at least percentage point annually to no less than 6% (with a maximum of 10%) unless the participant elects otherwise.
Can we change our plan for this year? No, you can’t add safe harbor provisions to an existing 401(k) plan during the plan year. Rather, you must amend your plan to add a safe harbor design for the next plan year. The amendment must be adopted before the first day of the new plan year.
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A Good Reason for Regular Compliance Audits
A recent Tax Court case* illustrates the need to keep abreast of changes in the law and to amend your plan accordingly. Failure to make sure your plan documents are in order and your plan is operating correctly could result in retroactive disqualification of the plan with harsh tax consequences.
“The EPCRS allows employers to correct problems . . . that could cause plan disqualification.."
The case involved a profit sharing plan that was not timely amended to comply with statutory changes. The plan had been inactive for a period of time, although it was not formally terminated. The IRS gave the plan sponsor the opportunity to correct the problems and pay a sanction. When the sponsor rejected the IRS’s offer, the IRS retroactively revoked the plan’s tax-exempt status.
In court, the plan sponsor essentially argued that the plan’s inactivity rendered it terminated. But the Tax Court disagreed, noting that a formal termination requires that a termination date be set, that plan participant benefits be determined based on the termination date, and that all plan assets be distributed in accordance with the plan as soon as administratively feasible after the termination date. The court also rejected several other arguments made by the plan sponsor and upheld the IRS’s retroactive disqualification of the plan.
Correcting Qualification Failures
The plan could have had a better outcome if it had taken advantage of plan correction opportunities offered by the IRS’s Employee Plans Compliance Resolution System (EPCRS). The EPCRS allows employers to correct problems with their retirement plans that could cause plan disqualification.
Plan document failures result from a plan provision that violates IRS requirement or from the absence of a plan provision. In the case discussed, the failure to amend the plan to reflect a legislative change was a plan document failure.
Operational failures arise when a sponsor fails to follow plan provisions. For example, if you mistakenly exclude employees who are eligible for plan participation, that’s considered an operational failure.
Demographic failures occur when nondiscrimination provisions, minimum participation requirements, or minimum coverage requirements (other than operational failures) are not satisfied — for example, where highly compensated employees are disproportionally favored.
The EPCRS Components
The EPCRS has three basic components.
The Self Correction Program (SCP) allows the sponsor of an IRS-approved plan to identify and correct operational failures without notifying the IRS or paying any fee.
The Voluntary Correction Program (VCP) is for plan errors that are not eligible for self-correction or it can be used if you want IRS assurance that the changes you’ve made to your plan are acceptable. You submit the corrections to the IRS and pay a compliance fee.
The Audit Closing Agreement Program (Audit CAP) is the opportunity the IRS offered to the plan in the Tax Court case. This program allows you to correct failures discovered when the plan or you (as the plan sponsor) is under examination by the IRS. Generally, under the Audit CAP, you would correct the failures, enter into a Closing Agreement with the IRS, and pay a sanction negotiated with the IRS.
* Christy & Swan Profit Sharing Plan v. Comm’r, TC Memo. 2011-62
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The general information in this publication is not intended to be nor should it be treated as tax, legal, or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purpose of avoiding tax penalties.
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