Public Retirement Systems: Effect of EGTRRA, USERRA, domestic partnership developments, and recent cases

Carol V. Calhoun, Counsel
Venable LLP
600 Massachusetts Avenue, NW
Washington, DC 20001
Phone: (202) 344-4715
Fax: (202) 344-8300
Mobile: (202) 441-5592
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Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), Public Law No. 107-16 (IRS sample plan amendments to comply with EGTRRA are now available.)
1. Portability
  1. In-service
    1. EGTRRA will permit in-service transfers of assets from a 403(b) plan (tax-sheltered annuity or custodial account) or governmental 457(b) plan (nonqualified deferred compensation plan) to purchase service credit under a qualified defined benefit plan, if both the distributing plan and the receiving plan permit this. (This has always been permitted in the case of governmental plans, if the transferring plan was a qualified 401(k) plan, rather than a 403(b) or 457(b), but most state and local governments are not eligible to establish 401(k) plans.)
    2. EGTRRA will permit in-service rollovers of IRAs (not just rollover IRAs) into 401(a), 403(b), or governmental 457(b) plan, if the receiving plan allows this.
    3. As a result of these changes, administrators of governmental defined benefit plans that have in the past allowed purchases of service credit over an extended period may want to consider allowing only purchases of, for example, whole years of service.
      1. Now that participants may be able to accumulate funds in other types of plans until they have enough to purchase service credit, pressure to allow small purchases may be lessened.
      2. Applicable state and local law would have to be consulted to determine the extent to which such changes would be permissible.
      3. Eliminating purchases of partial service credit may create problems for a few participants, even if they can accumulate money in a 401(k), 403(b), or 457(b) plan. At least for some participants, maximum deferrals are increased if contributions can be made to a defined contribution plan and picked-up contributions can be made to purchase service credit under a defined benefit plan.
    4. States may be under more pressure to create statewide 403(b) and 457(b) plans, so that participants can accumulate funds for the purchase of service credit in 403(b) and 457(b) plans without problems resulting from limitations on distributions by local plans and providers.
    5. EGTRRA will permit (but not require) in-service distributions from 457(b) plans under domestic relations orders. In the past, although the IRS in practice permitted benefits under a 457(b) plan to be transferred pursuant to a domestic relations order, distribution of such benefits to an alternate payee could not begin until the participant had otherwise satisfied the requirements for a distribution.
  2. Upon termination of employment
    1. Rollovers
      1. EGTRRA will permit direct rollovers from any 401(a), 403(b), or governmental 457(b) plan to any IRA or another 401(a), 403(b), or governmental 457(b) plan that will accept them.
      2. Unlike in-service transfers, rollovers from a 403(b) or 457(b) plan at a time when a distribution is otherwise available can go to any 401(a) plan that permits the receipt of such rollovers, not just to a defined benefit 401(a) plan, and not just for the purchase of service credit.
      3. A distributing plan is required to make a direct rollover upon the participant’s request if the distribution is a qualified rollover distribution. This contrasts with in-service transfers at a time when distributions are not otherwise permitted, which can take place only if the language of the transferring plan permits them.
      4. A qualified private plan will, after issuance of regulations by the Department of Labor, be required to roll over automatic cash-outs of over $1,000 to an IRA, unless the participant requests otherwise. It is unclear whether this provision applies to governmental plans. However, it may provide a basis, in those states in which courts tend to look to ERISA in applying state fiduciary statutes, for making automatic rollovers when a participant cannot be located and a minimum distribution requirement applies. This is typically more advantageous to a participant than, for example, payment to a bank account in the participant’s name, because a missing participant may not learn of the bank account’s existence until too late to roll over the money. Also, federal income tax withholding would be required on a pay-out to a bank account, but not on a pay-out to an IRA.
      5. Rollovers of after-tax contributions will now be allowed.
    2. 457(b) plans, which formerly could not make distributions until “separation from service,” can now make them upon “severance of employment” if the plan language permits this.
      1. The difference is that upon a change in the employer, an employee could receive a distribution even if the employee were still doing the same job at the same desk for the new employer, so long as the plan does not go to the new employer.
      2. This may be useful in privatization situations, in which employees cease to be covered by a governmental plan.
      3. However, because of the uncertainty of the definition of “employer” in a governmental plan context, plans must be careful that the employee is in fact working for a new employer, not an entity that is treated as part of the same employer, after the change.
      4. The requirement that the new employer not maintain the plan may be a problem in the case of a statewide plan, since many employers will commonly contribute to the same plan.
    3. The constructive receipt doctrine is abolished for 457(b) plans. In nontechnical language, this means that a plan can permit an employee to retain the right to modify the distribution schedule after termination of employment without causing the employee to be taxed on all amounts s/he could have received.
2. New Retirement Plan Limits
  1. 401(a) Plans
    1. All 401(a) Plans
      1. Maximum compensation taken into account for non-grandfathered retirees in calculating plan benefits or contributions increases from $170,000 to $200,000 per year.
    2. Defined benefit plans
      1. Dollar limit increases from $140,000 to $160,000 for non-grandfathered retirees.
      2. Actuarial adjustments for early and late retirement more generous for non-safety employees.
    3. Defined contribution plans
      1. Dollar limit on annual additions rises from $35,000 to $40,000 for 2002, then by $1,000 increments until 2006.
      2. Percentage limit on annual additions rises from 25% to 100%.
    4. Grandfathered 401(k) Plans
      1. Base dollar limit on deferrals rises from $10,500 to $11,000, effective 1/1/2002.
      2. Additional catch-up dollar limits on deferrals for those age 50 or over, starting at $1,000 for 2002, rising to $5,000 for 2006, and thereafter adjusted for cost of living changes. Proposed regulations concerning the catch-ups are now available.
      3. 401(k) and 403(b) deferrals need no longer be coordinated with 457(b) deferrals.
  2. 403(b) Plans
    1. Exclusion allowance eliminated.
    2. Percentage limit on annual additions to 403(b) plans under section 415(c), like that for 401(k) plans, rises from 25% to 100%.
    3. The definition of “compensation” for purposes of the new 100% of compensation limit on annual additions to a 403(b) plan under section 415(c) is the same as the old definition of “includible compensation” for maximum exclusion allowance purposes. (Code section 415(c)(3)(E), added by EGTRRA section 632(a)(3)(D).
    4. Clarification that 403(b) plan is combined with qualified plan of employer controlled by the participant (e.g., the Keogh plan of a clinic operated by a doctor who is also a professor at the medical school which sponsors the 403(b)), in applying the section 415(c) limits. However, it is not combined with a qualified plan of the employer that sponsors the 403(b). This had been an issue since the repeal of section 415(e).
    5. Base limits on elective contributions become identical to those for 401(k) plans (see above). However, 403(b) plans are still eligible for the special “catch-up” provisions under section 402(g).
    6. Additional catch-up dollar limits on deferrals for those age 50 or over, starting at $1,000 for 2002, rising to $5,000 for 2006, and thereafter adjusted for cost of living changes.
    7. Annual additions dollar limit changes same as for 401(a) plans.
    8. Coordination among elective contribution limits for 401(k) and 403(b) plans, and those for 457(b) plans, eliminated.
  3. 457(b) Plans
    1. Dollar limits on elective contributions to 457(b) plans become identical to those for 401(k) and 403(b) plans (see above).
    2. For each of the three years prior to retirement, the catch-up under 457(b)(3) is increased from $15,000 to twice the otherwise applicable dollar limit as set forth above.
    3. Catch-up limits for participants over 50, like those for 401(k) and 403(b) plans. However, these do not apply for any year in which the separate catch-up under section 457(b)(3) applies.
    4. Although percentage of compensation limits for 457(b) plans go to 100% of compensation (nominally the same as for 401(k) and 403(b) plans), the actual percentage of compensation limit for elective 457(b) plan contributions is lower than that for elective contributions to 401(k) and 403(b) plans. This results from the fact that elective contributions to the 457(b) plan are not considered part of “compensation” for purposes of calculating the 100% of compensation limit on contributions to 457(b) plans.
    5. Coordination among elective contribution limits for 401(k) and 403(b) plans, and those for 457(b) plans, eliminated.
3. Encouragement of Individual Retirement Savings
  1. IRAs and Roth IRAs can be added to workplace retirement plans.
  2. Tax credits for certain individuals for retirement savings.
4. Other Changes
  1. Minimum distribution requirements added for 457(b) plans.
  2. 10% penalty on early distributions, like that for qualified and 403(b) plans, added for 457(b) plans, to the extent that a distribution from a 457 plan is attributable to an amount transferred to such plan from a qualified retirement plan, a 403(b) plan, or an IRA.
  3. Distributions from a 457(b) plan to an alternate payee pursuant to a domestic relations order will be taxed to the payee, not to the participant. (This is the same as the current rule for 401(a) and 403(b) plans.)
  4. User fees eliminated for determination letter requests for new (less than 5 years old) 401(a) plans for small (less than 100 employees) employers.
  5. Safe harbor for hardship distributions (during which new contributions cannot be made) reduced from 1 year to 6 months.
Uniformed Services Employment and Reemployment Rights Act (“USERRA”) (38 U.S.C. §§ 4301 et seq.) assumes greater importance due to build-up in forces to counteract terrorism
1. Who is eligible for USERRA rights?
2. Employee benefits guaranteed by USERRA during military leave
3. Employee benefits guaranteed by USERRA upon reemployment
4. Issues
Vermont Civil Unions Law, and other provisions of state and local law or plans permitting domestic relations orders between same-sex partners
1. Is an order dividing property between parties to a civil union even a “domestic relations order” for Internal Revenue Code purposes?
  1. Code defines domestic relations order to be one for the benefit of a spouse, child, or dependent.
  2. Due to federal Defense of Marriage Act, a party to a civil union, even though considered a “spouse” under Vermont law, is not treated as a spouse for Code purposes.
  3. “Dependent” excludes situations in which parties are financially independent.
  4. Even if one party is financially dependent on another, relationship in violation of applicable local law precludes dependency status
    1. Can validity of applicable law be challenged?
      1. See Williams v. State, 1998 Extra LEXIS 260, Baltimore City Circuit Court, January 14, 1999, in which Maryland sodomy law, previously found unconstitutional as to heterosexuals, was also found unconsitutional as to homosexuals. This was followed by a settlement in which the Maryland Attorney General agreed not to enforce the state’s sodomy laws.
      2. Could individual in a domestic partnership therefore argue that “relationship” is not in violation of local law, because law is unconstitutional as to private, consensual relationship?
    2. Under what circumstances is “relationship” illegal? For example, if parties are merely roommates, presumably relationship is legal. To take an extreme example, would a single instance of sexual contact cause the entire relationship to be considered to be in violation of local law?
2. Providing health insurance for domestic partners normally results in adverse tax consequences only to the employee involved. And because governmental entities are not subject to Internal Revenue Code limitations on assignment or alienation of benefits, the mere distribution to a domestic partner at a time that the participant was entitled to a distribution would normally have adverse tax consequences only to the participant whose partner received the distribution. But because distribution limitations are often requirements for maintenance of the plan’s tax-favored (401(a), 403(b), or 457(b)) status, complying with an order in favor of a domestic partner could in theory create tax problems for all participants and contributing employers.
3. Does the combination of the Defense of Marriage Act and applicable state law mean that in some instances, a plan can comply with both federal and state law requirements only by taking rights away from opposite-sex married couples, to the extent that federal law does not permit such rights to be granted to parties to a domestic partnership?
Supreme Court Denials of Certiorari
1. On October 1, 2001, the Supreme Court denied certiorari in Cochran v. Trans-General Life Insurance Co., 122 S. Ct. 198, which was on appeal from the 6^th Circuit (No. 99-2102, unpublished April 13, 2001), and in Glenn v. Life Insurance Company of North America (a Cigna company) (122 S. Ct. 212), which was on appeal from the 8^th Circuit (240 F.3d 679 (2001)).
2. Both cases dealt with the issue of whether, after the Supreme Court’s decision in Firestone v. Bruch, an ERISA plan could ever give a fiduciary which stood to gain financially from a denial of benefits the discretionary right to interpret plan provisions governing benefits, without such fiduciary’s decision being subject to challenge in court under a de novo standard (i.e., the court would give no deference to the fiduciary’s decision). In both cases, the Circuit Courts (whose decisions were left in place by the Supreme Court’s denial of certiorari) had applied an arbitrary and capricious standard (i.e., the court would respect the fiduciary’s decision unless it was arbitrary and capricious) rather than a de novo standard.
3. Governmental plans are not subject to the fiduciary provisions of ERISA. However, many state courts look to ERISA in applying fiduciary provisions of state statutory or common law.
4. To the extent applied to governmental plans (at least by analogy), these decisions are particularly good news for state and local retirement systems. Such plans are rarely insured by a third party, and therefore a plan’s decision to deny benefits always in some sense benefits the plan.
5. However, the earlier Firestone v. Bruch decision required that the plan’s own language give the fiduciary discretionary authority to determine benefits before an arbitrary and capricious standard would apply. This puts a premium on proper plan drafting.

Public Retirement Systems: Effect of EGTRRA, USERRA, domestic partnership developments, and recent cases (Posted on October 2, 2001 by Carol V. Calhoun)

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