Retirement and 401(k) Plans: New Mandatory Rollover Rule for Involuntary Distributions (March 2005)

by Hugh Davis

March 28, 2005 is an important day for tax-qualified retirement plans. On that date, in-voluntary distributions from qualified plans become subject to the new “mandatory rollover” rule. 

Involuntary Distributions from Retirement Plans

Federal pension laws allow a qualified plan to make an involuntary distribution (or “cashout”) of a participant’s vested benefit following the participant’s termination of employment if the benefit is $5,000 or less, ignoring rollover benefits. If the plan document so provides (and almost all plans do), the plan may make the distribution without the participant’s consent. 

Example: Acme Novelties has a 401(k) plan, and the plan document provides that accounts of $5,000 or less (ignoring rollovers) will be automatically cashed out immediately after a participant’s termination of employment. W. E. Coyote terminates employment with Acme, and he has a $4,000 vested account balance in the plan. The plan sends him a distribution/rollover election form. Because Mr. Coyote does not return the form, the Acme plan distributes $4,000 in cash to Mr. Coyote. This is an involuntary cashout. 

Mandatory Rollovers of Involuntary Distributions after March 27

The new mandatory rollover rule completely changes what plans can do with cashout distributions. The rule is fairly straightforward: after March 27, 2005, any involuntary distribution of a plan benefit exceeding $1,000 must be automatically rolled over into an IRA established by the plan administrator for the participant, unless the participant specifically elects otherwise. The involuntary cashout is still permitted, but the plan has to set up an IRA and roll the benefit over. 

Example: As in the example above, W. E. Coyote has a $4,000 vested account balance in the Acme plan when his employment terminates. The plan sends him a distribution/rollover election form, but Mr. Coyote does not return it. To cash Mr. Coyote out, the Acme plan must set up an IRA on his behalf and distribute the $4,000 balance to the IRA. 

Plan sponsors should note that the $1,000 threshold applies to all contribution sources, including rollovers. 

Plan Sponsor Decisions and Actions

Sponsors of plans that have mandatory cashouts for benefits in excess of $1,000 will have to decide how to comply with the new rule before the end of their current plan year. Sponsors have two options, as described below.

Option 1: Eliminate Mandatory Cashouts in Excess of $1,000

As a practical matter, compliance with the mandatory rollover rule will be impossible for most plans. Mandatory rollovers are not attractive to IRA providers, and few are willing to accept them. For that reason, most plan sponsors will decide to amend their plan(s) to eliminate cashouts in excess of $1,000 (or even to eliminate cashouts entirely). This is true even though it will in many cases result in higher administrative costs. 

A sponsor that chooses this option must take the following steps:

• Implement new distribution procedures no later than March 28, 2005, and revise administrative forms to be consistent with the lower cashout limit; 
• Notify plan participants (by way of a new summary plan description or a summary of material modifications) that the plan’s involuntary cashout rules are changing, and explain the new provisions; and
• Amend the plan before the end of its current plan year to reduce the cashout limit to $1,000 or less. (In other words, a plan with a March 31 plan year will have to be amended before the end of this month.)

Option 2: Implement Mandatory Rollovers for Cashouts in Excess of $1,000

Note: A plan sponsor should consider this option only if it finds an IRA provider willing and able to accept mandatory rollovers before the end of the current plan year. If the end of the plan year is approaching and the sponsor has not finalized mandatory rollover arrangements with an IRA provider, the sponsor should implement option 1. In a future year when it is ready to implement mandatory rollovers, the sponsor can re-introduce cashouts in excess of $1,000. 

To implement mandatory rollovers for cashouts in excess of $1,000, a plan sponsor should:

• Select an IRA provider and an initial investment option for the IRA; 
• Enter into a written agreement with the IRA provider;
• Explain the new mandatory rollover procedures to plan participants (by way of a new summary plan description or a summary of material modifications);
• Amend the plan before the end of the current plan year to comply with the mandatory rollover rule; and
• Revise administrative forms for plan distributions, including the special tax notice, to make them consistent with the plan’s new mandatory rollover procedures. 

Sponsors should note that there are detailed Department of Labor requirements for the first three items listed above.

What to do Now

Plan sponsors that are not already considering these issues should contact their outside advisors and recordkeepers as soon as possible. As noted above, operational compliance is required by no later than March 28. 

If you have any questions about the new rules or would like our assistance in bringing your plan into compliance, please feel free to contact a member of our firm’s Employee Benefits Group.

Physical Address:  3600 Glenwood Avenue, Raleigh, NC 27612