Business Owners: Rules For Qualified Retirement Plans

Business owners who maintain a qualified plan for their businesses are required to operate them under cash-out/automatic rollover rules. In this article, we provide a summary of these rules and the steps business owners may need to take to incorporate them into a qualified plan.

Most of the requirements explained here apply to the plan administrator, which, for most plans operated by small businesses, is you - the business owner.

The cash-out rules concern the distribution procedure that occurs once an employee ceases to work for your business. If an individual participant no longer works for you and has a vested balance of $5,000 or less in your qualified plan, your plan may include a provision to distribute that amount to the participant without that person's written consent. This is referred to an involuntary cash-out.

The Process of the Change to the Rules
In 2004, the U.S. Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) changed the involuntary cash-out rules, requiring plan administrators to either:

  • Roll over involuntary cash-out amounts between $1,000 and $5,000 to a Traditional IRA - referred to as an automatic rollover; or
  • To reduce the cash-out ceiling from $5,000 to $1,000

On September 28, 2004, the final cash-out regulations were issued. These regulations explained how the automatic rollovers should be handled, and stated that the effective date of these rules is March 28, 2005. In addition, the IRS issued Notice 2005-5, providing administrative and procedural guidance that plan administrators may use to implement these changes.

The Options
As mentioned above, there are two options a business owner may have for automatic rollovers of involuntary cash-out amounts. These options are as follows:

  • Choose the cash-out ceiling of $5,000 and provide for automatic rollovers of involuntary cash-out amounts between $1,000 and $5,000. Under this option, involuntary cash-out balances of $1,000 or less do not require automatic rollovers.
  • Reduce the cash-out ceiling to $1,000 so that balances of $1,000 or less can be distributed as involuntary cash-outs (not handled as automatic rollovers). Balances in excess of $1,000 must remain in the plan until participants submit withdrawal requests.

Your options may depend on whether you use another party's plan document, such as a prototype plan, or your own individually designed plan. For instance, your prototype sponsor may chose only one option and require that you use that same option. On the other hand, the prototype sponsor may acknowledge both options and allow you to choose. If you operate your plan under a prototype, check with the sponsor to determine your options.

Option No.1: The Automatic Rollover
The following are a few of the requirements that apply should you choose the automatic rollover option.

Written Agreement
Under the automatic rollover option, the plan administrator must sign a written agreement with an IRA provider. If the agreement satisfies the safe-harbor requirements defined in the final Department of Labor (DOL) regulations, the plan administrator will not be required to monitor the IRA to ensure its provider adheres to the agreement.

Items that must be addressed in the agreement include the way in which the rollover contribution will be invested and the fees and expenses that will apply to the IRA. For instance, the agreement must state that the investments have to be of a nature that preserves the balance of the IRA and provides a reasonable (but not necessarily guaranteed) rate of return. In addition, the investments must be provided by a state or federally regulated financial service institution, where assets are insured by one of the following: the Federal Deposit Insurance Corporation (FDIC), the Federal Credit Union Act (for credit unions), the State Guarantee Association (for insurance companies) or the Investment Company Act of 1940 (for brokerage firms).

Notice to Affected Individuals
Prior to rolling over the amount to the IRA, the plan administrator must notify affected individuals in writing. This notification is provided in the summary plan description (SPD) or a summary of material modification (SMM). The SPD is usually given to participants when the plan is established or when they become eligible to participate in the plan, and the SMM is usually provided when there are significant plan changes that affect participants and beneficiaries. Both documents must be written in non-technical terms so that the participants can easily understand it. Also, participant and beneficiaries must be provided with these documents within 210 days after the end of the plan year to which the amendment applies.

Establishing the IRA
At the time of the automatic rollover, the plan administrator must sign the adoption agreement to establish the IRA and mail the disclosure statement and IRA agreement to the participant. The plan administrator cannot, however, make any beneficiary designations for the IRA, which means that the beneficiary designation will be determined by the default provision of the IRA agreement. This default provision stays in place until the participant makes an affirmative election to choose his or her beneficiary for the IRA

Option No.2: The Involuntary Cash-Out Reduction
If the plan administrator chooses to reduce the involuntary cash-out ceiling to $1,000, balances in excess of $1,000 cannot be distributed from the plan without the written consent of the participant. However, the plan administrator is not required to establish IRAs for affected participants. But like those participants whose former employers use option No.1, participants whose former employers have reduced the cash-out ceiling must be provided with written notification of the distribution.

If you have the opportunity to choose either option discussed above, give careful consideration on how your selection will affect the administration of your plan. For instance, should you choose the involuntary cash-out reduction, ask yourself whether it will be more costly to maintain plan balances of $1,001 to $5,000 instead of cashing out these amounts.

Regardless of how you deal with the rules, your plan administrator (you) should review the requirements in the DOL's final regulations and IRS Notice 2005-5 to ensure your plan operates in compliance with these rules; toward that end, if you are not clear on the regulations, be sure to enlist the assistance of a competent and qualified plan administrator.