On September 5, 2009, the U.S. Department of the Treasury announced the issuance of several Internal Revenue Service (IRS) rulings and notices and other initiatives intended, as stated in Treasury’s press release, “to make it easier for working families to save, particularly for retirement.” Although none of the items breaks significant new ground, the various pieces of guidance provide helpful clarifications and updates in several areas. The initiatives include:
- A ruling and notices providing guidance on 401(k) and SIMPLE IRA automatic enrollment and automatic contribution increase arrangements (Rev. Rul. 2009-30, Notice 2009-65, Notice 2009-66, and Notice 2009-67);
- Rulings describing how unused vacation pay and pay for other leave can be contributed to a 401(k) plan (Rev. Rul. 2009-31 and Rev. Rul. 2009-32);
- A notice providing a new model Internal Revenue Code (“Code”) section 402(f) notice on rollover opportunities and tax rules following termination of employment (Notice 2009-68);
- Enhancements to the IRS Web site directed at plan participants and sponsors;
- A new program allowing tax refunds to be directed to purchase U.S. Savings Bonds; and
- A reiteration of the Obama Administration’s legislative proposals regarding automatic contribution IRAs and the expansion of the saver’s credit.
The IRS issued a ruling and notices providing (1) guidance on the timing and other aspects of automatic increases in contributions for 401(k) plans; (2) sample amendment language for automatic contribution arrangements for 401(k) plans; (3) guidance providing that SIMPLE IRAs may include automatic contribution arrangements; and (4) sample amendment language for automatic contribution arrangements for SIMPLE IRAs.
As background, recall that the Pension Protection Act of 2006 added several new rules for 401(k) automatic contribution arrangements, including a safe harbor arrangement or qualified automatic contribution arrangement (QACA) that requires automatic increases, an eligible automatic contribution arrangement (EACA) allowing penalty-free withdrawals under Code section 414(w), and qualified default investment alternative (QDIA) rules under section 404(c)(5) of the Employee Retirement Income Security Act of 1974 (ERISA). Specifically, a QACA is deemed to satisfy the actual deferral percentage (ADP) and actual contribution percentage (ACP) nondiscrimination tests under a design-based 401(k) safe harbor. It must provide for automatic contributions at specified minimum levels that automatically increase and must meet certain employer contribution, notice and vesting requirements. An EACA is an arrangement that allows an automatically enrolled participant to withdraw contributions made within 90 days after the first contribution without incurring early withdrawal penalties under Code section 72(t). EACA contributions must be invested in a QDIA, and the employer must meet certain employee notice requirements. Employers implementing an EACA may take advantage of an extended six-month period for making corrective distributions of 401(k) or matching contributions that do not meet the ADP or ACP test without incurring excise taxes. A QACA that also satisfies the requirements for being an EACA may allow for the 90-day penalty-free return of contributions. Default contributions under both an EACA and a QACA must be a uniform percentage of compensation for all eligible employees, with exceptions for default increases in contributions based on the number of years that have elapsed since the employee’s first default contribution to the plan.
Automatic Increase Arrangements for 401(k) Plans. Many employers have implemented or considered arrangements under which employees are automatically enrolled in the employer’s 401(k) plan at a certain contribution level and the contribution level is automatically increased each year by a specified amount unless the employee opts out or until a target level of contributions is reached. One issue of concern for employers has been the timing at which the automatic increases are or may be applied, particularly for QACAs and EACAs. Revenue Ruling 2009-30 provides guidance on the time for implementing automatic increases and other aspects of automatic contribution arrangements.
In Rev. Rul. 2009-30, the IRS uses two hypothetical 401(k) profit sharing plans to illustrate how 401(k) plans can offer an increasing default contribution feature while meeting applicable tax requirements. In the first situation, Plan A features an automatic contribution arrangement with an initial default contribution of 4% of plan compensation for employees who fail to make a contribution election. The default contribution percentage under the plan increases each year on the employee’s employment anniversary date, which is when the employer provides annual pay increases. The annual increase equals the greater of 1% of compensation or a percentage of compensation representing 30% of the employee’s base pay increase for that year. Automatic contributions are capped at 11%. Under Plan A, an employee may reduce the contribution percentage or opt out of contributions at any time.
The Revenue Ruling concludes that default contributions made pursuant to Plan A satisfy the requirements of Code section 401(k), although the contributions are made pursuant to a default election in the absence of an affirmative employee election, rather than being paid to the employee as cash. Furthermore, the IRS notes that the default contributions do not cease to be 401(k) elective contributions simply because (1) the default percentage increases over time based on increases in the employee’s compensation; (2) the increases apply at different times of year based on each employee’s anniversary date; and (3) the annual percentage increases for different employees may vary based on each employee’s annual pay increase.
In the second situation, the IRS considers Plan B, a plan intended to satisfy both the EACA and QACA rules that is maintained by an employer that usually implements annual compensation increases as of April 1 of each year. Plan B provides for an initial default contribution of 3% of plan compensation in the first year and an annual increase of 1% effective following each April 1, when the employer provides its usual annual pay increases, not to exceed 10%. Employees may change the deferral percentage under Plan B or opt out of deferral contributions at any time.
Addressing the QACA and EACA uniformity requirements, the Revenue Ruling concludes that the default contributions made to Plan B meet the requirements of Code section 401(k). While the increasing default contributions under Plan B would cause the plan to violate the general EACA/QACA uniform contribution percentage requirements noted above, the IRS reasons that the increases are eligible for an exception because they apply in the same manner to all eligible employees for whom the same number of years have elapsed since default contributions were first made under the plan. The fact that annual default contribution increases occur on a date other than the first day of the plan year does not change this result. The timing of the increases also satisfies the rules requiring automatic increases for QACAs since the increases apply earlier than would be required under the applicable regulations. The IRS notes that if the employer wants to delay applying the first automatic increase until April 1 of the second plan year after the participant is automatically enrolled, the initial automatic contribution percentage should be 4%, rather than 3%, to ensure that the QACA meets the minimum contribution requirements at all times.
Sutherland Comment: The Revenue Ruling is helpful in clarifying the extent to which employers who want to coordinate increases in automatic contributions with increases in employees’ pay can do so. Not surprisingly, plans that use an automatic contribution feature that is neither an EACA or a QACA have the most flexibility. However, the Revenue Ruling makes clear that an employer that generally implements pay increases for all employees on a day other than January 1 of each year but on or around the same day each year can use that day to trigger automatic contribution increases and can still be in compliance with the uniformity requirements for either an EACA or a QACA.
Sample Amendment Language for 401(k) Plans. Notice 2009-65 provides sample amendment language for implementing automatic enrollment and automatic increase arrangements in a 401(k) plan. The document accompanying Treasury’s press release, entitled “Retirement Security for American Families,” indicates that Treasury and the IRS intend the sample amendment language to streamline the amendment process by providing pre-approved language. Consistent with this intent, the Notice provides that an employer that adopts the sample language, as modified for the particular plan and plan administration, will not lose reliance on an existing determination letter or cause a prototype plan to lose its pre-approved prototype status.
The format of the sample amendment is most useful for employers that have adopted a prototype plan; it includes an amendment to a “basic plan document” and an amendment to an “adoption agreement.” The Notice indicates that employers with individually designed plans can adapt the sample language for their plans and that any adopting employer will likely need to modify the sample language to fit its particular plan and its administrative procedures.
The Notice provides two sample amendments: one for automatic contribution arrangements that are not designed to meet the requirements of an EACA, and a second that is intended to meet those requirements. Neither of the amendments includes provisions for a QACA.
The first sample amendment provides language for both automatic enrollment and automatic increases, but it does not require that both be used in the plan. The amendment also includes language providing for annual notice to participants regarding the automatic contributions, and permits the automatic contributions to be applicable initially to (1) all participants; (2) only those participants who have not made an affirmative election; or (3) only new participants who have not made an affirmative election. The second sample amendment is similar, but includes certain special EACA rules.
Sutherland Comment: The first sample amendment provides for an annual notification to participants of the automatic enrollment and increase arrangement within 30 to 90 days of the beginning of the plan year, similar to the statutory requirements for EACAs and QACAs. Although an annual notification, in addition to reasonable notice before the automatic enrollment or increase takes effect, is not specifically required by the 401(k) regulations permitting automatic enrollment, the sample amendment is another indication that the IRS favors such annual notification, particularly for arrangements that include automatic increases. Employers with automatic contribution arrangements should consider whether to provide annual notice if they are not already doing so.
SIMPLE IRA Automatic Enrollment and Automatic Increase Arrangements. Notice 2009-66 provides that a SIMPLE IRA plan may automatically enroll eligible employees in the plan and increase the amount of each participant’s automatic contributions based on the length of his or her enrollment in the plan, provided that the participants have a reasonable opportunity to opt out of such treatment.
If a SIMPLE IRA includes an automatic contribution arrangement, the annual SIMPLE IRA notice must include the following additional information: (1) the percentage rate of contributions made absent an affirmative election; (2) an explanation of the employee’s right to elect to contribute at a different rate or to opt out of contributing; and (3) a description of how default salary reduction contributions are invested in the absence of an investment election by the employee. The Notice further states that if automatic contributions to a SIMPLE IRA are invested in a QDIA, then the protections of ERISA section 404(c) will apply with respect to the investment.
The Notice notes that the Worker, Retiree, and Employer Recovery Act of 2008 added SIMPLE IRAs to the list of types of plans that can implement an EACA (as described above). In the Notice, the IRS asks for comments regarding the implementation of an EACA in connection with a SIMPLE IRA.
Finally, the IRS published a sample amendment in Notice 2009-67 that may be used to add an automatic contribution arrangement to a SIMPLE IRA plan. The amendment is designed to be used by prototype providers that sponsor SIMPLE IRA plans, not by individual employers that have adopted a prototype SIMPLE IRA, although the employer must adopt the amendment provided by the prototype sponsor to implement an automatic contribution arrangement. In the Notice providing the sample amendment, the IRS also notes that it expects to issue a revised Form 5305-SIMPLE that will include an automatic contribution arrangement.
Contributing Vacation and Sick Leave Pay to 401(k) Plans
Many practitioners and plan sponsors have been aware of the potential for allowing employees to contribute unused vacation or sick leave pay to a 401(k) plan since at least the 1990s, when the IRS issued a technical advice memorandum discussing such an arrangement. Although Technical Advice Memorandum 9635002 and, later, Private Letter Ruling 200311043 provided some insight into IRS thinking on certain aspects of such an arrangement, the IRS has never published formal guidance on which employers could rely when amending plans to permit such contributions. In Rev. Rul. 2009-31 and Rev. Rul. 2009-32, the IRS provides specific guidance on several types of vacation and sick leave pay contributions to 401(k) plans.
Rev. Rul. 2009-31 addresses the consequences of allowing contributions of vacation and sick leave pay (referred to in the Revenue Ruling as paid time off, or PTO) by a current employee in a scenario in which the PTO would otherwise be forfeited and in a scenario in which the PTO would otherwise be cashed out.
The first situation addressed by the IRS is one in which an employer’s PTO plan is a “use it or lose it” design, under which the employee forfeits any unused PTO at the end of the year. The employer amends its 401(k) plan to provide for a contribution equal to the value of the unused PTO at the end of the year. The contribution is allocated as of December 31, 2009, but is not actually made until February 28, 2010. The Revenue Ruling concludes that such a contribution is permissible, that it will be treated as an employer nonelective contribution for 2010, and that the contribution will be subject to testing under Code section 401(a)(4) for nondiscrimination. These aspects of the Revenue Ruling are largely the same as the Technical Advice Memorandum and Private Letter Ruling noted above. Because the contribution would be subject to testing under section 401(a)(4) and would be highly unlikely to meet any design-based safe harbor, such a design would normally require expensive rate general testing and may not even pass the general test. Offering the PTO contribution program solely to non-highly compensated employees would avoid this problem, but employers may not find this an acceptable alternative because it is often the highly compensated employees who end up with the greatest amount of unused PTO.
The second scenario addressed by the Revenue Ruling is a PTO plan that provides for a limited carryover of unused PTO and a cash-out of unused PTO that exceeds the carryover allowance, with the cash-out paid in the following February. The employer amends its 401(k) plan to permit employees to elect to receive the PTO cash-out or contribute the PTO cash-out to the 401(k) plan. Although the PTO relates to 2009, it is to be paid in cash or contributed to the 401(k) plan in February 2010. The Revenue Ruling states that the employees’ election will be treated as a cash-or-deferred election under Code section 401(k), subject to the Code section 402(g) limitation for 2010 and other requirements for elective contributions. The IRS had not previously elaborated on the consequences of this type of arrangement, but the results flow directly from the existing regulations and guidance.
The Revenue Ruling does not address other scenarios involving deferrals of accrued leave that would not otherwise be cashed out. These scenarios raise a variety of questions, including whether such an arrangement, even if elective, would be viewed as a nonelective employer contribution subject to testing under Code section 401(a)(4), because the accrued leave is not available as cash.
Sutherland Comment: The Revenue Ruling states that the amendment to the 401(k) plan in the scenario allowing a cash-or-deferred election is made in December 2008. Although the Revenue Ruling is not explicit on the point, the IRS position may be that it is necessary to implement such an amendment before the year that the applicable leave time is accrued. Otherwise, there could be a concern that the plan is not established before the accrued leave is “currently available,” as required by Treas. Reg. section 1.401(k)-1(a)(3)(iii)(A).
Rev. Rul. 2009-32 is similar to Rev. Rul. 2009-31, but it addresses contributions of leave following termination of employment. In the first situation addressed, unused PTO is forfeited following termination of employment. The employer amends the PTO plan to provide that the unused leave is contributed to the 401(k) plan upon termination of employment, an employee terminates employment, and the employee’s unused PTO is contributed to the plan during the same calendar year/plan year. As in Rev. Rul. 2009-31, this contribution is treated as an employer non-elective contribution subject to the Code section 401(a)(4) nondiscrimination testing rules.
The second scenario is the same as the first, except that the termination of employment occurs on December 28, 2009, and the unused leave amount is contributed to the 401(k) plan and allocated to the participant’s account as of January 18, 2010. The contribution is treated as subject to the 2010 Code section 415 limit. The Revenue Ruling further concludes that even if the participant does not have any other section 415 compensation for 2010, the section 415(c) limit of 100% of compensation will not be violated, because the leave itself could have been carried over under the employer’s PTO plan, and therefore will be considered section 415 compensation for 2010. This conclusion is somewhat surprising given that the leave was not in fact used or available in 2010, but it is a practical and reasonable result under the circumstances presented.
The third and fourth scenarios are variations on the first and second situations in which the participant can elect to defer unused PTO that would otherwise be cashed out. The Revenue Ruling concludes that these contributions are treated as elective 401(k) contributions, subject to the applicable Code section 415 and section 402(g) limits for the years in which they are made.
There are numerous specific assumptions and caveats that the IRS includes in these two Revenue Rulings. Accordingly, each employer’s fact pattern will need to be analyzed carefully before a decision is made to add a feature for contributions of vacation or other leave pay.
Model Distribution Notice
Employers are required under Code section 402(f) to provide notice to plan participants upon termination of employment describing the tax consequences of taking a distribution, the ability to roll over funds into another retirement plan, and other tax rules. The IRS last provided a model 402(f) notice in December 2001 under Notice 2002-3. Since then, many changes to the laws governing rollovers have been made, and Roth 401(k) accounts have been added to the Code. Plan administrators have used various forms of updates to the 402(f) notice, but administrators have been awaiting an updated model notice from the IRS for some time. Notice 2009-68 provides two model 402(f) notices: one for distributions from a designated Roth account and one for distributions from a non-Roth account. These model notices provide a safe harbor for meeting the requirements of section 402(f).
Written in question-and-answer format, the updated 402(f) notices are intended both to simplify the explanation of a participant’s rollover options and to reflect the following changes made to the Code since Notice 2002-3:
- The addition of section 402A, which allows for designated Roth contributions and provides that rollover distributions of those contributions may be made only to another designated Roth account or Roth IRA of the participant;
- The amendment of section 401(a)(31)(B), requiring that a mandatory distribution of more than $1,000 be paid in a direct rollover to an IRA unless the participant affirmatively elects otherwise;
- The updated definition of “qualified rollover contribution” under section 408A, which includes rollover contributions from section 402(c)(8)(B) eligible retirement plans;
- The addition of section 402(c)(11), which provides for direct rollovers from an eligible employer plan to an inherited IRA for designated nonspouse beneficiaries;
- The addition of section 414(w), which provides for EACAs and rules governing distributions from those arrangements;
- The amendment of section 72(t)(2)(G) to provide that the 10% tax on early distributions is inapplicable to qualified reservist distributions;
- The addition of section 72(t)(10), which provides that the 10% tax on early distributions is inapplicable to governmental defined benefit plans if the distribution is to a qualified public safety employee who separates from service after age 50; and
- The addition of section 402(l), which provides a limited exclusion from gross income for distributions from a governmental eligible employer plan that are paid directly to an accident or health plan or a qualified long-term care insurance contract for premiums of an eligible retired public safety officer and his or her spouse or dependents.
The updated model 402(f) notices are generally more readable and user-friendly than the old model notice: the old model’s broad discussion has been reorganized into more discrete questions and answers that highlight the most important points regarding rollover options, procedures, and tax consequences. In addition, special rules that may be tangential or inapplicable to certain plans are contained at the end of the notice in a single “Special Rules and Options” section. The Notice indicates that both model 402(f) notices should be provided to a participant who is eligible to receive an eligible rollover distribution from both a designated Roth account and a non-Roth account.
The Notice permits a plan administrator to customize the model notices by omitting any portion that is inapplicable to the plan (for instance, a plan that does not hold after-tax employee contributions may omit the section “If your payment includes after-tax contributions” from the safe harbor notice for non-Roth distributions). A plan administrator is also permitted to add information to the model notices, so long as such information is not inconsistent with section 402(f). The Notice provides that if the law governing the tax treatment of distributions described in one of the model notices is amended after September 28, 2009, the affected notice will not satisfy section 402(f) to the extent that it no longer accurately describes relevant law. It further provides that use of the model notice contained in Notice 2002-3, updated to reflect the applicable law changes since publication of Notice 2002-3, will continue to satisfy the safe harbor through December 31, 2009.
Sutherland Comment: Because the old model notice will no longer satisfy the safe harbor, effective January 1, 2010, plan sponsors should begin working with administrators now to prepare for the implementation of the new model notice, including customizing the model notice as appropriate for their particular plans and circumstances.
Enhanced IRS Web Site Information
The IRS has updated its Web site in two ways. First, focusing on employees, the section of the Web site entitled “Life Events That Can Affect Retirement Savings” provides consolidated information about the affect that significant life events (such as starting a new job, terminating employment, marriage and having children) can have on retirement planning. Second, for employers, the IRS has created a separate “Retirement Plan Navigator” site. The site pulls together, with an up-to-date look and feel, resources such as plan comparison charts, plan “check-up” compliance guides, information on plan corrections, and similar materials.
Tax Refund Purchase of I-Bonds
In a series of questions and answers on the IRS Web site, Treasury and the IRS announced that beginning in 2010, taxpayers will be able to use their tax refunds to purchase U.S. Savings Bonds by checking a box and completing certain forms attached to the Form 1040. The bonds available will be Series I Savings Bonds, which are low risk and provide protection against inflation. Participants in the program will not need to open an account in advance with Treasury, and the bonds will be mailed directly to taxpayers shortly after they file their income tax returns. Beginning in 2011, taxpayers will be able to use their refunds to buy savings bonds through this streamlined method in the joint names of the taxpayer and a co-owner, such as a child or grandchild.
The Treasury press release also reiterates the Administration’s commitment to two legislative proposals included in the Obama Administration’s budget—the creation of automatic IRAs and the reform and expansion of the saver’s credit to match retirement savings.
Under the automatic IRA proposal, employers of a certain size would be required to offer an automatic IRA to employees that would be funded through regular payroll deductions. Employees would receive a standard notice informing them of the automatic IRA option and would be given the opportunity to participate in the program or opt out. Any employee not making an affirmative election would be enrolled at a default rate of 3% of compensation. Employees could opt out at any time and could elect to defer more or less than the default rate. Employers would have a number of alternatives for determining the IRA providers.
Under the Obama Administration’s proposal to reform and expand the saver’s credit, the existing (nonrefundable) saver’s credit for retirement savings would be made fully refundable, and the credit would be deposited automatically in the qualified retirement plan account or IRA to which the individual contributed. The credit would match half of an eligible individual’s qualified retirement savings contributions up to $500 each year and would be available to low- and middle-income families.
For additional information about the Obama Administration’s budget proposals on retirement savings and insurance products, see our May 14, 2009, Legal Alert. Also, for information regarding a Government Accountability Office report on other alternatives for enhancing retirement security that various policy groups have recommended to Congress, see our August 28, 2009, Legal Alert.