Employers May Provide IRA Rollover as Default Option for Small Plan Balances

Current tax law allows a qualified retirement plan to involuntarily distribute a departing employee's retirement balance to the employee in cash if his vested balance is $5,000 or less. Alternatively, most plans allow an employee to choose to roll over the balance into another qualified plan or an individual retirement account (IRA). While most employees with small balances take the cash option, they tend to be more likely to roll the assets into another qualified plan or IRA as the balances increase.

In Rev. Rul. 2000-36, the IRS approved a company's plan to make an IRA rollover the default option for cashed-out benefits. In the ruling, a corporation maintained a defined contribution plan for its employees. The plan did not permit after-tax contributions or other additions that would not be included in gross income if distributed to the employee. The plan provided that an employee who separated from service with an account balance of $5,000 or less would receive an involuntary distribution of plan assets, but also included a direct rollover option for all distributions. However, as is the customary practice, an employee had to affirmatively elect a direct rollover to another qualified plan or IRA or the plan balance would be distributed in a single-sum cash payment.

The corporation amended its plan so that the default form of payment of any involuntary cash-out between $1,000 and $5,000 would be a direct rollover to an IRA. The default provision would apply only if the employee did not affirmatively request a cash payment or a rollover to another plan or IRA. If the employee failed to make an affirmative election, the corporation's plan administrator would select an unrelated IRA trustee, establish an IRA with the trustee on behalf of the departing employee and make initial investment choices for the account.

The corporation would amend the required Sec. 402(f) notice on eligible rollover distributions to explain the new default option. The new notice would contain other relevant information, including the IRA trustee's name, address and telephone number, information on IRA maintenance and withdrawal fees and how the IRA funds would be invested. In addition, the default rollover would not occur fewer than 30 days nor more than 90 days after the employee received the Sec. 402(f) notice.

Rev. Rul. 2000-36 held that the change in the default option is allowed. Specifically, the Service reasoned that the status of an optional form of benefit is not a "protected benefit" under the Sec. 411(d)(6) anticutback rules. Thus, changing the default provision from a cash payment to an IRA rollover does not violate those rules. Moreover, under the plan's procedures, each departing employee will receive notice of the default procedure and the direct rollover option.

In addition to the IRS, the Department of Labor (DOL) reviewed the facts of the ruling and determined that, as long as the default direct rollover distribution constitutes an employee's entire benefit, the employee will cease to be a plan participant and the distributed assets will cease to be plan assets. The DOL did point out that the selection of an IRA trustee and the choice of IRA investments are fiduciary acts, subject to fiduciary standards and the prohibited transaction provisions of the Employee Retirement Income Security Act of 1974. Moreover, the plan provisions on the direct rollover default and the employee's ability to affirmatively opt out must be included in the plan description.

From Rebecca Williams, J.D., New York, NY