Nearly five years in the making, the Department of Labor (DOL) has published its long-awaited plan sponsor fee disclosure regulations under ERISA section 408(b)(2). With these new regulations taking effect on July 1, 2012, plan sponsors and service providers alike will be scrambling to prepare.

Why is Fee Disclosure such a Big Deal?

The Employee Retirement Income Security Act (ERISA) is one of the main federal laws that govern the operation of employer-sponsored retirement plans. Among the many topics it covers, ERISA sets forth the rules that apply to plan fiduciaries. Generally speaking, plan fiduciaries include those who have discretion over the administration or assets of a plan as well as those who provide investment advice to a plan for a fee. Since its passage in 1974, ERISA has included a requirement that a plan can only pay reasonable fees for required services such as recordkeeping, compliance or government reporting. If a plan pays fees that are not reasonable, such payments are prohibited transactions subject to penalties by the DOL and IRS.

While this requirement may seem, well… reasonable, service providers have not been legally obligated to disclose their compensation. That was not as much of a challenge in 1974 when the predominant type of retirement plan was the defined benefit plan. However, as the retirement plan world shifted from defined benefit to defined contribution daily-valued, participant-directed 401(k), the platforms and financial products became more sophisticated and complex. Service providers began receiving compensation via expenses built into plan investments rather than by directly billing plan sponsors. Some providers began marketing their services as no- or low-cost since their fees were being subsidized by the investments rather than being billed to the plan or the plan sponsor.

Having a plan automatically pay to operate itself might be convenient, but it may result in plan fiduciaries who are unable to dissect complex fee structures to determine how much each service provider is being paid. If fiduciaries do not know the amount of the fees, there is no way they can determine whether those fees are reasonable. With fee structures differing from provider to provider, it has also become difficult for fiduciaries to compare the fees and services of multiple vendors to determine which offers the best value.

What is the Solution?

Recognizing this growing disconnect, the DOL embarked on a three-pronged initiative to help ensure that fiduciaries have access to information they need to fulfill the reasonableness requirement. First is the expanded fee reporting on Form 5500, Schedule C, which was effective for plan years beginning in 2009 and is generally required for plans with more than 100 participants. The second prong is the required disclosure to plan participants at various times throughout the year.

Third is the requirement for service providers to disclose fee and service information to plan sponsors. Regulations implementing this requirement were first proposed in December 2007. After being revoked, re-proposed and semi-finalized, the sponsor-level fee disclosure regulations were finalized in February of this year.

Are all Service Providers Required to Comply?

The short answer is "No." The regulations coin a new term "Covered Service Provider" (CSP) to describe those subject to the rules. CSPs fall into three general categories:

1. Registered Investment Advisors and other fiduciary advisors;
2. Those who provide a plan investment platform; and
3. Service providers who receive indirect compensation, e.g. revenue sharing, commissions, etc.

These might seem straightforward, but the devil is in the details. Let's consider several examples to help clarify.

Investment Professionals

The first category clearly indicates that Registered Investment Advisors and other fiduciary advisors are CSPs. But, what about those who are non-fiduciary brokers? Such individuals do not fit into the first category; however, since they typically receive commissions, they are CSPs under the third category.

Platform Providers

This group seems relatively clear-cut. Any vendor, regardless of how it is compensated, that provides the investment platform to a participant-directed, defined contribution plan is a CSP. However, there are some nuances. Assume an investment professional provides the investment platform and partners with a separate firm who provides recordkeeping. In this case, the investment professional, not the recordkeeper, is likely the platform provider; therefore, the recordkeeper would probably not be a category 2 CSP. However, since most recordkeepers receive revenue sharing payments, they will typically be category 3 CSPs.

Third Party Administrators

TPAs cannot be classified as a group because their services and compensation arrangements can vary widely. Consider a TPA that provides annual compliance testing and government reporting services but does not provide recordkeeping. If all fees are paid by the plan sponsor or directly from the plan, that TPA is not a CSP and is not subject to the new fee disclosure requirements. This is due to the fact that all fees are being paid directly and are, presumably, readily identifiable.

However, assume that the same firm regularly partners with an insurance company for recordkeeping services. The insurance company pays the TPA a marketing allowance based on the combined assets of all mutual clients. That marketing allowance is indirect compensation, making the TPA a category 3 CSP.

Other Providers

Whether other providers are CSPs depends largely on how they are compensated. Attorneys and accountants generally will not be CSPs since their typical compensation structures do not include indirect compensation. The regulations require that the fees paid to affiliates or subcontractors of a CSP must also be disclosed, so it is important to consider the relationships service providers may have with other companies. Since those affiliates often have no direct relationship with the plan, the CSP must include their compensation with its disclosure.

Regardless of the category, a service provider must have a reasonable expectation that its fees will be $1,000 or more under the life of its contract with the plan in order for it to be a CSP.

What must be Disclosed?

There is quite a list of information a CSP must provide to a covered plan. It is all designed to help plan fiduciaries understand the fees being paid and the services to which they relate. In addition, full disclosure of all compensation will help highlight any potential conflicts of interest in the recommendations that service providers make to their clients.

Who: The CSP must identify itself and, if applicable, provide a written statement that it will provide services as a fiduciary or a Registered Investment Advisor.

What: The CSP must identify the services it provides to a plan under the contract or arrangement.

How: The CSP must describe how it will receive each category of compensation. For example, some fees may be directly billed to the plan, while others may be deducted from investment returns or paid via revenue sharing.

How Much: The CSP must report all direct and indirect compensation paid to itself and/or any affiliates and should include anything of monetary value, e.g. gifts, trips, etc. The fees should be tied to the services to which they relate, and for indirect compensation, the payer must also be identified. If recordkeeping is part of a bundle of services and the CSP is unable to determine the portion of total compensation related to that service, the CSP must provide a reasonable, good-faith estimate or use the prevailing market rate for similar services. If there are any fees related to the termination of the agreement, the CSP must disclose those in addition to providing a description of how any pre-paid amounts will be pro-rated and refunded.

In addition to the above, fiduciary CSPs are required to provide general information about the investment options offered under the plan, including expense ratios, wrap fees, historical rates of return, comparisons to benchmarks, etc.

When must the Information be Disclosed?

The goal of the regulations is to ensure plan fiduciaries have the information to determine if a service provider's fees are reasonable in advance of making the hiring decision. If a plan has already hired a service provider that is a CSP, the CSP must provide the initial disclosures no later than July 1, 2012. For all future arrangements, the CSP must disclose "reasonably in advance of the date the contract is entered into, extended or renewed." The inclusion of the words "extended or renewed" can present a trap for the unwary. It is not uncommon for a contract to expire (after one or two plan years) and automatically renew each year thereafter. In those instances, the disclosures must be provided each year prior to the renewal date.

In many situations, the investment menu is not determined until after the contract is signed. How can the CSP provide all the investment disclosures in advance? If this circumstance occurs, the investment information must be provided no later than 30 days after the CSP knows which platform, funds, etc., will be used.

When any of the previously disclosed information changes, the CSP must communicate those changes as soon as possible but no later than 60 days after becoming aware of the change.

What are the Consequences of Non-Compliance?

The DOL has made compliance an integral part of the reasonable fee requirement; therefore, if there is no disclosure, the fees are automatically deemed unreasonable. That means there is a prohibited transaction. The non-disclosing CSP is subject to an excise tax equal to 15% of the amount involved and may be required to unwind the arrangement by returning the fees collected.

Prohibited transaction penalties usually apply to all parties involved, which means the plan representative making the hiring decision (the responsible plan fiduciary) may also be on the hook. However, the regulations provide some relief if the responsible plan fiduciary did not know the CSP was non-compliant and, immediately upon discovering the failure, made a written request to the CSP for the required disclosures. If the CSP does not respond to the request within 90 days, in order to avoid liability for the prohibited transaction, the responsible plan fiduciary must notify the DOL in writing of the CSP's failure and may be required to fire the CSP.

When are the New Rules Effective?

The service provider fee disclosure rules are effective on July 1, 2012. In addition, since the participant-level fee disclosure rules are so closely linked, their effective date has also been pushed back to July 1st. For existing service provider arrangements, plan sponsors should expect to receive the required disclosure information no later than that date. The initial annual participant disclosure is due August 30, 2012 (60 days after the effective date) and the initial quarterly participant disclosure is due November 14, 2012 (45 days after the close of the first quarter after the effective date).

It will be interesting to see how these new rules unfold. But one thing is for sure… plan sponsors and participants will not have any shortage of reading material by the end of this year.

This information is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.

© 2012 Benefit Insights, Inc. All rights reserved.

Given the complex nature of administering qualified retirement plans in accordance with ever-changing pension law, mistakes are inevitable. When the IRS discovers plan mistakes through audit, the plan risks being disqualified which results in severe consequences to the plan sponsor and participants.

Fortunately, the IRS recognizes that mistakes are a fact of life and has responded by developing voluntary error resolution programs. It has also posted on its web site the top ten failures reported through these resolution programs. Since the IRS recently announced its intent to conduct more audits this year, plan sponsors should become aware of the more common types of compliance problems and, if found in their plans, voluntarily correct errors by using the IRS correction programs rather than take a chance that an audit will reveal the mistakes.

Plan Disqualification

In order to reap tax advantages, qualified plans are responsible for complying with complex IRS requirements. Failure to meet these requirements can lead to plan disqualification which results in severe consequences including:

• Prior corporate deductions are reversed;
• The plan trust becomes taxable;
• Participants are subject to immediate income taxation of vested contributions made on their behalf and cannot roll over these amounts into an IRA or another qualified plan; and
• Plan fiduciaries may face the risk of lawsuits by participants who were forced to prematurely recognize income.

To create awareness of common errors that may result in plan disqualification, the IRS has released the following list of the top ten failures found in the Voluntary Correction Program.

Top 10 Plan Qualification Failures

1. Failure to timely adopt amendments required by tax law changes.
    
2. Failure to follow the plan definition of compensation for determining contributions. This error results when certain types of compensation are incorrectly excluded or included (such as bonuses, commission or overtime) which can result in participants receiving either higher or lower contributions than the amount they should have received.
    
3. Failure to include eligible employees in the plan or failure to exclude ineligible employees from the plan. By making this mistake, eligible employees may not receive contributions they are entitled to receive. Conversely, the employer may be making contributions for employees who are not entitled to receive contributions.
    
4. Failure to satisfy loan provisions. Errors regarding loan provisions include failure to withhold loan payments which results in a defaulted loan, issuing loans that exceed the maximum dollar amount (generally the lesser of 50% of the vested account balance or $50,000) and loans with non-compliant payment schedules.
    
5. Impermissible in-service withdrawals. This failure can occur when a distribution is made to a participant and the law or plan terms do not permit a distribution. For example, making a hardship distribution even though the plan does not permit hardship withdrawals.
    
6. Failure to satisfy the minimum distribution rules. In general, participants who fall into the following two categories must begin receiving minimum distributions: (1) more than 5% owners who have reached age 70½, even if they are still actively employed; and (2) non-owner employees who have terminated employment and have reached age 70½.
    
7. Employer eligibility failure. In this failure an employer adopts a plan that it legally is not permitted to adopt. For example, the adoption of a Code Section 403(b) plan by an employer that is not a tax-exempt organization.
    
8. Failure to pass ADP/ACP nondiscrimination tests. This failure can occur for a variety of reasons including incorrectly classifying employees as either Highly Compensated or non-Highly Compensated employees, using incorrect compensation for testing purposes or excluding from the test eligible employees who elected not to participate in the 401(k) plan.
    
9. Failure to properly provide top heavy contributions to non-Key employees. In general, a plan is considered to be top heavy if more than 60% of the plan assets are for Key employees. If the plan is top heavy, non-Key employees are entitled to receive minimum contributions. One error that can occur is not using total compensation to calculate the minimum contribution--total compensation must be used even if the plan has a different definition of compensation for allocation purposes. Also, a 1,000 hour requirement cannot be imposed even if it is required by the plan for allocation purposes.
    
10. Exceeding the annual contribution limits. The law limits the annual amount of contributions a participant can receive in a defined contribution plan. The annual limit is the lesser of 100% of compensation or an indexed dollar amount ($49,000 for 2009). If not monitored correctly, this limit can be exceeded when taking into account the total of all employer contributions, employee deferrals and forfeitures allocated to the participant's account (all plans sponsored by the employer and related employers must be aggregated for purposes of this limitation).

Plan sponsors who uncover plan qualification failures, such as those listed above, should promptly take advantage of the IRS's Employee Plans Compliance Resolution System.

Employee Plans Compliance Resolution System (EPCRS)

EPCRS is a series of correction programs that can be used by plan sponsors to correct common plan failures and bring the plan back in compliance. "I'm from the government and I'm here to help" is actually true in this case! These programs may be used to correct qualification failures which generally fall into three categories:

• Plan Document Failures: Failure of the document to conform to the Internal Revenue Code and IRS regulations. Plan sponsors who fail to timely adopt required plan amendments fall within this group.

• Operational Failures: Includes failure to follow the terms of the plan document, such as failure to cover eligible employees, failing to satisfy the top heavy requirements and failing the ADP and ACP tests for 401(k) plans.

• Demographic Failures: Failure to meet minimum participation, minimum coverage or nondiscrimination requirements.

The IRS has provided pre-approved methods for correcting many types of common failures. The typical correction method is to put the plan and participants in the position they would have been had the plan been administered correctly. This may require additional contributions (plus earnings) for certain participants. In some cases, the failure can be corrected by a retroactive amendment to the plan. Below is an overview of the three EPCRS programs.

Self Correction Program (SCP)

SCP allows qualified plan sponsors to correct operational failures without filing with the IRS or paying a penalty tax. The program allows the correction of both insignificant defects as well as, in limited circumstances, significant defects. SCP cannot be utilized for demographic and plan document failures or if the failure is egregious. The plan must have established practices and procedures (formal or informal) designed to promote overall plan compliance.

Plan sponsors should document the steps that were taken for fixing the failure in case they are later asked to justify their actions and should also put administrative procedures in place so the mistake does not happen again.

Generally, in order for a correction to be considered insignificant, it must be an isolated incident, and the plan must otherwise have a history of compliance in all other areas. Several factors need to be analyzed to determine if the correction is deemed insignificant including the number of errors that occurred, the percentage of plan assets and contributions involved in the error and the number of plan participants affected.

Insignificant defects can be corrected at any time following discovery. Also, SCP can be utilized for insignificant defects even if the plan is already under examination by the IRS.

Significant Corrections

To be eligible to utilize SCP for a significant operational failure, the plan must have a current determination letter or, in the case of a pre-approved plan, an opinion letter. For significant corrections, SCP is not available if the plan is already under examination by the IRS.

Significant failure correction must be completed, or substantially completed, by the end of the second plan year following the plan year in which the error occurred.

Voluntary Correction Program (VCP)

Defects that are not eligible for SCP, such as significant operational defects beyond the two-year correction period, plan document failures or demographic failures, may be corrected using VCP. This program is not available if the plan is already under examination by the IRS.

The plan sponsor submits an application to the IRS outlining the failures and proposed correction methods and also pays a fee based on the number of participants. The IRS reviews the application and issues a Compliance Statement setting forth the agreed terms of correction.

If a plan sponsor is hesitant about disclosing plan failures to the IRS, a John Doe submission can be filed which allows the plan sponsor to propose a correction to the IRS anonymously. After a correction method is agreed upon in writing, the plan and plan sponsor are then identified.

Audit Closing Agreement Program (Audit CAP)

Audit CAP is available for problems that were not corrected voluntarily but instead were discovered during an IRS audit. By utilizing Audit CAP, the plan avoids the consequences of disqualification. In addition to correcting plan defects, the plan sponsor must pay a penalty equal to a percentage of the amount of tax that would have been due if the plan were disqualified. The fee is generally negotiated based on the severity of the failure.

Conclusion

Because of the severe penalties associated with plan disqualification, plan sponsors should be aware of and on the lookout for common plan failures. Frequent internal audits of all aspects of plan administration can quite possibly prevent insignificant defects from becoming significant.

If the plan sponsor discovers any instance of noncompliance, the plan's advisors should be consulted to help determine the appropriate correction method. Fortunately, there are several EPCRS programs available for voluntarily correcting plan failures. The least expensive way to correct defects is to discover them early and before the IRS.

This information is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. You should not act or rely on any information in this newsletter without first seeking the advice of a qualified tax advisor such as an attorney or CPA.

© 2009 Benefit Insights, Inc. All rights reserved.

Every qualified retirement plan has a specific deadline by which employer contributions must be deposited to the plan for each plan year. However, the rules concerning participants' contributions have not been as clear. For example, in 401(k) plans, employees typically defer a portion of their weekly or biweekly paychecks. How soon should these contributions be deposited into the plan?

The question of when participant salary deferrals must be deposited into the plan is a long-standing issue and one about which the Department of Labor (DOL) has been quite vocal. The DOL has also been very active and aggressive in its enforcement in this area. Fortunately, final regulations issued earlier this year have provided welcome guidance for plans sponsored by small employers.

Plan Asset Rule

The regulation describing the deposit requirement is sometimes referred to as the "plan asset rule" since it actually specifies the timing within which participant contributions are deemed to become assets of the plan. This translates into a deposit deadline because it is considered an illegal loan from the plan if an employer is still holding those amounts on or after the date they are deemed to be plan assets. Pre-tax salary deferrals and after-tax employee contributions withheld from payroll as well as loan repayments are considered participant contributions for purposes of the rule.

General Deposit Timing Rule

There are two tests to determine when deferrals have become plan assets and, thus, whether they have been timely deposited. The better known of the two specifies that deferrals become plan assets, at the latest, on the 15th business day of the month following the month in which they were withheld from employees' paychecks. For example, any deferrals withheld during the month of May become plan assets, at the latest, as of the 15th business day of June.

The second test provides that, if it is possible for a plan sponsor to segregate deferrals from its general assets earlier than the 15th business day of the following month, then those deferrals become plan assets as soon as it is reasonably possible to segregate such amounts. This rule presents several operational issues to consider.

It is not uncommon for an employer to have several payroll periods in a month but to wait to deposit salary deferrals until after the final payroll of that month. However, the DOL has indicated that, if it is administratively possible to make a deposit within a certain number of days following the final payroll of the month, it should also be possible to make a deposit within the same number of days after each mid-month payroll. Therefore, any mid-month salary deferrals and loan repayments held and deposited with the final monthly payroll would be considered delinquent.

Example

ABC Company, Inc. has biweekly payroll with pay dates of Friday, April 16 and Friday, April 30, 2010. Salary deferrals for both pay periods are deposited on Wednesday, May 5th. Since the date of deposit is only 3 business days following the last pay date in April, the DOL would likely assert that deferrals from the April 16th payroll should have been deposited no later than April 21st and treat them as 14 days delinquent.

The Confusion

Since what is "reasonably possible" is open to interpretation, there has been a great deal of confusion in the industry as to how to appropriately determine when deferrals become plan assets. This confusion has been fueled by inconsistent DOL enforcement of the issue. For example, in some regions of the country, DOL investigators have treated 10 to 12 calendar days following payroll as timely while other regions have enforced a 3 to 5 calendar day standard. They set the standard and require plan sponsors to present evidence that a longer timeframe should be allowed.

To make matters more challenging, some DOL investigators have claimed the rule requires that deferrals not only be deposited within the requisite timeframe but also allocated to participant accounts and invested. In an effort to comply with such an ambiguous rule, some employers have gone to the other extreme and deposited deferrals as soon as they knew the amounts, even if prior to the actual payroll date.

While such an approach solves the DOL issue, it creates another problem in that IRS regulations prohibit depositing deferrals prior to the pay date to which they relate.

Safe Harbor Deadline Offers Welcome Guidance for Small Plans

Earlier this year, the DOL finalized new regulations that provide much needed clarity to this rule. In short, the new regulations create a safe harbor timeframe in which to deposit employee contributions and loan repayments. As long as those amounts are deposited into the plan no later than the 7th business day following payroll, they are deemed to be timely, even if the employer is able to make the deposit earlier.

The regulations also clarify that it is only the deposit, not the allocation or investment, that must occur within the requisite window.

While the new guidance removes much of the ambiguity, there are several important points to note. First, as with other plan-related safe harbors, the 7-day safe harbor is optional. Employers who choose to make deposits outside of this window or do so inadvertently lose reliance on the safe harbor and are judged by the "as soon as reasonably possible" standard which may call for a 3 to 5 day deposit window. Thus, a deposit on the 8th day will not be considered one day late—it will be 3 to 5 days late.

Second, the safe harbor is only available to plans with fewer than 100 participants as of the first day of a given plan year. While many plan sponsors may define a participant as someone who is actively contributing to the plan, the DOL considers anyone eligible to make contributions to be a participant in addition to terminated employees who still have plan balances. This means that larger plans cannot assume that the DOL will consider deposits made within 7 business days to be timely.

What's the Worst that can Happen?

As noted above, the DOL treats late deposits as a loan of plan assets to the plan sponsor. Such a loan is a "prohibited transaction" (PT) and a breach of fiduciary responsibility. As a PT, the delinquency subjects the plan sponsor to a 15% excise tax. The excise tax is applied again for each year (or portion of a year) in which the PT remains uncorrected.

In addition, another PT, subject to its own excise tax, is deemed to occur each year until correction is made. This is often referred to as a cascading or pyramiding excise tax. There is no proration based on the number of days that elapse, so even though a PT occurs near the end of the year, the full excise tax applies.

Form 5500 Reporting of Late Deposits

Late deposits are required to be reported each year on Form 5500 (line 4a of Schedule H or I, whichever is applicable). New rules imposing penalties on service-providers who improperly complete Form 5500 make it unlikely preparers will "look the other way" on this reporting requirement even if the deposit is only a few days late. In addition, CPAs who audit large plans are required to review the timeliness of deferral deposits and note any delinquencies in their reports.

As if the above isn't enough, the DOL issues monthly press releases announcing lawsuits it has filed against large and small companies alike for failure to timely remit salary deferrals of amounts as low as $5,000.

Further, the DOL recently announced the Contributory Plan Criminal Project that could result in criminal prosecution of employers who "may convert employee payroll contributions for their own personal use or may use employee contributions to pay business expenses."

The Fix is In

Since there are numerous avenues for the DOL to become aware of delinquencies, it is in an employer's best interest to voluntarily take corrective action as soon as possible before an investigator knocks at the door. The DOL's Voluntary Fiduciary Correction Program (VFCP) provides specific guidance on how to correct a late deposit.

Step 1

Deposit all outstanding delinquent amounts as soon as possible.

Step 2

Provide an additional contribution to participants to make them whole for any lost investment earnings. This is required even if the stock market has had negative returns during the timeframe in question.

The DOL provides an online calculator on its website to use to determine the lost earnings amount. The following information is required to use the calculator:

• Amount of late deferrals;
• Loss Date: The date the deferrals should have been deposited;
• Recovery Date: The date the deferrals were actually deposited; and
• Final Payment Date: The date the lost earnings amount will be deposited.

If multiple payrolls are delinquent, each must be entered separately into the calculator.

Step 3

Submit documentation of the correction to the DOL and request a no-action letter.

Some employers choose to make the corrective contributions but forego the formal submission. While that approach may make the participants whole, the employer does not have any assurance against DOL action and must still pay the excise tax. As long as the deferrals in question were not more than 180 days delinquent and the employer follows VFCP to apply for a no-action letter, the excise tax is waived.

Conclusion

The new safe harbor regulation greatly clarifies the deposit requirement for employers that sponsor smaller 401(k) plans. Those who choose not to avail themselves of this relief should carefully review their process for transmitting employee contributions to their plans and maintain careful documentation describing the amount of time it takes to complete the process each pay period as well as an explanation of why it cannot be completed more quickly.

The DOL has made it clear that it plans to continue actively enforcing the deposit timing rules, to ensure employee contributions are used for the purpose for which they were intended. Therefore, it is important for all plan sponsors to review their deposit procedures to ensure contributions are being made on a timely basis.

This information is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. You should not act or rely on any information in this newsletter without first seeking the advice of a qualified tax advisor such as an attorney or CPA.

© 2010 Benefit Insights, Inc. All rights reserved.

Designated Roth contributions (a/k/a Roth 401(k) or Roth deferrals) have been available since 2006, but a change in the tax laws governing Roth IRAs has reenergized discussions about this feature. This article is in Q&A format and addresses some of the more common questions about Roth 401(k) contributions. But first, a brief overview…

Traditional deferrals reduce a participant's income for federal and, in most cases, state tax purposes at the time of contribution. Those amounts grow on a tax-deferred basis until the participant takes a distribution, which is taxable as ordinary income. Roth deferrals are fully taxable to the participant at the time of contribution. However, if certain requirements are met, so-called "qualified distributions" of Roth deferrals and the earnings thereon are completely tax free.

Apart from the tax differences, Roth deferrals are treated the same as traditional deferrals for all plan purposes. The normal limits and non-discrimination requirements apply. Roth deferrals are also subject to the same withdrawal restrictions, i.e. death, disability, retirement, financial hardship, etc.

What types of plans can allow Roth deferrals?

Both 401(k) and 403(b) plans can include a Roth component.

Are there any income restrictions preventing higher wage earners from making Roth 401(k) contributions?

No. Unlike Roth IRAs, any employee eligible for the plan can make Roth deferrals regardless of income.

What are the limits on the amount of Roth deferrals a participant can contribute?

The salary deferral limit is $16,500 for 2010. Roth and pre-tax deferrals are added together for purposes of this limit.

Can catch-up contributions be designated as Roth deferrals?

Yes. Catch-up contributions merely represent an increase in the regular deferral limit for those who are catch-up eligible.

What is all the buzz about Roth conversions in 2010?

Prior to 2010, those above a certain income threshold (generally $120,000 for individuals and $176,000 for married couples) were not permitted to make Roth IRA contributions. Starting this year, that income cap is removed for those who wish to convert non-Roth IRAs into Roth IRA accounts. The amounts converted must be included in taxable income; however, those who convert during 2010 have the option to spread that tax liability equally over two years.

Can a participant elect to convert pre-tax 401(k) deferrals into Roth 401(k) deferrals?

No. The regulations make it very clear that when a participant elects to make pre-tax deferrals, that election is irrevocable. While the participant may change how future contributions are designated, existing contributions cannot be converted within the plan. However, there has been discussion on Capitol Hill about changing the law to allow conversions inside the 401(k) plan similar to the IRA conversions that are allowed beginning in 2010.

Can Roth 401(k) accounts be directly rolled over into another 401(k) plan or a Roth IRA?

Yes. Roth accounts from a qualified plan or 403(b) plan can be rolled into another qualified plan or 403(b) plan that allows Roth contributions. These amounts can also be rolled into a Roth IRA.

Can a Roth IRA be rolled over into a Roth 401(k) or 403(b)?

No. Roth IRAs can only be rolled into other Roth IRAs.

What are the requirements that must be satisfied to receive a tax-free distribution from a Roth account?

A participant must complete a so-called five-year period and the distribution must occur on or after attainment of age 59½, death or disability. A tax-free Roth distribution is referred to as a qualified distribution.

What is the five-year period and when does it start?

The five-year period is generally a holding period a participant must satisfy to take a qualified distribution. It begins on the first day of the first taxable year in which a participant first makes Roth deferrals to the plan. For example, if a participant makes his first Roth deferral on October 1, 2010, the five-year period starts on January 1, 2010.

Is the plan sponsor or the participant responsible for tracking the five-year period?

Plan sponsors and their service providers are required to track the Roth five-year period as well as the amount of basis for each participant. This requirement is likely to present significant record-keeping challenges, especially in takeover situations.

Does the five-year period start over when a participant goes to work for another company and makes Roth deferrals into his new employer's plan?

It depends. If the participant rolls over his Roth account to the new plan, the portion of the five-year period already satisfied is transferred to the new plan. However, if the participant does not roll over the Roth account, his five-year period starts over with respect to contributions to the new plan.

Is there any coordination between the Roth 401(k) and Roth IRA five-year periods?

No. The two five-year periods are determined independently of one another. Thus, a rollover of a Roth deferral account into a Roth IRA requires the five-year period to be redetermined.

What happens if a participant takes a loan from the Roth account and then defaults, requiring deemed distribution of the outstanding balance?

A deemed distribution of a participant loan is never treated as a qualified distribution even if it occurs after the participant has satisfied the five-year period and attained age 59½, died or become disabled. Therefore, the portion of the deemed distribution attributable to Roth is subject to income tax. To avoid confusion in this area, the loan policy can be written to restrict participant loans to non-Roth accounts.

Do Roth deferrals affect ADP testing?

Yes. Roth deferrals are included with pre-tax deferrals for purposes of the ADP test. However, since Roth deferrals are not tax-deductible, lower-paid participants may be unable to defer at the same level as with pre-tax deferrals.

Example: Marge earns $50,000 and has $5,000 available to save for retirement. She is in a combined 25% tax bracket. If Marge makes pre-tax deferrals, she can contribute the full $5,000 to the plan. However, if Marge makes Roth deferrals, she must pay $1,250 (25% of $5,000) in taxes, leaving her with only $3,750 to contribute to the plan. Since Marge is a non-highly compensated employee, her lower deferral percentage would have a negative impact on the ADP test.

Employers may want to consider a safe-harbor 401(k) plan if they are likely to experience this situation.

Can availability of Roth deferrals be restricted to those whose incomes are high enough to maximize their contributions?

No. The availability of Roth deferrals is subject to the minimum coverage rules for 401(k) plans and the universal availability rules for 403(b) plans.

Are Roth deferrals considered when calculating the employer matching contribution?

Unless plan terms specify otherwise, pre-tax and Roth deferrals are both considered in the employer match calculation. Matching contributions are always treated as tax-deferred regardless of whether Roth deferrals are used in the calculation.

Are Roth deferrals subject to Required Minimum Distributions?

Yes. The regulations specifically provide that Roth deferrals are subject to the required minimum distribution rules. This is in contrast to Roth IRAs which do not require minimum distributions. It appears that a participant may avoid required minimum distributions on Roth deferrals by rolling over these amounts to a Roth IRA prior to the attainment of age 70½.

Do the automatic IRA rollover rules apply to Roth deferrals?

No. Roth and pre-tax accounts are considered separately for purposes of the automatic rollover rules. Therefore, to the extent the Roth and/or pre-tax portion of a participant's account is less than $1,000, it is not required to be automatically rolled over even though the combined vested account balance may exceed $1,000.

Can a plan that does not otherwise allow Roth contributions accept a Roth rollover?

No. Regulations clearly state that a designated Roth account can only be rolled over into another 401(k) or 403(b) plan that has a designated Roth program.

Is the employer required to report any information at the time Roth deferrals are contributed to the plan?

Yes. Employers must report Roth deferrals in box 12 of Form W-2 with code AA for 401(k) plans and BB for 403(b) plans.

How are Roth distributions reported on Form 1099-R?

Roth distributions must be reported on a separate Form 1099-R using Code B. The non-taxable basis is reported in Box 5, and the beginning of the five-year period is reported in an unnumbered box next to Box 10.

Are there any reporting requirements for a participant who elects Roth deferrals?

No. The participant is not required to report any additional information with respect to Roth 401(k) or 403(b) contributions. However, a participant rolling over a Roth deferral account into a Roth IRA must keep track of the rollover amounts and the five-year period with respect to the IRA.

Which is better for participants — Roth or pre-tax deferrals?

The answer to this question depends on each individual's financial situation and is beyond the scope of this article. Factors such as current and future tax brackets, estate planning needs and more will impact the decision, so participants should consult their tax and/or legal advisors for assistance in reviewing all of the relevant facts and circumstances.

Conclusion

While Roth IRAs are enjoying significant publicity due to the change in the conversion rules, it is interesting to note that there has not been significant implementation of the feature in 401(k) plans. According to the Profit Sharing/401(k) Council of America's 52nd Annual Survey, 36.7% of plans allowed Roth contributions in 2008; however, only 15.6% of participants that had the Roth option available elected to take advantage of it.

Plan sponsors who are considering Roth 401(k) deferrals should consult with their advisors and service providers to review the potential advantages and disadvantages that the Roth feature provides.

This information is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. You should not act or rely on any information in this newsletter without first seeking the advice of a qualified tax advisor such as an attorney or CPA.

© 2010 Benefit Insights, Inc. All rights reserved.

The continuing popularity of the 401(k) plan has made it the most widely used savings plan in the country. As employers have had to shift limited resources to cover the ever-increasing cost of other benefits, the ability for employees to contribute to their retirement savings helped to ensure the continuation of these plans.

There are numerous regulations that govern 401(k) plans by encouraging broad based participation and preventing owners and highly paid employees from receiving disproportionately greater benefits than other employees. Plans must either satisfy a series of nondiscrimination tests each year or be designed to satisfy certain "safe harbor" standards that are predetermined not to be discriminatory.

While the term "safe harbor" is used in many different retirement plan contexts, it has a very specific meaning when it comes to 401(k) nondiscrimination tests. Before considering the specifics, it is helpful to have a general understanding of the nondiscrimination rules.

Nondiscrimination Testing

Contributions to a 401(k) plan may include employee salary deferrals, employer matching contributions and/or profit sharing (a/k/a nonelective) contributions. Each year, the plan must demonstrate that contributions for highly compensated employees (HCEs) are not disproportionately larger than those for non-HCEs (NHCEs). HCEs are generally owners of more than 5% of the company and any employee with compensation in the prior plan year over a specified level ($110,000 for 2009 and 2010).

The actual deferral percentage (ADP) test and the actual contribution percentage (ACP) test are run after the end of each plan year. The ADP test compares the average deferral rate for the HCE group to that of the NHCE group. In most cases, as long as the HCE average is not more than 2 percentage points greater than the NHCE average, the test passes. The ACP test works the same way except that it analyzes employer matching contributions. Consider this example:

Elaine owns a small company and has one employee, Mark, who earns $150,000 per year. She has eight other employees who all earn under $100,000 per year. All employees are eligible to participate in the company's 401(k) plan. Elaine and Mark are considered HCEs, while the other eight employees are NHCEs. If the average deferral rate for the NHCEs is 3%, then the average for Elaine and Mark cannot exceed 5%. If Mark defers 2% of his compensation, Elaine could defer up to 8% of her compensation and keep their average at or below 5%.

The top heavy determination is another test that is based on the assets in the plan. If, on the last day of the previous year, the combined accounts of certain company officers and owners (referred to as "key employees") exceed 60% of the plan's total assets, the plan is considered top heavy. Such plans are generally required to provide a minimum contribution of 3% of compensation for all eligible non-key employees. This can come as an unwelcome surprise for employers that had not anticipated or budgeted for contributions to their retirement plans.

Safe Harbor Plan Eliminates Nondiscrimination Testing

The primary benefit of the safe harbor 401(k) plan is that the plan is deemed to automatically satisfy the ADP and ACP tests. This allows HCEs to defer up to the annual dollar limit ($16,500 for 2010) regardless of how much or how little the NHCEs defer. In addition, plans that include only employee salary deferrals and safe harbor contributions (described below) are deemed to satisfy the top-heavy requirements. As a trade-off, safe harbor plans must meet a number of requirements including minimum employer contributions, immediate vesting and participant notices.

Safe Harbor Contributions

The employer can satisfy the contribution requirement by making either a nonelective contribution or a matching contribution on behalf of each eligible NHCE. The contribution can, but is not required to, be made on behalf of HCEs as well.

Nonelective Contribution

The nonelective contribution must be at least 3% of compensation for the plan year for each eligible employee regardless of whether or not they make salary deferral contributions. Compensation earned prior to an employee's eligibility date can be ignored. Plans that allocate profit sharing contributions using a new comparability (a/k/a cross-tested) formula may prefer the nonelective option, because the safe harbor contribution may also be used to satisfy some of the complex testing requirements applicable to such plans.

Matching Contribution

The matching option requires the employer to match participants' elective deferrals at the rate of 100% of the first 3% of compensation deferred, plus 50% of the next 2% of compensation deferred (maximum match of 4%). The employer can choose to make an enhanced match, for example, 100% of the first 4% of compensation deferred, as long as certain guidelines are followed.

Additional matching contributions can also be made, and they will be exempt from the ACP test, as long as:

• They are not based on deferrals in excess of 6% of compensation, and
• If they are discretionary, they do not exceed 4% of compensation.

How the Plan is Established

Any 401(k) plan can be set up as, or amended to become, a safe harbor plan. Generally, safe harbor provisions must be in effect for the entire plan year, although a new plan can be established during the year as long as it will be in effect for at least three months. This can be reduced to as little as one month for newly formed companies with a short initial fiscal year. Existing profit sharing plans without 401(k) provisions can be amended mid-year to become safe harbor 401(k) plans, subject to the three-month requirement.

The plan document must specify whether the plan will use the nonelective or matching contributions formula, and it must address all other safe harbor requirements described below.

Notice Requirement

A notice must be provided to eligible employees within a reasonable period before the beginning of the plan year (or safe harbor effective date). It will automatically be considered timely if distributed 30 to 90 days prior to the beginning of the plan year. For plans that provide for immediate eligibility, new hires should be provided the notice on their dates of hire.

The notice must contain the basic features of the plan, including the safe harbor contribution to be provided and rules relating to elective deferrals, other contributions, withdrawals, vesting, etc. Some details can be provided by reference to the Summary Plan Description.

Safe harbor plans using the nonelective contribution can be designed as "maybe" plans. Such a design requires that two notices be provided to participants. The timing of the first notice is the same 30 to 90 days described above, and it must inform participants that the employer might make a safe harbor contribution for the coming year. The second notice is provided 30 to 90 days before the end of the year and informs participants whether or not the contribution will be made. In addition to satisfying this expanded notice requirement, the "maybe" provisions must be reflected in the plan document.

Other Rules

Safe harbor employer contributions must be fully vested and are not available for in-service distribution prior to age 59½. An eligible participant cannot be required to work a specified number of hours or be employed on the last day of the plan year in order to receive the safe harbor contribution.

Suspension of Contribution

The safe harbor matching contribution can be eliminated during the year by adopting a formal plan amendment and providing notice to participants 30 days prior to the effective date. Contributions must be made through the end of the 30-day period. Plans making this change lose safe harbor status for the entire year, subjecting them not only to the ADP/ACP tests but also to the top heavy minimum contribution requirement which could be more expensive than the safe harbor match would have been.

As a result of the struggling economy, the IRS issued proposed regulations in 2009 (which can be relied upon pending final regulations) that also allow employers to suspend safe harbor nonelective contributions if they are experiencing a substantial business hardship. This is determined based upon whether or not:

• The employer is operating at an economic loss;
• There is substantial unemployment or underemployment in the trade of business and in the industry concerned;
• The sales and profits of the industry concerned are depressed or declining; and
• It is reasonable to expect that the plan would not continue unless the contributions are reduced or suspended.

The 30-day notice and testing requirements that apply to the suspension of safe harbor matching contributions also apply to the suspension of safe harbor nonelective contributions.

Automatic Enrollment Safe Harbor

A modified version of the safe harbor plan is available for 401(k) plans that contain automatic enrollment features. They provide that eligible employees will automatically defer a specified percentage of their compensation into the plan unless they elect not to participate, and the default deferral rate must generally escalate each year.

The rules for so-called Qualified Automatic Contribution Arrangements (QACA) are similar to the regular safe harbor rules, except that the QACA matching requirement is 100% of the first 1% of compensation deferred, plus 50% of the next 5% of compensation deferred (maximum match of 3.5%). In addition, safe harbor contributions under the QACA must be 100% vested after two years of service rather than the immediate vesting required of traditional safe harbor plans. The participant notice must contain additional information describing the automatic enrollment features.

Eligible Combined Plan

Beginning in 2010, there is a new type of safe harbor plan that includes the combination of a 401(k) and a defined benefit formula in the same plan. In order to qualify for this arrangement, the plan must include an automatic enrollment 401(k) provision, a safe harbor match or nonelective contribution as well as a minimum defined benefit. The so-called DB(k) plan is only available for employers with fewer than 500 employees and is so new that the IRS has not yet issued regulations describing the mechanics of how the plans are supposed to operate.

Conclusion

A safe harbor design is an excellent way for many employers to get the most out of their 401(k) plans. By eliminating ADP/ACP nondiscrimination testing, all employees can contribute up to the annual deferral limit and not be concerned about the possibility of refunds after year-end. Safe harbor contributions may also eliminate top heavy requirements and can be coordinated with other contribution allocations. There is much to like about the safe harbor 401(k) plan.

This information is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. You should not act or rely on any information in this newsletter without first seeking the advice of a qualified tax advisor such as an attorney or CPA.

© 2010 Benefit Insights, Inc. All rights reserved.

USA Today recently ran an article describing how many companies are using alternative work arrangements to meet staffing needs during the economic recovery. Such arrangements may include use of leased employees, independent contractors or part-time/seasonal workers, all of which are commonly referred to as contingent workers.

One of several reasons often cited is the savings in benefit-related costs; however, it takes careful planning to ensure benefit plans properly reflect those intentions. The analysis generally requires employers to answer three key questions:

1. Which workers are legally considered to be my employees?
2. What does my plan document say about employees?
3. Will my plan be considered discriminatory if I exclude certain workers?

Who Are Your Employees?

You may be thinking, "Of course I know who my employees are!" However, the answer can be much more complex than it seems and has tripped-up many well-intentioned companies. In fact, employers as large as Microsoft, Coca-Cola and Time Warner have found themselves in litigation over this very issue.

To avoid the complexities, some employers simply include all workers in their benefit plans, but this option also has its drawbacks. The federal laws governing retirement plans mandate that plans be maintained and operated for the exclusive benefit and in the best interest of employees. By covering workers that are not employees, a plan sponsor violates this foundational rule.

Perhaps the easiest way to examine the situation is through a series of examples, so let's consider the following basic fact pattern:

Spencer is a college student who is home for break and looking for work. Shady Oaks Golf Club is looking for temporary help but does not need to bring on full-time employees. Spencer speaks to Aaron, the hiring manager at Shady Oaks, and they discuss several arrangements.

Independent Contractor

Aaron tells Spencer that he can come on board as an independent contractor. He will work as a groundskeeper and is to report to work daily from 7:30 a.m. to 5:00 p.m. and will use the club's equipment. His hourly compensation will be reported on Form 1099, no taxes will be withheld and he will not be eligible for benefits. Both agree to these terms in writing. Is Spencer an independent contractor or an employee?

Unfortunately, it's not as simple as pointing to Aaron and Spencer's agreement or the fact that Spencer will receive a 1099 instead of a W-2. The IRS has provided guidelines for employers to use in its so-called "Twenty Factor Test" which focuses on whether a company, Shady Oaks in this case, has the right to control the worker. Several of the factors include whether the company has the right to:

• Set the work schedule;
• Establish the work location;
• Pay by the time worked rather than by the job or on commission;
• Furnish equipment for the worker's use; and
• Require work-related training.

Based on these criteria, it is likely that Spencer is legally an employee of Shady Oaks even though he is being treated as a contractor. Apart from liability for the payroll taxes it didn't withhold from Spencer's compensation, Shady Oaks may also be required to provide retroactive benefits to Spencer due to the misclassification.

Employees Not Working Full-Time

Aaron hires Spencer as a W-2 employee but specifies that he will not receive benefits, because he is not working on a full-time basis.

This situation is much more straightforward in that Spencer and Aaron both consider Spencer to be an employee of Shady Oaks. The issue is whether or not he is somehow less of an employee such that he can be excluded from company benefits.

In 2006, the IRS issued a Quality Assurance Bulletin to address this issue. It indicates that employees who work other than full-time schedules are still employees and that the plan documents, not employment agreements, must be consulted to determine eligibility for benefits. Examples of classifications that are often mishandled include:

• Part-Time Employees: those who work less than a standard 40-hour work week;
• Temporary Employees: those who are employed for a limited period delineated by specific dates or the duration of a project;
• Seasonal Employees: those who work during a specific season such as retail workers during the holidays or snow-plow operators in winter; and
• Per Diem Employees: those who do not have a set work schedule but are called in as needed.

The list also includes those whose normal work schedule is less than a certain number of hours, e.g. someone who is normally scheduled to work less than 20 hours per week.

Based on the Quality Assurance Bulletin, Spencer is a regular employee whose eligibility for Shady Oaks' retirement plan must be determined by the plan document regardless of the side agreement he made with Aaron.

What Does the Plan Document Say About Exclusions?

Plan documents are generally written to include all employees unless a certain classification is specifically excluded. Common exclusions are independent contractors, union members and non-resident aliens. However, documents can be tailored to a company's needs by excluding others such as students, interns, groundskeepers, etc.

Proper Classification

Proper worker classification is key to knowing if the plan excludes certain individuals. In the 1990s, a group of workers classified as independent contractors sued Microsoft, claiming they were entitled to benefits. Microsoft defended itself by pointing out that the plan document specifically excluded independent contractors. While the court agreed that the exclusion was in place, it ruled that the workers in question were not actually contractors but common law employees; therefore, they did not fall under the documented exclusion. Microsoft was ordered to pay nearly $100 million in back benefits.

While this is a high profile case involving a large company, the IRS is aware of the issue of misclassification and looks for it when auditing plans of all sizes.

Precise Document Language

Classification issues can sometimes be addressed by precise wording in the plan document. The Microsoft case prompted many document amendments to exclude workers classified as independent contractors on the payroll records of the company. This more precise exclusion takes the determination out of the realm of the common law definition of employee and ties it to how the particular plan sponsor classifies workers.

Another example of a classification that may require precision is that of student. If a plan excludes students, is the intention to exclude all students or just college students? What about a senior executive who decides to go back and earn an MBA? That person is a college student. Should he or she now be excluded from the plan? Careful planning and precise wording at the beginning can eliminate much of the frustration and liability that can arise later due to ambiguity.

Election to Waive Benefits

Employers will sometimes indicate that a particular individual waived benefits. In the above examples, Spencer agreed in writing to forego benefits. Again, the plan document must be consulted. Many retirement plans simply do not allow a participant to waive benefits. In that situation, Spencer's waiver cannot be applied to the retirement plan whether he wants the benefits or not. For plans that do allow waivers, regulations prescribe the process. Specifically, the waiver must be in writing, must indicate that it is irrevocable and must be signed before the employee becomes eligible. For a plan that provides immediate eligibility, that means the waiver must be signed before the employee's first day on the job.

What Does the Plan Document Say About Eligibility?

Once it is determined which classifications are covered by the plan, it is necessary to understand the age and service requirements an employee must satisfy to join. The law generally limits the maximum age requirement to 21 and the maximum service requirement to one year (defined as completion of 1,000 hours in a 12-month period) but plans are free to implement more generous rules.

This is where the part-time/seasonal/temporary classifications come into play. As noted above, these individuals must be treated as any other employees. That means if a plan permits employees to join after completion of 30 days of service, seasonal employees who remain employed for more than 30 days become eligible. Similarly, an employee who works 20 hours a week for a year becomes eligible for a plan that imposes the maximum wait of 1,000 hours in a 12-month period (20 hours per week x 52 weeks = 1,040 hours).

Furthermore, regulations require that service be combined for employees who are terminated and rehired within certain timeframes. If Spencer works for Shady Oaks during winter break, spring break and summer vacation all in the same year, his service during all three of those stints is combined to determine if he has worked the requisite 1,000 hours.

The easy solution may seem to be to simply exclude these groups. However, the Quality Assurance Bulletin indicates that doing so will, in most cases, violate the maximum statutory eligibility requirements, in that it indirectly keeps someone out of the plan based on the amount of time they work even though that time may be greater than the one year maximum. It may be possible, however, to exclude these individuals by some other means. For example, if all of Shady Oaks' seasonal employees are groundskeepers like Spencer, they could write their plan document to exclude groundskeepers (type of work) rather than seasonal employees (length of service).

What About Nondiscrimination Issues?

There is one final step to determine if the plan can exclude contingent workers and that is ensuring that the exclusions do not violate the nondiscrimination requirements. The primary test involved is the ratio percentage test. While a full description of the test is beyond the scope of this article, it generally dictates that a plan cannot exclude any more than 30% of its Non-Highly Compensated Employees, i.e. non-owners and those who earn less than $110,000 per year. In other words, if the sum of all the excluded employees is less than 30% of the total number of NHCEs, the plan satisfies the ratio percentage test and the exclusions are permitted.

Conclusion

The use of contingent workers carries many benefit-related issues. It is possible, in many cases, to exclude them from retirement benefits, but all three components discussed above (proper classification, precise document language and a passing nondiscrimination test) are required. Given the complexities involved, it is very important for employers facing this challenge to work with knowledgeable experts who can provide guidance every step of the way.

This information is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. You should not act or rely on any information in this newsletter without first seeking the advice of a qualified tax advisor such as an attorney or CPA.

© 2011 Benefit Insights, Inc. All rights reserved.

The record storage business is booming. A Google search yields pages and pages of links to companies offering to safely and securely store vital personal and/or business records.

As the regulatory environment in which businesses operate becomes increasingly complex, the need to maintain thorough records of various activities becomes increasingly important. Employee benefit plans are no exception. The rights afforded to plan participants are protected by strict legal standards, which means plan sponsors must be able to document that all promised benefits have been provided.

With the number of employees that come and go over time, benefits documentation can pile up very quickly, leading many plan sponsors to ask, "When can I get rid of all this stuff?" As with most questions related to benefit plans, the answer is a resounding "it depends."

The Rules

Both the Internal Revenue Service (IRS) and Department of Labor (DOL) have rules that provide some basic guidance on record retention. Some of these guidelines are derived from the timeframe during which one of the agencies can conduct an audit of an employee benefit plan. This is referred to as the statute of limitations.

IRS Statute of Limitations

Generally speaking, the IRS statute of limitations runs for a period of three years from the date Form 5500 is filed for a given year. The Form 5500 must be filed no later than the end of the 7th month following the close of a plan year. That deadline may be extended by an additional 2½ months. That means that a calendar year plan may file its Form 5500 as late as October 15th of the following year.

Example: A calendar year 401(k) plan files its Form 5500 for the 2007 plan year on October 15, 2008. The IRS statute of limitations remains open, allowing them to audit the 2007 plan year until October 15, 2011.

Those who have been through an IRS audit of their 401(k) plan can confirm that the information requested is quite extensive and covers the entire range of plan operations from plan document maintenance to properly enrolling new participants to withholding the appropriate taxes from distributions.

ERISA Record Retention Requirements

In addition to the IRS statute of limitations, ERISA includes several sections focusing on record retention. ERISA Section 107 requires that anyone filing an employee benefit plan report, such as Form 5500, must maintain sufficient records to support all information included on the report for at least six years from the date the report is filed.

Example: Using the same assumptions from the above example, records to support all data on the 2007 Form 5500 must be retained until October 15, 2014—7 years and 9½ months from the start of the 2007 plan year.

So, does that mean it is finally safe to clean out the filing cabinets every 8 years? Unfortunately, ERISA makes it a little more complicated than that. Section 209 imposes an additional obligation to maintain all records necessary to determine benefits that are or may become due to each employee. In 1980, the DOL issued proposed regulations interpreting this section to mean that records must be retained "as long as a possibility exists that they might be relevant to a determination of the benefit entitlements of a participant or beneficiary."

The Devil is in the Details

The length of time records might be relevant to determine benefits varies from plan to plan and from employee to employee, making it very challenging for plan sponsors to know if and when they can finally dispose of historical plan records. There are any number of situations that may arise well beyond the 8-year timeframe described above.

Schedule SSA/Form 8955-SSA

Consider this example. Employers are required to file Schedule SSA with each year’s Form 5500 to report former participants with balances remaining in the plan. Although the Schedule SSA has been discontinued, the IRS is developing Form 8955-SSA to replace it. While the Schedule SSA did allow employers to "un-report" these participants once they take distributions, it was optional to do so. As a result, it has been somewhat common practice to only add newly terminated employees to the list without ever removing those who have received their benefits.

The information from the schedule is provided to the Social Security Administration. When retirees apply for Social Security benefits, the SSA database notifies them that they may be entitled to benefits from the previous employer’s plan. Without clear records showing the participant already received his plan benefits, it can be very difficult to convince a now-retired, former employee (possibly from several decades ago) that the letter he received from the government is incorrect. The matter can be further complicated when it involves the beneficiary of a deceased former employee.

Beyond Benefits

The need to reference historical records to determine benefits can be triggered by issues extraneous to the plan. Employment disputes are a prime example. The infamous court case involving Microsoft’s misclassification of employees as independent contractors arose from a 1989-1990 IRS payroll-tax audit of the company.

Once it was determined these workers were employees, the question of entitlement to benefits quickly followed. It was not until 1999 that the Ninth Circuit Court of Appeals settled the dispute and awarded back benefits to the misclassified workers. The Microsoft case illustrates how a payroll-tax issue required review of records more than 10 years old to determine benefits.

So, What is the Solution?

Because of the countless variables that exist, there is no one-size-fits-all solution; however, there are several steps plan sponsors can take to point themselves in the right direction.

Take Inventory

One of the first steps to take is to determine what records currently exist and where they are stored. Some may be electronic; some may be in binders; and some may be in boxes in storage. That inventory will highlight any gaps that may need to be filled and provide some perspective to allow the assessment of alternative retention options.

A service-provider’s recordkeeping system may be utilized to track and house information on historical plan activity; however, the determination of benefits is ultimately the responsibility of the plan sponsor. Therefore, copies of all reports generated by the recordkeeper should be maintained. This is especially important when changing service providers as typically they are only required to retain records for a limited period of time.

Review Operational Policies and Procedures

If a plan operates efficiently and consistently, there are likely to be fewer issues that require digging into the archives. For example, consider a review of all previous Schedules SSA that have been filed. If any previously reported participants have received their benefits, un-report them on the next filing and establish a process to do so each year.

As current employees leave the company, take steps to process distributions quickly. Terminated participants with vested balances below $5,000 can generally be forced out of the plan with 30-days advance notice. Any former employees who receive distributions prior to the filing deadline for the Schedule SSA/Form 8955-SSA do not have to be reported.

Use Electronic Storage

Physical storage space can be expensive, so many plan sponsors have turned to electronic storage for some or all of their plan records. While there are no absolute restrictions on maintaining electronic records, there are some practicalities to consider.

Records must be easily accessible. Unreasonable delays in retrieving information can provoke an already disgruntled former employee to take the next step and call his attorney. If the dispute is already being litigated, delays can have a negative impact on the proceedings.

Security is very important. Plan records include everything a thief needs to abscond with the identities of all the participants: social security numbers, birth dates, addresses, etc. Therefore, electronic storage must be secure. This could range from placing inherently unsecure media under lock and key to employing various forms of encryption. Although benefit plans are primarily the purview of federal law, many states are implementing stringent new laws governing the protection of personal information. Employers must be mindful of any such state laws that may be applicable.

Technology changes...quickly. Not only have storage media changed significantly in only the last 15 years but data encryption has also advanced at lightning speed. Just because plan records are securely backed-up using the technology du jour does not mean out-of-sight-out-of-mind. As there are advancements in technology, record retention policies should provide for the occasional migration to more current systems to preserve the integrity and security of the data.

Seek Professional Assistance

Depending on the circumstances and the volume of information in question, it may be prudent to work with an attorney or consultant specializing in record retention requirements. In addition to helping craft a policy, such a professional may also be able to make recommendations for vendors or technologies to most cost-effectively implement the policy.

Records to Retain

Records that should be maintained include (but are not limited to) the following:

• Plan documents, including amendments and determination letters/opinion letters;
• Summary Plan Descriptions and Summaries of Material Modification;
• Company resolutions declaring match and/or profit sharing contributions;
• Participant notices and documentation of the dates and method of delivery;
• Participant elections such as deferral and investment elections;
• Census information including payroll data and employment history;
• Nondiscrimination test results;
• Form 5500 including schedules and attachments;
• Plan account and financial statements;
• Recordkeeping/valuation reports at both the plan and participant level;
• Participant loan documentation including amortization schedules and promissory notes; and
• Participant distribution forms including special tax notices, election forms and 1099-R forms.

Conclusion

Corralling benefit plan records may seem like a daunting task, especially considering the relative infrequency that information must be accessed. Beyond the required seven- to eight-year timeframe plan records must be maintained, it only takes one claim to demonstrate the value of an organized system. As the saying goes, some careful planning and knowledgeable advice will allow creation of an "ounce of prevention" policy to minimize the likelihood of the "pound of cure" dispute years in the future.

This information is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. You should not act or rely on any information in this newsletter without first seeking the advice of a qualified tax advisor such as an attorney or CPA.

© 2010 Benefit Insights, Inc. All rights reserved.

Cash balance plans have enjoyed a recent resurgence in popularity. However, these plans, which can provide tax-deductible benefits as much as five times greater than 401(k) profit sharing plans, have actually existed for more than 30 years. When the Pension Protection Act of 2006 (PPA) resolved much of the legal uncertainty of these plans, small and large companies alike showed a renewed interest. According to a recent research report, the number of cash balance plans increased by more than 23% from 2006 to 2007 and more than 75% of existing cash balance plans are sponsored by companies with fewer than 50 employees.

What is a Cash Balance Plan?

Before answering this question, some general background information helps put the discussion in context. A defined contribution (DC) plan, such as a 401(k) profit sharing plan, dictates the contributions that go into the plan each year. Contributions, which are usually discretionary, include employee salary deferrals, employer matching contributions and employer profit sharing contributions. The maximum amount a participant can receive in a DC plan each year is $49,000 for those under age 50 and $54,500 for those age 50 or older. These contributions and the investment returns they generate determine a participant's ultimate retirement benefit.

A defined benefit (DB) plan promises a benefit using a formula that is usually based on compensation and years of service. For example, a DB plan might provide an annual benefit equal to 1% of average compensation for each year of service. If a participant has average compensation of $65,000 over 10 years with the company, the annual benefit is equal to $6,500 ($65,000 x 1% x 10 years of service) for the rest of the participant's life.

Rather than limiting contributions, the IRS limits the maximum annual benefit a DB plan can provide to a participant to $195,000 per year. The contribution is a function of how much is needed to fund the promised benefits. While there are a number of variables, the following table summarizes the tax-deductible contributions to fund maximum benefits for DB participants of different ages:

The employer is said to bear the investment risk because the higher the return on investment, the lower the portion of the funding that must come from the company and vice versa. To the extent a DB plan is not fully funded, contributions are generally required each year.

A cash balance plan is a type of plan that is sometimes referred to as a hybrid plan, because it includes both DB and DC characteristics. Cash balance plans generally express benefits in the form of contributions much like a DC plan while requiring regular funding of those promised benefits like a DB plan.

Contribution Credits

Unlike traditional DB plans that express benefits using a formula that can appear esoteric to the average employee, cash balance plans express benefits using specific contribution crediting rates that could be percentages or flat dollar amounts. For example, the plan might provide for an annual contribution credit equal to $1,000 per participant or 5% of each participant's compensation.

Similar to a new comparability, i.e. cross-tested, profit sharing plan, a cash balance plan may provide different levels of benefit to different employees. A typical design might provide $100,000 per year to owners and 5% of compensation to employees. Keep in mind that the plan's benefits must satisfy nondiscrimination testing, so what works in one situation will not necessarily work in all situations.

The contribution credit is added to a notional or hypothetical account for each participant, and he can look at a benefit statement to see the incremental increase each year similar to a 401(k) statement.

Interest Credits

The interest crediting rate is the rate at which the plan guarantees interest on the accumulated contribution credits. The interest is added to each participant's hypothetical account just like the contribution credits.

Sounds simple, right? Believe it or not, there are hundreds of pages of regulations detailing how cash balance plans can and cannot establish interest crediting rates. In a nutshell, these regulations mandate that plans can only use a "market rate of return." Examples of market rates include the 30-year Treasury rate; the interest rate on long-term, investment-grade bonds; a stock market index such as the S&P 500; or the actual rate of return of the plan's investments.

Selecting a rate for a plan is often an issue of risk tolerance. The higher the crediting rate, the higher the benefit over time; however, since the rate must be guaranteed, a higher rate also means higher risk in the event the actual investments do not achieve the guarantee.

One common question is whether losses can be credited if the market rate the plan uses is negative. The answer is "it depends." A plan can credit investment losses to hypothetical accounts, subject to the "preservation of capital rule." This rule provides that crediting losses cannot reduce a participant's hypothetical account to an amount less than the sum of all contribution credits.

Example: Russell is a participant in a cash balance plan that provides annual contribution credits equal to 5% of compensation and interest credits equal to the S&P 500 annual return.

Russell's benefits over this two-year period would be reflected as follows:

Note that 2008's interest crediting rate of -37% actually yields a loss of $2,183 ($5,900 x -37%). However, the preservation of capital rule only permits the plan to allocate a loss of $150 in order for Russell's benefit to remain no less than the sum of his contribution credits.

In order to minimize volatility, many plans elect to use the 30-year Treasury rate which has generally remained between 2.5% and 5% since 2008.

Vesting and Payment of Benefits

PPA requires that cash balance plans provide full vesting after completion of no more than three years of service, so the six-year graded schedule that is common in 401(k) profit sharing plans cannot be utilized. Since cash balance plans are DB plans, they are required to offer joint and survivor annuities as the default form of benefit payment; however, they can also allow participants to take lump sum distributions.

Whereas traditional DB plans require a number of complex calculations to determine the lump sum equivalent of an annuity, a participant's hypothetical account balance in a cash balance plan is deemed to be the lump sum amount. Cash balance plans are also permitted to offer in-service distributions when a participant reaches age 62 or older.

Funding

The plan's actuary calculates the required funding based on a number of factors including the amount of the promised benefits that have accumulated for all participants, each participant's proximity to retirement age and participant life expectancy.

Let's go back to our friend Russell and assume he is 30 years old at the end of 2008. The actuary must calculate what Russell's $5,750 hypothetical account will be worth 35 years later when he reaches the plan's retirement age of 65. Let's assume that projected value is $28,000. The actuary must then determine how much the employer must contribute now in order to ensure there is $28,000 available to cover Russell's future benefit. This process is repeated to arrive at an aggregate funding requirement for the plan based on all the variables for all plan participants.

The funding level the actuary calculates is compared to the actual assets in the plan to determine how much more the employer must contribute to keep the plan fully funded. The higher the plan's funding level, the lower the required contribution; and the lower the plan's funding level, the higher the required contribution. Thus, the required contribution for any given year is not necessarily equal to the sum of the contribution credits and the interest credits for that year, and the amount contributed is not earmarked to fund benefits for any specific participant. Rather, it is applied to increase the funded status of the entire plan.

In order to provide added security to the retirement benefits promised by these plans, the PPA established more strict funding requirements. Plans for which the ratio of actual to required funding falls below 80% are prohibited from increasing plan benefits, and the plan's ability to pay lump sum distributions to departing participants is restricted. Plans with a funding ratio below 60% must freeze future benefits and the ability to make lump sum payments is eliminated.

While it might seem obvious that an underfunded plan should freeze future benefits, employers can find themselves in an unenviable position when they must tell former employees seeking benefit distributions that they cannot receive their full benefit due to a funding problem.

Investment Accounts

While most DC plans allow participants to direct the investment of their own accounts, all of the assets in a cash balance plan are generally maintained in a pooled account and invested by the plan trustee(s) or a professional investment manager. Since the plan sponsor must guarantee benefits regardless of the actual return on investment, a disciplined investment strategy is necessary. Some will seek to exactly mirror the plan's interest crediting rate so that the plan's investments are generating the exact amount of income needed. Others will seek to generate slightly higher returns to improve the plan's funding ratio and reduce the amount the employer must contribute.

It is suggested that the plan sponsor work together with the actuary and investment manager to determine the most appropriate strategy given the plan design and the sponsor's risk tolerance and cash flow.

Other Considerations

There are several additional points worth noting. First is that like other qualified retirement plans, the assets held in a cash balance plan are protected from the plan sponsor's creditors and legal judgments. This may be particularly advantageous for business owners in higher-risk occupations.

Second, all types of defined benefit plans are generally required to purchase coverage from the Pension Benefit Guaranty Corporation (PBGC). The PBGC insures a portion of the plan's promised benefits in the event the sponsor becomes insolvent and is unable to satisfy its funding obligation. Certain types of employers such as professional organizations, e.g. doctors and attorneys, with fewer than 25 employees are exempt from coverage. While there are a number of factors that impact the cost of PBGC coverage, the flat rate premium is generally $35 per participant.

Is a Cash Balance Plan Right For You?

Cash balance plans are powerful tools that can address a variety of planning needs from tax and retirement planning to estate and business succession planning. One of the most important requirements is consistent cash flow. Since annual contributions are generally required, a business that has irregular cash flow could have trouble meeting its funding obligations during slower years, leading to benefit restrictions and excise taxes. In addition, the annual costs of maintaining the plan are typically paid by the plan sponsor and not from the plan itself since any reductions in plan assets will reduce the funded status and require additional contributions.

To maximize the ability to provide greater benefits to a company's key employees, cash balance plans are usually used in conjunction with 401(k) profit sharing plans. However, the stability of the demographic make-up of the workforce is an important variable to be considered when designing the benefit formulas.

Companies considering cash balance plans should work with qualified, experienced professionals who can discuss the pros and cons and tailor a plan design to meet their goals.

This information is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. You should not act or rely on any information in this newsletter without first seeking the advice of a qualified tax advisor such as an attorney or CPA.

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