Retirement Plan Provisions That May Confuse

The Internal Revenue Service (IRS) permits plans to be flexible to satisfy broad employer and employee needs, but this flexibility can come with a cost, according to speakers at the 2014 American Society of Pension Professionals and Actuaries (ASPPA) Annual Conference.

For example, plan sponsors have some leeway in determining age and service requirements for employees to enter the plan.  But, plan sponsors must be careful that the requirements they select match their intent. Robert M. Richter, vice president in SunGard’s wealth and retirement administration business, pointed to the situation in which a plan document says an employee is eligible to enter the plan on the first day of the month coinciding with or following six months of service. For an employee hired 3/1/2014, terminated 6/1/2014, and rehired 10/1/14, plan entry will take place on 10/1 because six months have passed since the employee’s commencement date. The plan may say the six months of service have to be consecutive, Richter said. If so, the employee would enter the plan the following year, on 4/1.

The point is, according to Donald J. Kieffer Jr., tax law specialist with the IRS’ tax exempt and government entities (TE/GE) division, when less than a year of service is required for eligibility, usually hours of service are not used, it is just a time lapse. Richard A. Hochman, president of McKay Hochman Company, noted employers could require a certain number of hours in these cases, but that could further complicate the entry date calculation. “Just because something is available, doesn’t mean you should do it,” he said.

Kieffer reminded attendees that the Employee Retirement Income Security Act (ERISA) requires that the latest an employee may enter a plan is the first day of the plan year or six months later, after the employee attains age 21 and one year of service. So, if the plan uses a younger age, it may extend the entry date. Also, the plan may require two years of service, but only if the employee is 100% vested in employer contributions immediately.

No matter what the eligibility requirements are, rehires can cause confusion for plan sponsors. Richter recommended plan sponsors avoid a one-year holdout rule, which disregards a rehire’s prior service until the rehire completes one year of service. Upon completion of the year of service, all of the employee’s service must be credited retroactively, so the rehire may potentially have to be given an allocation of contributions for prior years. Richter noted that the IRS says 401(k) plans cannot use the one-year holdout rule because employees cannot go back and retroactively defer a portion of their salaries to the plan.

Another rehire rule no longer seems beneficial to plan sponsors due to new, earlier vesting requirements. Richter noted the rule of parity allows plan sponsors to disregard prior service if a rehire was not vested and had five one-year breaks in service, or the number of breaks in service equals or exceeds the number of prior years of service. Kieffer explained that this was useful when plans were allowed to use longer vesting schedules, but the only place this provision may be useful now is in traditional defined benefit (DB) plans with longer (10-year) vesting rules. 

Richter added that the rule of parity does not apply if the participant was vested prior to termination, meaning most rehired participants will re-enter the plan immediately, so plan sponsors are saying ‘Why use the rule,’ and removing the requirement from their plans.

“Plan sponsors are just better off using all years of service for rehired employees,” he says.

Another issue resulting from eligibility and service crediting provisions, according to Richter, comes up when plans provide for a shift to a plan year computation period for years of service after the initial eligibility computation period. He warned that plan sponsors should avoid this provision if they require two years of service for eligibility. He gave an example of how this can result in situations plan sponsors did not intend: If an employee is hired 11/1/13, his eligibility computation period is 11/1/13 to 10/31/14, his second computation period is 1/1/14 to 12/31/14, so he will have two years of service for vesting and other purposes after just 13 months of employment.

Kieffer noted that the IRS has become concerned that the exclusion of seasonal or part-time employees is really criteria based on age or service conditions; this is evident from quality assurance bulletins on the IRS website. He recommended plan sponsors revisit exclusions for part-time employees.

Richter added that in plans other than standardized prototype plans, sponsors are allowed to exclude employees by name. But he says it is not a good idea to include such provisions because it affects the method the plan sponsor can use for satisfying minimum coverage testing and may make it harder to pass.

The speakers then turned to issues that can come up due to benefits provisions in retirement plans, focusing first on the definition of compensation. Hochman said plan sponsors should avoid use of a non-safe harbor definition of compensation. The safe harbor definition of compensation, defined in Internal Revenue Code Section 414(s), is the only compensation that can be used for permitted disparity allocation formulas for contributions, and must be used for the average deferral percentage (ADP) nondiscrimination test of safe harbor plans. If the safe harbor definition of compensation is not used, a plan may lose safe harbor status.

Kieffer added that plan sponsors have to watch out that when defining compensation, they are not subtracting more from gross compensation for the definition of compensation for highly compensated employees (HCEs) than for non-highly compensated employees (NHCEs).

Hochman also said plan sponsors should avoid having different definitions of compensation for IRC Section 415 testing and for allocating contributions. If a plan sponsor has to contribute a minimum contribution to the plan due to the plan being top heavy, the allocation of that contribution must be based on Section 415 compensation. If the plan sponsor uses a different compensation for allocating regular contributions, participants will have contributions based on two different definitions of compensation.

Plan sponsors should also be careful about imposing eligibility requirements for matching contributions, Kieffer said. If matching contributions are made when deferrals are made throughout the year, but the plan requires employment at the end of the year and/or 1,000 hours of service for participants to receive the match, what does the plan sponsor do when the participant’s account has received matching contributions, but did not satisfy requirements to share? “ I would not argue for de-allocation of those amounts,” Kieffer said.

There could also be an issue if matching contributions are allocated throughout the year, but the plan says catch-up contributions are not matched, according to Richter. In some cases, the plan sponsor may not know if there is a catch-up contribution for a participant until after testing is done. If a participant’s deferrals are greater than the statutory limit, and the participant is older than age 50, some deferrals may be re-characterized as catch-up contributions. What is done with the match on those re-characterized deferrals?

Factors to consider about forfeiture provisions of the plan include how participant account forfeitures will be used and when they occur. Hoffman noted that many plans use forfeitures to reduce discretionary employer contributions. But, if the employer doesn’t make a contribution, the forfeiture amounts may not be held in suspense. In this case, plan sponsors could specify that a contribution amount in the amount of the forfeitures would be declared, or forfeitures could be used to pay plan expenses.

Kieffer noted that forfeitures currently cannot be used to offset non-elective safe harbor contributions, because of the rule that these contributions must be fully vested when made. ASPPA has recommended that regulators change this rule, and it is being considered.

Plans should also specify when a forfeiture occurs and what happens when it occurs. For example, if the forfeiture occurs upon distribution of a vested account, is it allocated at that time or invested, where is it invested? The forfeiture may be held in the distributed participants account and not actually occur until it is allocated or used to pay plan expenses. Plans may also specify that forfeitures may be used in the following plan year.

Finally, the speakers discussed mandatory small-account balance cash-out rules. Employers that experience high employee turnover especially may want to include mandatory cash-out provisions in their retirement plans. One issue is that plans may exclude rolled-over account balances in the determination of the $1,000 threshold for automatically cashing out former participant accounts. This could prevent some plan sponsors from getting rid of small plan balances.

The exclusion of rollover accounts in the determination of whether a small balance meets a plan’s mandatory cash-out rule does not override the rule that accounts greater than $1,000 must be rolled over to individual retirement accounts (IRAs). For example, if a plan provides for mandatory cash-out of balances less than $5,000 and excludes rollovers in determining this threshold (the law requires amounts between $1,000 and $5,000 to be rolled over), and a participant has $500 in an employer contribution account and $1 million in a rollover account, the plan sponsor must roll the entire balance into an IRA because the total balance is greater than $1,000.