Employee Benefits Bulletin

Transcription

1 Volume 5 Issue 1 May 2005 Employee Benefits Bulletin ADAMS AND REESE / LANGE SIMPSON LLP Concord Center 2100 Third Avenue North, Suite 1100 Birmingham, AL Tel: Fax: ERISA AND EMPLOYEE BENEFITS PRACTICE TEAM Allison Odom, Attorney (713) allison.odom@arlaw.com Frances King Quick, Attorney (205) frances.quick@arlaw.com JoAnne Ray, Attorney (713) joanne.ray@arlaw.com Robert C. Schmidt, Attorney (225) robert.schmidt@arlaw.com John Martin Sheffield, Attorney (205) martin.sheffield@arlaw.com Diane Averitt, Paralegal (205) diane.averitt@arlaw.com Shirley Bonner, Paralegal (713) shirley.bonner@arlaw.com Laurie Anders, Legal Secretary (225) laurie.anders@arlaw.com Teri Cardwell, Legal Secretary (205) teri.cardwell@arlaw.com Norman Stein, Contributing Editor Baton Rouge Birmingham Houston Jackson Nashville Mobile New Orleans Washington, DC Five Easy Pieces on Section 401(k) Plans IRS Issues Final 401(k) Regs Late last year, the Department of Treasury and IRS issued the final version of new comprehensive regulations for 401(k) plans. These regulations, which replace the original (k) regulations, were first proposed in mid Effective for plan years beginning on or after January 1, 2006, the regulations cover both section 401(k) and section 401(m), which sets rules for matching contributions. The regulations have two purposes: 1) to update the regulations to reflect legislative changes and administrative rulings since 1991, and 2) to resolve some outstanding 401(k) issues. This article focuses on regulatory provisions that effect the second purpose, since these are the provisions that will affect administration of 401(k) plans and the tax treatment of their sponsors and their participants. The regulations are complex and long, well over 100 pages in the Federal Register. This article covers the regulations highlights. Wringing the QNEC. In the proposed regulations, the IRS addressed what it perceived to be an abusive practice among some 401(k) plans: giving qualified non-elective contributions ("QNECs") or qualified matching contributions ("QMACs") to the lowest-paid employees to satisfy the actual deferral percentage ("ADP") or actual contribution percentage ("ACP") tests at minimal cost. How did this work? Suppose that a firm s highly compensated employees had an ADP of 10%, which means that the ADP for the other employees would have to be at least 8%. Suppose that there were three other employees, as follows: Employee Compensation Deferral Percentage Abigail $50,000 5% Bob $40,000 5% Carol $ 2,000 0% Effective for plan years beginning on or after January 1, 2006, the regulations cover both section 401(k) and section 401(m), which sets rules for matching contributions. If you no longer wish to receive this bulletin or have an address change, please send an to info@adamsandreese.com. This newsletter is a periodic publication of Adams and Reese / Lange Simpson LLP and is intended for general purposes only. The information contained in this newsletter should not be construed as legal advice or a legal opinion and is not to be used as a substitute for the advice of counsel. This newsletter is sent to friends and clients of Adams and Reese / Lange Simpson LLP. The sending of this newsletter is not a privileged communication and does not create a lawyer/client relationship. No representation is made that the quality of the legal services to be performed is greater than the quality of legal services performed by other lawyers. FREE BACKGROUND INFORMATION IS AVAILABLE UPON REQUEST. Author: Charles P. Adams, Jr. Not certified by the Texas Board of Legal Specialization except as noted.

2 The group s ADP is 5%, but can be increased to 8% if the firm makes a 14% QNEC for Carol. The cost of that 14% QNEC? $280. A not-too-expensive fix. The proposed regulations decided to curb (but not end) this approach to satisfying the ADP test. In a test that the final regulations adopt, QNECs higher than 5% of compensation cannot be used to satisfy the ADP test to the extent the QNECs exceed something called the "representative contribution rate." A plan s representative contribution rate is twice the average QNEC made on behalf of at least half of all the non-highly compensated employees. The same approach is used for QMACs. It should be said that the Regulations place limitations on, rather than prohibit, the use of these "bottom-up" QNECs in satisfying the ADP and ACP tests. Pre-fund Hardly Ever. The final Regulations by and large preserve a proposed rule that prevents a plan from treating an employee deferral as a qualified elective deferral if it is prefunded, i.e., funded before the employee has earned the wages from which the deferral is made. A similar rule applies to prefunded matching contributions. Many commentators on the proposed regulations sharply criticized these rules, which reverse a prior IRS administration position, but the Department of Treasury and IRS stood firm. There are, however, a few exceptions to the rules, including an exception when the employer pre-funds for bona fide administrative reasons rather than for the purpose of accelerating deductions. The final regulations arm the IRS with authority to police 401(k) plans for abuse in the non-discrimination rules, even in situations in which a plan satisfies all specific statutory and regulatory requirements. Aggregating ESOP and Non-ESOP Plan Components. The Regulations reverse a prior regulatory position and generally permit an ESOP component of a 401(k) plan to be aggregated with the non-esop component for ADP and ACP testing. Easing the Meaning of Hardship. The Regulations expand the circumstances under which a participant can take a hardship withdrawal, by adding two new hardship safe harbors, one for funeral expenses for certain close relatives and the other for repairs to homes that are damaged by fire, storm or other casualty. Restricting the Meaning of Medical Hardship. The Regulations take the position that "hardship" medical expenses will not include nonprescription drugs or medicine (other than insulin), even though a cafeteria plan can now reimburse such expenses. Non-applicability of New Definition of Dependent. Last year Congress amended the Internal Revenue Code to add residency requirements for claiming a full-time student as a dependent. The regulations provide that a plan may continue to use the earlier, broader definition of dependent for purposes of the educational and medical expense hardship safe harbors. Caution Signs for Non-discrimination Safe Harbor. The regulations make clear that plan features that qualify a plan for safe-harbor testing must be adopted by the start of the plan year and, with only limited exceptions, the safe harbor provisions must be active during the entire year. Anti-abuse Police Power. The final regulations arm the IRS with authority to police 401(k) plans for abuse in the non-discrimination rules, even in situations in which a plan satisfies all specific statutory and regulatory requirements. In other words, 401(k) plans must now meet both the letter and, as the IRS sees it, the spirit of the law. The anti-abuse rule will apply when repeated changes to plan testing procedures or plan provisions have the effect of distorting the ADP or otherwise manipulate the 401(k) nondiscrimination rules, if the plan sponsor has a principal purpose of achieving such a result. Constructive Receipt and Elective Deferrals. The regulations "clarify" that elective contributions to a qualified plan other than a qualifying section 401(k) plan will result in an employee s constructive receipt of income. Effective Date. The Regulations become effective for plan years beginning on or after January 1, A firm, however, can opt to apply the regulations to a plan in 2005, which might be beneficial if a plan participant wants a hardship distribution under one of the liberalized safe-harbor exceptions or if the plan wishes to aggregate an ESOP and non-esop component for purposes of ADP testing. But the Regulations effective date provisions make plain that the Regulatory provisions are not a Chinese menu of choices, and that a plan sponsor that wishes to use the Regulations liberalizing provisions must also accept the Regulations new limitations. 2 Employee Benefits Bulletin, May 2005

3 What to Do Now? Plan sponsors should review both the terms of their plans and each plan s administrative practices to determine what changes, if any, are needed to comply with the regulations for plan years beginning in Troubling News from the Department of Labor for Automatic- Enrollment 401(k) Plans A number of employers, both large and small, have recently amended their section 401(k) plans to provide for automatic enrollment of new employees. In such plans, a new employee must affirmatively opt out of the plan rather than affirmatively opt into the plan. This type of plan tends to achieve much higher levels of employee participation than other 401(k) plans. Last year, the IRS gave plan sponsors a clear green light to adopt automatic-enrollment 401(k) plans, indicating that such plans would not violate any applicable requirements of the Internal Revenue Code. And the new section 401(k) regulations continue to endorse such plans. But the Department of Labor has just taken a position that may well temper enthusiasm for automatic enrollment. Here is the issue that the Department of Labor considered: ERISA section 404(c) can relieve plan fiduciaries from liability when each participant chooses how to invest the assets in his or her account. But what happens in an automatic enrollment plan if a participant does not affirmatively select how to allocate his account among plan investment options? In such cases, the plan will have a default investment allocation. In the case of a default allocation, is an employee exercising control over the investment of his or her account, thus entitling the plan fiduciary to section 404(c) s limitation on fiduciary liability? The Department of Labor has indicated that it does not. Thus, sponsors of automatic enrollment 401(k) plans must be careful in selecting default options. Selecting a default investment option raises the recurring question whether to use a money market fund that preserves principal or, for instance, a life cycle fund with annual rebalancing. The creation of a Roth feature to a 401(k) plan can allow valued employees to obtain significantly greater tax benefits than they could in a traditional 401(k) plan. IRS Proposes Roth 401(k) Regulations Beginning next year, sponsors of section 401(k) plans may, if they wish, add a Roth 401(k) feature. An employee who makes a Roth contribution to a 401(k) plan will include the contributions in taxable income for the year of contribution, but will not pay tax on withdrawals from the Roth account. Last month the IRS published proposed regulations on Roth 401(k) plans. The regulations contain no major surprises. Basically, a firm that wants a Roth option for its 401(k) plan will have to establish new administrative procedures and segregated accounts to hold Roth contributions. This will add a bit of complexity and expense to the 401(k) plan. Why consider adding a Roth feature to a 401(k) plan? There are at least three reasons, which will generally be applicable to firms with a group of well-compensated employees. First, the maximum limits on elective deferrals are effectively higher for a Roth 401(k) plan than for a traditional 401(k) plan. Why is this, since in 2006 an employee can contribute $15,000 to either a regular 401(k) or a Roth 401(k) account? The answer is that a Roth elective deferral in effect includes not only the contribution but also the tax the employee pays on the contribution in the year of deferral. Thus, a $15,000 contribution to a Roth account is effectively $23, (the $15,000 contribution, plus the $8, in income tax that the employee must pay on the contribution). Thus, the creation of a Roth feature to a 401(k) plan can allow valued employees to obtain significantly greater tax benefits than they could in a traditional 401(k) plan. Second, a Roth feature can effectively increase the deferral percentage for highly compensated employees in plans subject to ADP testing. Some 401(k) plans are subject to ADP testing, a procedure which essentially limits elective deferrals (as a percentage of pay) for highly compensated employees to a multiple of the elective deferrals (as a percentage of pay) of the non-highly compensated employees. For example, if the non-highly compensated group of employees defers on average 4% of pay, then the highly compensated employees, as a group, can defer no more than 6% of their own pay. As we have already seen, a Roth 401(k) deferral is effectively larger than a traditional Employee Benefits Bulletin, May

4 401(k) deferral of the same nominal dollar amount. Thus, attaching a Roth option to a 401(k) plan allows highly compensated employees an indirect means of increasing contributions otherwise limited by the ADP test. Third, a Roth feature is attractive to an employee who believes that his or her marginal tax rate will be higher in retirement than in the year of contribution. This can be especially attractive to young professionals, who will likely see their income rise over their career. It may also be attractive to anyone who believes that the large deficits that the government is currently running will ultimately result in increased income tax rates. Fifth Circuit Court of Appeals Decides an Important but Controversial 401(k) Case Last month, the United States Court of Appeals for the Fifth Circuit decided Milofsky v. American Airlines, Inc. a potentially significant case involving 401(k) plans. The case involved some participants who contended that the plan fiduciaries failed to transfer their accounts from an old section 401(k) plan (which had been maintained by a company that American Airlines acquired) to the American Airlines 401(k) plan. The plaintiffs in the case asked for money damages to compensate them for losses allegedly caused by the delay in transferring their assets to the latter plan. The Court, however, observed that money damages in ERISA are only available in cases in which the plan, rather than individual plaintiffs, suffer a harm. In this case, the Court held that even though it was the plan that would have formally suffered a loss since the plan had formal title to all investment assets, the reality was that the losses were suffered by the individual participants whose accounts were harmed by the fiduciary failures. Thus, money damages were not available to the plaintiffs. The case has implications for 401(k) plans in which individuals decide how to allocate their account balances among different investment options offered by the plan. Assume, for example, that the fiduciary offered some imprudent investment options, which only some plan participants chose. Under Milofsky, those participants arguably would not have standing to sue for recovery of their investment losses. If Milofsky in fact has this effect, and if it is adopted by other courts, it will significantly limit the liability of fiduciaries in most 401(k) plans. The decision, however, is controversial and might be unacceptable to other circuits and/or limited in subsequent cases in the Fifth Circuit. The Accidental Origins of the 401(k) Plan The 401(k) plan has revolutionized the shape and tenor of retirement savings in this country, ushering in an era in which the individual account plan has replaced the defined benefit plan as the primary retirement savings vehicle for most employees. As a result, one might think that Congress showed great vision, when it enacted section 401(k) in In fact, though, Congress had a very modest goal in adding section 401(k) to the Internal Revenue Code. Some banks and other financial institutions offered their employees a year-end choice of a cash bonus or contribution to a profit-sharing plan. The IRS, however, was concerned that employees who chose to take a profit-sharing contribution in lieu of cash might nevertheless have income under the constructive receipt doctrine. It was to resolve this limited issue that Congress adopted section 401(k). But it wasn t long before a few creative ERISA consultants saw in section 401(k) the outline for the type of plan that we now associate with the section, a plan in which employees can during the course of the year defer a portion of their regular salary. And in 1981, the IRS and Department of Treasury issued proposed regulations that endorsed this reading of section 401(k). So, the 401(k) plan revolution was one of accident rather than deliberate Congressional design. Last month, the United States Court of Appeals for the Fifth Circuit decided a potentially significant case involving 401(k) plans. The decision, however, is controversial and might be unacceptable to other circuits and/or limited in subsequent cases in the Fifth Circuit. New Guidance in Brief Phased Retirement: IRS Considering Comments to Proposed Regulations Last November, the IRS issued proposed regulations on phased retirement, which would permit pension plans to begin payments to certain older employees who phase into retirement by reducing their work hours rather than retiring all at once. A number of trade and public interest groups, consultants, and actuaries have commented on the proposed regulations and a hearing on them was planned for March. A future edition of this newsletter will discuss the issue of phased retirement. 4 Employee Benefits Bulletin, May 2005

5 New Rules for Orphan Plans A thorny issue under Title I of ERISA is how to terminate a plan that no longer has a sponsor or a plan that has been abandoned by its sponsor. For example, the employer sponsoring a plan might have died or simply cannot be found. Or the employer might be bankrupt and no individual fiduciary can be located to authorize benefit distributions or terminate the plan. To deal with this problem, the Department of Labor recently issued proposed regulations that would allow a person or entity holding the assets to terminate the plan if the individual or entity would be eligible to serve as a trustee or issuer of an IRA. The proposed regulations provide streamlined reporting, disclosure and administrative requirements, and also purport to limit fiduciary liability if the regulatory terms are followed. New Guidance for HSAs and HRAs The IRS released two revenue rulings in April related to health-care plans. The first revenue ruling, Rev. Rul considered health reimbursement plans. In that ruling, the IRS holds that a health reimbursement plan does REEMPLOYMENT RIGHTS U.S. Department of Labor YOUR RIGHTS UNDER USERRA THE UNIFORMED SERVICES EMPLOYMENT AND REEMPLOYMENT RIGHTS ACT USERRA protects the job rights of individuals who voluntarily or involuntarily leave employment positions to undertake military service. USERRA also prohibits employers from discriminating against past and present members of the uniformed services, and applicants to the uniformed services. You have the right to be reemployed in your civilian job if you leave that job to perform service in the uniformed service and: you ensure that your employer receives advance written or verbal notice of your service; you have five years or less of cumulative service in the uniformed services while with that particular employer; you return to work or apply for reemployment in a timely manner after conclusion of service; and you have not been separated from service with a disqualifying discharge or under other than honorable conditions. If you are eligible to be reemployed, you must be restored to the job and benefits you would have attained if you had not been absent due to military service or, in some cases, a comparable job. RIGHT TO BE FREE FROM DISCRIMINATION AND RETALIATION If you: are a past or present member of the uniformed service; have applied for membership in the uniformed service; or are obligated to serve in the uniformed service; then an employer may not deny you any of the following because of this status: initial employment; reemployment; retention in employment; promotion; or any benefit of employment. In addition, an employer may not retaliate against anyone assisting in the enforcement of USERRA rights, including testifying or making a statement in connection with a proceeding under USERRA, even if that person has no service connection. The Department of Labor s USERRA notice can be downloaded from their website at HEALTH INSURANCE PROTECTION If you leave your job to perform military service, you have the right to elect to continue your existing employer-based health plan coverage for you and your dependents for up to 24 months while in the military. Even if you don't elect to continue coverage during your military service, you have the right to be reinstated in your employer's health plan when you are reemployed, generally without any waiting periods or exclusions (e.g., pre-existing condition exclusions) except for service-connected illnesses or injuries. ENFORCEMENT The U.S. Department of Labor, Veterans Employment and Training Service (VETS) is authorized to investigate and resolve complaints of USERRA violations. For assistance in filing a complaint, or for any other information on USERRA, contact VETS at USA-DOL or visit its website at An interactive online USERRA Advisor can be viewed at If you file a complaint with VETS and VETS is unable to resolve it, you may request that your case be referred to the Department of Justice or the Office of Special Counsel, depending on the employer, for representation. You may also bypass the VETS process and bring a civil action against an employer for violations of USERRA. The rights listed here may vary depending on the circumstances. This notice was prepared by VETS, and may be viewed on the internet at this address: Federal law requires employers to notify employees of their rights under USERRA, and employers may meet this requirement by displaying this notice where they customarily place notices for employees Publication Date February 2005 not satisfy the requirements of section 105 if the plan permits an employee or beneficiary to ever receive a cash payment or unrelated fringe benefit, whether or not such other benefit would itself be taxable. The result is that any payments from the plan, even if ultimately paid out for medical expenses, are included in the employee s income. The second revenue ruling, Rev. Rul , considered a health savings account. The ruling held that an individual could make contributions for a plan even though the individual s spouse has a non-hsa qualifying plan. The individual can make a self-only contribution to an HSA so long as the individual is not covered in the spouse s plan. Moreover, the individual can make a family contribution if the HSA also covers a dependent, so long as neither the individual nor the dependent is covered in the spouse s plan. DOL Releases USERRA Rights Notice Poster In December of last year, Congress enacted the Veterans Benefits Improvement Act, which increased the period in which an employer must provide continuing health care coverage to an employee on military leave from 18 months to two years. VBIA also requires that the employer provide employees with a notice of their USERRA entitlements. On March 10, the Department of Labor released the contents of such notice, in the form of a poster. An employer can satisfy the notice requirements by posting the poster in a prominent place where employees customarily check for such information. (The notice can also be provided by mail, hand-delivery, or by electronic mail.) The notice is available at Drop us a note If you have a question or would like to see a particular topic addressed, please let us know by ing us at teri.cardwell@adamsandreese.com or by writing to us at: Adams and Reese/Lange Simpson LLP Attn. Teri Cardwell Concord Center rd Ave. North, Suite 1100 Birmingham, AL We will try to address your question or topic in a future newsletter. Employee Benefits Bulletin, May

6 Adams and Reese/Lange Simpson LLP Concord Center rd Ave. North, Suite 1100 Birmingham, AL BATON ROUGE BIRMINGHAM HOUSTON JACKSON MOBILE NASHVILLE NEW ORLEANS WASHINGTON, DC