The IRS has now updated its sample rollover notice to employees to reflect the changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), P.L. 107-16. Notice 2002-3, 2002-2 IRB 1 (December 26, 2001). In the process, it has also clarified for employers some of its interpretations of the changes made by EGTRRA in the rollover rules.

Background

State of the Law prior to EGTRRA

Before EGTRRA was enacted, an employee who was entitled to a “qualified rollover distribution” (most distributions other than certain annuities and required distributions) from a qualified plan was entitled to avoid taxation of the distribution by rolling it over to another qualified plan or individual retirement account (IRA). The rollover could be accomplished in one of two ways:

• The employee could direct that the distribution be directly rolled over from the qualified plan to any other qualified plan in which he was a participant, or to any IRA, if the receiving plan permitted the rollover.
• The employee could take the distribution, then roll it over to another qualified plan or IRA that permitted the rollover. However, because any distribution eligible for rollover would be subject to federal income tax withholding at a 20% rate, the employee would have to make up the 20% out of his or her personal funds in order to escape federal income tax on the distribution.

For example, suppose the employee’s account balance in a qualified plan were $10,000, and the employee requested a complete distribution. The plan would withhold $2,000 in income taxes from the distribution and pay the employee the remaining $8,000. If the employee wanted to avoid federal income taxes on the distribution, s/he would have to roll over to a qualified plan or IRA not only the $8,000 received, but another $2,000 to make up for the income taxes withheld. When the employee ultimately filed a federal income tax return for that year, the $2,000 withheld could be used to pay income taxes owed by the employee on other income, or could be refunded to the employee.

Similar rules applied for purposes of rollovers from tax-deferred annuities or custodial accounts maintained by 501(c)(3) organizations or public schools (403(b) plans). However, a rollover from a 401(a) plan to a 403(b) plan, or vice versa, was not permitted.

Normally, a distribution from an IRA could be rolled over only to another IRA, not to a qualified plan or a 403(b) plan. However, an exception applied in the case of a conduit IRA, which is an IRA that consists entirely of a prior rollover from a qualified plan or 403(b) plan, plus earnings. A distribution from a conduit IRA could be rolled over to the same type of plan (qualified plan or 403(b) plan) from which it was originally derived.

For an unfunded deferred compensation arrangement for employees of a tax-exempt or governmental entity (457(b) plan), the rules were even more restrictive. Rollovers were not allowed at all. Federal income taxes could in theory be avoided by having a distribution from a 457(b) plan directly transferred to another 457(b) plan, but not to a 401(a) or 403(b) plan, or an IRA. However, the utility of this rule was severely limited by a separate rule (“constructive receipt rule”) which said that an employee would be taxed on a distribution from a 457(b) plan on the earliest date on which the employee had the right to receive the distribution, even if s/he did not actually receive the distribution until a later date, unless the delay in the distribution was pursuant to a one-time irrevocable election made upon termination of employment. Thus, an employee could not simply leave money in a 457(b) plan upon termination of employment, and decide when to take a distribution only after he was covered by a new 457(b) plan that would accept the distribution.

A qualified plan was required to provide a notice to a recipient of a qualified rollover distribution of his or her rollover rights. Before EGTRRA, Notice 2000-11 provided a sample notice for this purpose.

Changes Made by EGTRRA

EGTRRA relaxed the above rules in several respects:

• Rollovers are now permitted between and among qualified plans, 403(b) plans, governmental 457(b) plans, and IRAs. (However, this new rule does not cover 457(b) plans of nongovernmental tax-exempt employers.)
• A distribution on account of the employee’s hardship is no longer eligible for rollover.
• A distribution of amounts attributable to an employee’s after-tax contributions to a qualified plan or 403(b) plan can now be directly rolled over to another plan. (After-tax contributions to a 457(b) plan cannot be rolled over, but such contributions are extremely rare in any event.) A rollover is not necessary to avoid immediate taxes on the portion of the distribution equal to the after-tax contributions, since a distribution of after-tax contributions is not taxable. However, rolling over the after-tax contributions will allow for continued tax deferral on any earnings on the contributions.
• The constructive receipt rule was repealed for governmental 457(b) plans. Thus, for example, an individual who has a benefit in a governmental 457(b) plan can now leave it with the plan until she is ready to have it rolled into another plan or IRA.
• A 403(b) plan or a governmental 457(b) plan, as well as a qualified plan, is now required to provide a rollover notice to each recipient of a qualified rollover distribution.

IRS Notice 2002-3 updated the previous sample rollover notice to reflect the EGTRRA changes. In so doing, the new notice gives guidance to plans regarding the IRS interpretation of certain of the EGTRRA provisions, and pointed out certain pitfalls and planning opportunities:

• An amount distributed from a 457(b) plan is not subject to an excise tax on early distributions, except to the extent that it consists of amounts previously rolled over to the 457(b) plan from a qualified plan, a 403(b) plan or an IRA. Some had suggested that the converse should also apply-a distribution from a qualified plan, for example, should be exempt from the excise tax on early distributions to the extent it consisted of amounts previously rolled into the qualified plan from a 457(b) plan. However, Notice 2002-3 states that, “any amount rolled over from the [governmental 457(b)] Plan to another type of eligible employer plan or to a traditional IRA will be subject to the additional 10% tax if it is distributed to you before you reach age 59½, unless an exception applies.” Thus, an individual who is considering rolling money from a governmental 457(b) plan to another type of plan will need to balance the potential for tax deferral against the adverse consequences that may ensue if he finds he needs to take a distribution of the money from the receiving plan before attaining age 59½ or meeting one of the exceptions.
• Tax on certain net unrealized appreciation on employer securities distributed from a qualified plan of a private employer can be deferred until the distributee sells the securities. For example, if a qualified plan held employer securities purchased for $1,500, and distributed to an individual when their value was $2,000, the individual could pay tax only on the $1,500, and defer tax on the other $500 until s/he sold the securities. However, the Notice states that, “Generally, you will no longer be able to use the special rule for net unrealized appreciation if you roll the stock over to a traditional IRA or another eligible employer plan.”
• Similarly, tax provisions allowing for ten-year averaging or capital gains treatment on lump sum distributions to certain individuals will be lost if the amounts are rolled over to an IRA, a governmental 457 plan, or a 403(b) plan. Indeed, if some distributions from a plan are rolled over to another plan, such treatment may be lost even as to future distributions from the distributing plan. This means that it may still be worthwhile to roll money from a 401(a) plan to a separate conduit IRA (which would hold only such amounts), rather than to a regular IRA, 403(b), or 457(b) plan in some instances. If the IRA does not hold money from any other source, the favorable tax treatment may be preserved.
• Only a traditional IRA, not a Roth IRA, can accept rollovers.
• A plan that elects to accept rollovers can limit the types of rollovers it accepts, for example by not accepting rollovers of after-tax employee contributions. However, if a plan accepts rollovers of after-tax employee contributions, the Notice says that it must account for them separately so that the taxation of ultimate distributions from the transferee plan can be determined.
• State income tax law does not necessarily follow federal income tax law. For example, suppose that state law previously provided for deferral of taxation on a distribution from a qualified plan only through rollover to another qualified plan or an IRA. If the state law has not been amended to reflect EGTRRA, a distribution that is tax-deferred for federal income tax purposes may still give rise to state income taxation. A notice to employees regarding their rollover rights should point out that state taxation may differ from federal taxation.

Notice 2002-3 provides a useful announcement to employees of their rights, and a handy outline for plans themselves of the new rollover rules. However, it also points out that the new rollover rights are a mixed blessing. An employee eligible to receive a distribution may have to consider several different features in determining whether a rollover will produce the best overall tax treatment.