New Mandatory Rollover Rules Will Apply to Government, Church Plans (Posted on December 29, 2004 by )

Section 657 of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) amended Internal Revenue Code (“Code”) section 401(a)(31) to provide that a distribution from an “eligible plan” of more than $1,000 had to be directly rolled over to an individual retirement account unless a participant affirmatively elected another form of distribution (e.g., to receive the amount in cash). The term “eligible plan” was defined as follows:

a plan which provides that any nonforfeitable accrued benefit for which the present value (as determined under section 411(a)(11)) does not exceed $5,000 shall be immediately distributed to the participant.

The effective date of the provision was tied to the issuance of regulations by the Department of Labor. Thus, the question arose as to whether a plan that was not subject to either Department of Labor regulations or section 411 (a governmental plan or a nonelecting church plan) would be subject to the EGTRRA change. Moreover, there was a question as to whether a mandatory distribution of an amount greater than that which section 411 would allow in the case of a plan that was subject to section 411 (i.e., greater than $5,000) would be subject to mandatory rollover rules.

These questions have just been answered in IRS Notice 2005-5 (December 28, 2004). Under the Notice, a governmental or church plan is subject to the mandatory rollover rules. Moreover, these rules apply even to a distribution that exceeds $5,000. However, a governmental plan will be deemed to be in compliance with the rules so long as the rules are applied to all distributions that take place on or after the close of the first legislative session of the legislative body with the authority to amend the plan that begins on or after January 1, 2006. A nonelecting church plan will be deemed to be in compliance with the rules so long as the rules are applied to all distributions that take place on or after 60 days after the first church convention that begins on or after January 1, 2006.

One question that arises with respect to these rules is what their effective date is in the case of a governmental plan that is adopted through some mechanism other than legislative action. For example, if appropriate officers of a municipality have been given the authority to amend a plan without action by the municipal legislature, is the plan subject to the March 28, 2005 effective date that would apply in the case of a nongovernmental plan? Or is the effective date determined with reference to the legislative session of the municipal legislature, on the theory that the legislature could amend the plan, even though as a practical matter it never does.

Moreover, even in the case of those plans that have a delayed effective date, the process of plan amendments must often be begun relatively quickly if the amendments are to be adopted before the deadline. For example, if plan amendments require legislative action, those amendments may have to be reviewed at various administrative levels before being submitted to the legislature.

Whenever the amendments become effective, they will require major changes in the way many governmental plans operate. Many governmental plans do not have direct knowledge of when a participant terminates employment, since they may cover employees of numerous employees throughout the state. Thus, even if a distribution was intended to be mandatory, they have often waited for some notice from the employer or employee before making it. Under the new rules, they will have to disburse the money to an individual retirement account when it is supposed to be distributed, even if they do not hear from the participant.

In addition, a governmental plan may have mandatory distributions of amounts greatly in excess of the $5,000 maximum that would apply to a private employer’s plan. With larger amounts at stake, fiduciary issues under applicable state law may become more acute. For example, if an amount is the subject of a mandatory transfer, and the participant’s location is unknown, the applicable plan personnel may have some duty to think through what investments would be prudent for an individual retirement plan if the plan may have to go on for some time with no investment direction from either the plan trustees or the participant.