Key Legislative and Tax Changes That Impact The Performance Of Your Fund (Posted on October 5, 2004 by )


Carol V. Calhoun, Counsel
Venable LLP
575 7th Street, NW
Washington, DC 20004
Phone: (202) 344-4715
Fax: (202) 344-8300
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Carol V. Calhoun

  1. Dealing with mandatory rollovers of involuntary cash-outs:
    1. The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) P.L. 107-16, 6/7/2001, 115 Stat. 38, Sec. 657(a)) added a provision requiring plans that include the involuntary cashout provision to automatically roll over accounts between $1,000 and $5,000 into traditional IRAs, in the absence of another affirmative direction of the participant (the “mandatory rollover rule”). However, the mandatory rollover rule will not become effective for distributions from all plans, including non-ERISA plans, until DOL “prescribes” final regulations for plans subject to the ERISA fiduciary rules.
    2. The DOL proposed regulations contained an unexpected revelation for non-ERISA plans. Footnote 7 in the preamble to the proposed regulations states:

      The Treasury and the IRS have advised the Department that the requirements of [the mandatory rollover rule] apply to a broad range of retirement plans including plans established under Code sections 401(a), 401(k), 403(a), 403(b) and 457.

    3. This creates a difficult situation for governmental plans, inasmuch as the rules are stated to be effective based on the issuance of DOL regulations, to which governmental plans would not normally be subject. Some questions:
      1. Cashouts in private plans cannot exceed $5,000, excluding prior rollover contributions if the plan’s involuntary cashout provision so provides. The mandatory rollover applies to cashouts of over $1,000. In the case of a governmental plan, would it also apply to mandatory cashouts of over $5,000?
      2. Type of Account. The mandatory cashout must be directed to a traditional IRA (i.e., an individual retirement account under Code Sec. 408(a) or an individual retirement annuity under Code Sec. 408(b)).
      3. Type of Investment. The proposed regulation would limit investments to investment products designed to preserve principal and provide a reasonable rate of return, whether or not this return is guaranteed, consistent with liquidity and taking into account the extent to which charges can be assessed against the account. DOL indicated that permissible investment products would include money market funds, interest-bearing savings accounts, certificates of deposits, and “stable value products” (including guaranteed investment contracts and similar investments). DOL expressly rejected the idea that the safe harbor should permit “mapping” the distribution into investment products identical or similar to those in which the participant had directed his or her investments prior to the mandatory rollover.
      4. Permissible Fees and Expenses. The fees and expenses relating to the IRA may include set-up charges, maintenance fees, investment expenses, termination costs and surrender charges, subject to two limitations.
        1. First, the fees and expenses relating to the “cashout” IRA may not exceed the fees and expenses charged by the provider for comparable IRAs established for voluntary rollover distributions.
        2. Second, the fees and expenses (except for the set-up charges) may be charged to the IRA only to the extent of the income earned by the IRA. In other words, fees may not be charged against the IRA’s principal. This unique restriction has already run into strong opposition.
      5. Disclosure. Before the mandatory cashout, participants must be furnished with a summary plan description (“SPD”) or a summary of material modifications (“SMM”) that includes an explanation of the mandatory cashout process. Non-ERISA plans are not required to have SPDs or provide SMMs; therefore, it is not clear how these rules would apply to them.
      6. No Prohibited Transaction. The fiduciary’s selection of an IRA must not result in a non-exempt prohibited transaction.
  2. Effect of minimum distribution rules on investments:
    1. Problematic Features
      1. COLAs/purchasing power protection provisions/thirteenth checks, other than as specified in regulations;
      2. Restrictions on joint and survivor annuities where the survivor is a non-spouse more than 10 years younger than the member;
      3. Other annuities with other types of survivor benefits;
      4. Annuities that change upon certain changes in circumstances.
    2. COLA Changes
      1. The temporary regulation barred any increase via a cost of living adjustment unless the increase is pursuant to 1) an annual percentage increase that does not exceed the annual percentage increase in a cost-of-living index that is based on prices of all items and issued by the Bureau of Labor Statistics (BLS) or 2) a plan amendment The final regulation retains these exceptions and expands the types of “indexes” which may be used in providing COLAs have been expanded so that the permitted indexed-based percentage increase can be up to
        1. the percentage increase in a BLS index (index for specific population or geographic area can be used);
        2. the percentage increase in a BLS index or a fixed percentage, whichever is less. However, the fixed percentage can exceed the BLS percentage increase, provided it does not exceed the BLS increase for that year plus the cumulative excesses in the increase of the BLS index over the fixed index for prior years;
        3. a percentage adjustment based upon an increase in the compensation for the position held by the member at retirement.
        4. Flat Percentage Increase that Cannot Exceed Index – The final regulation allows for a percentage increase at a specified time (e.g. at specific ages). However, the increase may not exceed the cumulative permissible increase in the permissible index since the annuity start date or the date of the most recent previous percentage increase, if later.
        5. Flat Percentage Increase of Not Greater than 5% – In a later part, the final regulation also provides that, in the case of an annuity provided by a IRC § 401(a) defined benefit plan, payments may be increased by a constant percentage applied not less frequently than annually at a rate not to exceed 5% per year.
        6. Increase Based on Actuarial Gain – That later part also provides that, in the case of an annuity provided by a IRC § 401(a) defined benefit plan, an increase can permissibly result from dividend payments or other payments that result from actuarial gains but only if
          1. the actuarial gain is measured no less frequently than annually;
          2. the payment is either made no later than the year following the year in which the actuarial experience is measured or paid in the same form as the payment of the annuity over the remaining period of the annuity;
          3. the actuarial gain taken into account is limited to the actuarial gain from investment experience;
          4. the assumed interest used to calculate such actuarial gains is not less than 3%; and
          5. the payments are not increasing as a constant percentage.
        7. Non-Conforming COLAs – Increases paid pursuant to COLAs/purchasing power protection provisions/thirteenth checks provisions not coming within any of the foregoing will only be permissible, if at all, under the grandfather/temporary relief discussed above.
      2. Restrictions on J&S Annuity With Younger Non-Spouse Beneficiary The 1987 and 2001 proposed regulations and the temporary regulation had a chart which barred the payment of a survivor portion of a joint and survivor annuity which exceeded a certain percentage of the member’s annuity, where the member and the beneficiary differed in age by more than 10 years. The applicable limit depended upon the difference between the age of the member and the age of the beneficiary. For example, under the chart, a surviving beneficiary who was 20 years younger than the member could not receive a survivor benefit which was greater than 73% of the member’s benefit
      3. Other Annuities with Other Types of Survivor Benefits
        1. In the case of an annuity provided by a IRC § 401(a) defined benefit plan, the final regulation appears to allow for a final payment to a survivor that does not exceed the actuarial present value of the member’s accrued benefit at the time of retirement over the total payments made before the death of the member (a “declining reserve annuity”).
        2. Otherwise the final regulation appears to bar the payment of any form of survivor benefit which is greater than the benefit being paid prior to the member’s death (unless the payment is permitted under one of the exceptions provided in the final regulation, e.g., a permitted COLA). This is the so-called “non-increasing benefit” rule.
        3. Some period certain annuities could be problematic depending upon the age of the member at retirement.
      4. Annuities that Change with Change in Circumstances
        1. The final regulation continues to allow for subsequent increase in a member’s annuity to the extent that a reduction was necessary to provide a survivor benefit. However, this only applies where the survivor has died or is no longer the member’s beneficiary “pursuant to a qualified domestic relations order.” (N.B., it is not clear whether the quoted language is to be taken literally; the preamble (p. 7) to the final regulation speaks of allowing “a pop-up in payments in the event of a divorce.”)
        2. The final regulation continues to allow a beneficiary to convert the survivor portion of the benefit to a lump sum. However, this appears only applicable where the conversion is at the beneficiary’s election.
        3. Subject to certain conditions, a “period certain only annuity” can be changed at any time.
        4. Subject to certain conditions, an annuity can be changed to a qualified joint and survivor annuity upon marriage in retirement.
        5. Certain payments to “children” can be considered payments to the spouse for the purposes of the final regulation, provided the payments revert to the spouse when “childhood” ceases. For these purposes, a disabled child is considered a “child” so long as the disability continues.
        6. N.B., if a system provides a optional form of retirement which is not specifically sanctioned in the final regulation, that option is only be permitted where grandfathered.
  3. Rev. Rul. 2004-67, 2004-28 I.R.B. 28 (July 12, 2004) confirmed that inclusion of a governmental section 457(b) plan in a group trust would not affect the group trust’s tax exemption, and provided model amendment language to reflect this change.
  4. Plans run by labor unions:
    1. Rev. Rul. 2004-57, 2004-24 I.R.B. 1048, set forth the conditions under which a plan offered and administered by a labor union would be treated as a an eligible governmental plan under Code section 457(b). It stated that a plan does not fail to be an eligible governmental plan under under Code section 457(b) solely because the plan is offered and administered by a union, provided that it covered only employees of the governmental employers that established and maintained the plan.
    2. Announcement 2004-52, 2004-24 I.R.B. 1071 provided relief to a 457(b) plan plan established before June 14, 2004 that did not meet the terms of Rev. Rul. 2004-57 as a result of being established and maintained by a labor organization instead of being established and maintained by an eligible governmental employer under the following conditions:
      1. contributions to the plan cease with respect to payroll periods that begin after December 31, 2004, and
      2. either of the following corrective actions is completed by December 31, 2005:
        1. The eligible employer as defined under § 457(e)(1)(A) adopts the plan, or
        2. The accounts of the employees under the plan are transferred (not rolled over) into an eligible governmental plan maintained by the eligible employer as defined under § 457(e)(1)(A) in accordance with the requirements of § 1.457-10(b)(4) of the Income Tax Regulations.
  5. Deemed IRAs (section 408(q))
    1. Definition: A deemed IRA is an arrangement under which a qualified retirement plan offers to employees the ability to keep their Individual Retirement Account (“IRA”) assets in the plan as a separate IRA account within the plan. The IRA portion of the plan is treated as a separate IRA, and is not subject to the normal rules governing qualified plans.
    2. Joint investment of assets between a qualified plan and a deemed IRA:
      1. The trust fund for a qualified plan can hold the deemed IRA assets.
      2. However, if the assets of a deemed IRA are held in the trust fund for a qualified plan, separate accounts must be maintained.
      3. Moreover, if either the IRA or the qualified plan fails to meet statutory requirements, both the qualified plan and the deemed IRA may lose their tax-favored status. By contrast, if the deemed IRA assets are held in trusts separate from those funding the qualified plan, a failure of the deemed IRA to meet statutory requirements will not jeopardize the tax-favored status of the qualified plan or vice versa. [Treas. Reg. § 1.408(q)-1. (July 22, 2004)] It may therefore be wise, where commingling of assets is desirable, for the plan and each deemed IRA to have a separate trust, and for all the trusts then to participate in a group trust described in Rev. Rul. 2004-67, 2004-28 I.R.B. 28, which is not subject to disqualification if one of the participating entities loses its tax-favored status.
    3. Special rules for governmental deemed IRAs
      1. Although normally the custodian of an IRA must be a bank or other approved entity, Temp. Treas. Reg. § 1.408-2(e)(8)T provides that a governmental unit is an acceptable trustee of a deemed IRA.
      2. The IRS may exempt a governmental unit from certain other requirements upon a showing that the governmental unit is able to administer the deemed IRAs in the best interest of the participants. And IRS may apply the other requirements in a manner that is consistent with the applicant’s status as a governmental unit.