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IRS guidance on safe harbor distribution notices; automatic enrollment/increase arrangements; contribution of unused paid time off to qualified plans

Oct 09, 2009

In the September 28, 2009, Internal Revenue Bulletin, the IRS published guidance concerning new safe harbor rollover notices, additional guidance on automatic enrollment/increase arrangements and guidance on the contribution of unused paid time off to qualified plans. In this article we briefly review the IRS's new guidance.

Safe harbor distribution notice (Notice 2009-68)

Code section 402(f) generally requires that the administrator of a qualified plan provide a written explanation to any recipient of an "eligible rollover distribution." Distributions in the ordinary course, for example, on termination of employment, generally would be eligible rollover distributions. An example of something that isn't an eligible rollover distribution: a distribution of contributions in excess of the 401(k) nondiscrimination limits.

The written explanation generally must describe the tax rules applicable to distributions – the direct rollover rules, the mandatory income tax withholding rules for distributions not directly rolled over, the tax treatment of distributions not rolled over and when distributions may be subject to different restrictions and tax consequences after being rolled over.

The plan administrator may comply with this notice requirement by using a model notice supplied by the IRS. Notice 2009-68 updates the IRS's model notice, picking up information related to Roth 401(k)/IRA distributions, distributions where an employee elects out of an automatic enrollment program and certain other issues. Further, the updates are intended to simplify the presentation and description of the participant's options.

There are two safe harbor explanations in the notice: one recommended for distributions from a non-Roth account and one recommended for distributions from a Roth account. The notice may be customized to omit certain information that does not apply to the plan.

Administrators will want to review the new model notice and update their own distribution notices accordingly. The Notice does allow the use of safe-harbor notices previously published by the IRS (updated for changes) through December 31, 2009.

Guidance concerning escalator feature in automatic enrollment/increase arrangements (Revenue Ruling 2009-30)

We have provided a number of articles concerning regulation of automatic enrollment/ increase arrangements (see, for instance, our article IRS finalizes automatic contribution regulations). Rev. Rul. 2009-30 addresses a couple of technical issues presented by Code rules applicable to them.

First issue: Is there a problem where, in any year, automatic increases under the arrangement are in part a function of each individual participant's pay increase? The situation under consideration involved a plan in which the increase "is equal to the greater of (1) 1 percentage point, or (2) a number of percentage points calculated as 30% of the percentage increase in the eligible employee's base pay." Rev. Rul. 2009-30 confirms such an arrangement would not cause the deferral to fail to be “elective” and holds that this approach to automatic enrollment does not violate Code rules. However, since under this program the automatic increase may be different (as a percent of pay) for different employees, the IRS notes that it would not qualify as a “qualified automatic contribution arrangement” (QACA) and, thus, would not qualify for the nondiscrimination testing safe harbor.

Second issue: Where a plan is intended to be a QACA or an "eligible automatic contribution arrangement" (EACA), is there a problem when default contribution increases occur on a date other than the first day of a plan year? Our article IRS finalizes automatic contribution regulations discusses the rules applicable to QACAs (which provide qualifying plans with a 401(k) nondiscrimination testing safe harbor) and EACAs (which allow eligible plans to provide employees defaulted into the plan a 90-day period to withdraw automatic contributions). The situation considered in Rev. Rul. 2009-30 involves a calendar year plan in which automatic contribution increases occur on April 1 (coincident with annual pay increases). The ruling holds that so long as automatic increases get the default contribution rates to the required minimums by the specified plan years for a QACA, safe harbor requirements are satisfied. In the example cited, the first increase occurs during the “initial period,” the plan year coincident with or following the plan year in which the participant is hired. So the default contribution would reach the required rate in advance of the second (and subsequent) plan years.

Rev. Rul. 2009-30 reflects the Obama administration's broad commitment to automatic enrollment as a way of increasing retirement savings, particularly of lower paid employees. We discuss the administration's initiatives with respect to this issue in our article Administration retirement proposals. In furtherance of that policy initiative, the IRS also published Notice 2009-65, providing two sample plan amendments that can be used to add certain automatic contribution features to 401(k) plans.

Guidance concerning contribution of unused paid time off (Revenue Ruling  2009-31 and 32)

Rev. Rul. 2009-31 addresses two different plan designs providing for the contribution of unused paid time off to a qualified plan. In Situation 1, unused paid time off is automatically contributed to a profit sharing plan; thus, the participant does not have the right to elect a cash distribution of unused paid time off. The contribution is subject to the Code section 415 contribution limits. Rev. Rul. 2009-31 holds that this arrangement generally does not violate Code rules applicable to qualified plans, so long as Code section 401(a) nondiscrimination rules are met, treating these amounts as nonelective employer contributions. In that regard, the IRS notes:

The amount contributed and allocated for each participant will vary based on the amount of the participant's unused paid time off. Thus, contributions for unused paid time off are likely to preclude a plan from satisfying a design-based safe harbor under [Code section] 401(a)(4). Therefore, testing based on the contributions made for individual participants generally will be required.

In Situation 2, participants are permitted to elect to have unused paid time off contributed to a 401(k) plan or paid in cash. The elective contribution to the 401(k) plan is subject to 401(k) contribution limits and nondiscrimination testing. Such deferrals would be tested under the ADP test for the applicable year. Rev. Rul. 2009-31 holds that this arrangement generally does not violate Code rules. 

Rev. Rul. 2009-32 generally applies similar principles to unused paid time off amounts payable at termination of employment.  Note that, since the participant is no longer employed, the limitation year in which the contribution is allocated to the plan can be critical due to Code section 415 limitations and the related definition of compensation.

Employers that sponsor a plan for payment of unused time off may want to consider whether one of these sorts of arrangements may be appropriate for their organization.