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Satisfying the 401(k) Rollover Safe Harbor for Small Accounts
Automatically rolling over funds in a terminated employee's tax-qualified retirement plan account to an individual retirement account (IRA)

by Dana Scott Fried, Esq.  10/1/2004
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On Sept. 27, 2004, the U.S. Department of Labor released a final regulation creating a "safe harbor" for plan sponsors that automatically roll over the funds in a terminated employee's tax-qualified retirement plan account to an individual retirement account (IRA). The new regulation takes effect March 28, 2005.

Terminated employees' failures to roll over small sums in their 401(k) or other tax-qualified defined contribution plan accounts is a common source of distress for retirement plan fiduciaries. Administrative expenses continue to be incurred on behalf of former employees to maintain small, inactive accounts; however, rolling these funds over to an IRA without specific instructions from the former employees can raise liability concerns under federal pension law.

The new safe harbor will protect plan fiduciaries who transfer automatic “cash-out” distributions not exceeding $5,000 to IRAs when former employees fail to elect between effecting a direct rollover to an IRA or receiving the distribution. Specifically, after March 28, 2005, if no election (or an incomplete election) has been made by the former employee, the safe harbor will protect plan fiduciaries from liability under the Employee Retirement Income Security Act of 1974 (ERISA) when they select a financial institution to provide the IRA and choose certain investments specified under the safe harbor for the IRA.

Gone, But Not Forgotten

A former employee who hasn't found a new job—or who found one that doesn't offer a tax-qualified retirement plan—might well prefer to leave accumulated funds in the ex-employer’s defined contribution plan. But the former employer, as plan sponsor, typically pays record-keeping fees on the basis of the number of participant accounts. This can prove costly, especially given that the employer will receive no future services from the departed employee.

In recognition of this concern, federal pension law has long provided that, prior to an individual’s attaining the “normal” retirement age under a tax-qualified plan (typically, age 65), a plan sponsor can only force the distribution to the extent that the amount is “de minimis.” The maximum benefit that could involuntarily be cashed-out was initially $3,500, and has since been increased to $5,000.

Historically, a terminated employee subject to an involuntary cash-out distribution could opt to roll the distribution over within 60 days to another tax-qualified retirement plan or an IRA, or could retain the funds on a fully taxable basis (plus a 10 percent penalty if the individual hasn't attained age 59½). Subsequently, federal pension law created “direct rollovers,” where the benefit distribution check is issued in the name of the individual's account under the receiving plan or IRA.

Solely where a direct rollover is used, no federal income tax withholding is required in connection with the distribution; otherwise, tax at the rate of 20 percent of the amount of the distribution must be withheld. If recipients later roll these funds into a qualified retirement plan, they can claim a tax refund for the withheld amount.

The law requires that involuntary cash-outs of greater than $1,000, for which no rollover election is made, must be directly transferred to an IRA as an “automatic rollover.” This has raised concerns under ERISA's fiduciary rules in connection with the decisions by the distributing plan fiduciary as to which financial institutions to use for automatic rollover IRAs and how to invest such rolled-over funds.

Securing Protection Under the Safe Harbor

To receive protection under the new safe harbor, fiduciaries must satisfy six conditions:

1. Distribution Amount

Automatic rollovers are limited to distributions that don't exceed $5,000. The safe harbor, consequently, applies to any distribution that is $5,000 or less (no $1,000 minimum).

2. IRA Providers

Automatic rollovers may only be made to IRAs and individual annuities maintained at:

 A state or federally regulated bank or savings association (the accounts of which are FDIC-insured);

•  An insurance company (the products of which are protected by state guaranty associations);

•  A mutual fund company (regulated under the Investment Company Act of 1940); or

•  Another financial institution eligible to offer IRAs under Treasury Department regulations.

The distributing plan’s fiduciary must enter into a written agreement with an IRA provider that specifically addresses, among other things, the investment of rolled-over funds and the attendant IRA fees and expenses.

Of critical importance: The fiduciary can rely on the IRA provider's commitments as set forth in the agreement and is not required to monitor the IRA provider’s compliance with these terms once the rollover has occurred. Further, the terms of the agreement must be enforceable by the participant on whose behalf the automatic rollover is made.

3. Investments

The agreement with the IRA provider must state that it will utilize investments for the rolled-over funds that are designed to preserve principal and provide a reasonable rate of return, whether or not the return is guaranteed. The final regulation specifically identifies as permissible investments:

Money market funds maintained by registered investment companies;

•  Interest-bearing savings accounts and certificates of deposit of banks or similar financial institutions; and

•  “Stable value products” issued by regulated financial institutions.

4. Fees and Expenses

IRAs receiving automatic rollovers may only provide for fees and expenses (such as establishment charges, maintenance fees, investment expenses, termination costs and surrender charges) that do not exceed the amounts charged for comparable IRAs that are not established to receive automatic rollovers.

5. Participant Notices

Prior to using the safe harbor for an automatic rollover, participants must be furnished with a Summary Plan Description or a Summary of Material Modifications that explains the investment product in which the distribution will be invested and the extent to which the IRA fees and expenses will be borne by the individual alone or shared with the distributing plan or plan sponsor.

In addition, a plan contact must be identified from whom to obtain further information concerning the plan’s procedures in connection with automatic rollovers, the IRA provider and the related fees and expenses. The identified plan contact can be a reference to a person, position or office, provided that an address and phone number for the contact is provided.

6. Prohibited Transaction Class Exemption

The safe harbor is not available where the distributing plan fiduciary engages in a nonexempt “prohibited transaction” under ERISA in connection with the selection of the IRA provider or investment products. For example, a plan fiduciary that receives consideration from a financial institution in exchange for selecting that financial institution would ordinarily constitute a prohibited transaction under ERISA.

On the same day the final regulation was published, however, the U.S. Department of Labor also issued a Prohibited Transaction Class Exemption, which permits a bank or other financial institution to select itself or its affiliate as the IRA provider for automatic rollovers from its own retirement plans, choose its own funds or investment products for the investment of such automatic rollovers and receive fees for such services. The Class Exemption was evidently designed to preclude IRA providers from being required to use their competitors to service their own retirement plans’ automatic rollovers.

Smooth Sailing

The safe harbor final regulation provides helpful relief to tax-qualified retirement plan fiduciaries. Plan sponsors wishing to avail themselves of the protections of the safe harbor now have several months during which they can establish IRA provider agreements and describe the plans’ automatic rollover rules to plan participants either by revising their plans’ Summary Plan Descriptions or by modifying them through the use of Summaries of Material Modifications.

Plan sponsors should consult their ERISA counsel in this regard at the soonest possible time, to ensure their compliance with the requirements of the safe harbor.

Dana Scott Fried is an ERISA/executive compensation partner with the law firm of Brown Raysman Millstein Felder & Steiner LLP in New York City.

Related Article:

Missing Retirement Plan Participants: Please Take Your Money!, SHRM Online Benefits Discipline, December  2010

Retirement Plan Sponsors Should Keep Track of Former Employees, SHRM Online Benefits Discipline, February 2009

Related Resource:

Final Rules on Automatic Rollovers, TransAmerica Center for Retirement Studies

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