If you offer a retirement plan as an employee benefit you'll be dealing with some complicated administrative issues. Even if you decide to outsource your administrative duties, you'll still need knowledge regarding plan issues such as reporting, recordkeeping and disclosure to be certain your administrative responsibilities are being met.
Due to the complexity of administering retirement plan benefits, most small business owners will probably choose to outsource the administration duties required. However, even if you outsource the administration duties or hire an employee to handle these duties, you'll need to have a broad overview of important considerations such as plan distributions, loans, rollovers, terminations, as well as fiduciary responsibilities and recordkeeping and reporting requirements to help you select an administrator and to do a better job of evaluating the administrator's work.
Retirement plan distributions
Distributions from a plan can be paid either as a single lump sum or in installments. There are special rules that apply to both.
Rules for installment distributions. The calculation of the annual distribution is determined by the employee's life expectancy. Although an employee may defer receipt of the distributions, the employee must begin taking distributions by April 1 of the calendar year after the year in which the participant turns age 70 1/2 or, if later, the year the participant retires.
The distributions may be distributed over:
- the life of the employee
- the lives of the employee and a designated beneficiary (e.g., a spouse)
- a period not extending beyond the life expectancy of the employee or the joint life and last survivor expectancy of the employee and the designated beneficiary
In the event the employee dies before any distributions are made, under what is referred to as the five-year rule, the entire interest of the employee must be distributed as of December 31 of the calendar year containing the fifth anniversary of the employee's death. There is one exception to the five-year rule, which says that any portion of an employee's interest that is payable to or for the benefit of a designated beneficiary must be distributed, beginning within one year of the employee's death, over the life of the beneficiary or a period not extending beyond the life expectancy of such beneficiary.
Lump-sum distribution rules. Lump-sum distributions trigger special tax rules. The tax treatment of lump-sum distributions depends on how old the employee is and which years the employee participated in the plan.
The general rule is that if the individual accepts the lump sum and does not roll it over into an Individual Retirement Account (IRA), the entire amount is taxable that year at regular income tax rates. If the individual attained age 50 on or before January 1, 1986, the individual can use five-year averaging at present tax rates or 10-year averaging at 1986 rates, whichever is better for the individual. As of the year 2000, five-year averaging is no longer available.
If the lump sum is rolled over into an IRA, no tax is due until distributions are taken from the IRA under the usual rules.
There are also special rules involving annuity contracts received as part of lump-sum distributions, employee securities included as part of lump-sum distributions, and lump-sum distributions received from a disqualified plan.
To qualify as a lump-sum distribution, the distribution must have been made for one of the following reasons:
- the employee's death
- the employee has reached age 59 1/2
- the employee has quit or has been fired (for this purpose, a self-employed person is not considered an employee)
- a self-employed has become disabled
Communications regarding distributions. A plan administrator must provide all plan participants with the following information about plan distributions:
- the tax implications of a plan distribution
- which distributions are eligible for tax-free rollover treatment
- information about forward averaging
A plan administrator must provide those who are receiving a distribution with the following information:
- a summary plan description
- documents summarizing the latest annual reports
- a statement of the individual's total accrued benefit
- a registration statement
Retirement plan loans
It's your decision whether to allow plan participants to borrow from the retirement plan. You don't have to allow loans if you don't want to. If you do, though, you should keep in mind that a loan will be considered a distribution (with dire tax consequences) if the rules aren't followed.
The key rules to follow are to make sure that the loan:
- bears a reasonable rate of interest (i.e., at least equal to the prime rate)
- is adequately secured
- is made in accordance with your plan document
- provides a reasonable repayment schedule
- is made available on a basis that does not discriminate in favor of employees who are officers, shareholders, or highly compensated individuals
If you allow loans, you also have a choice of whether to allow loans only against the funds in that employee's account or against the full plan value. As a small employer, you're probably much better off limiting the loans only to the funds in that employee's account because a loan default could be particularly crippling to your other participants.
Most plans restrict the loan amount to no more than one-half of the employee's vested account or benefit.
Rules for retirement plan rollovers
A rollover is defined as a transfer of retirement assets from one retirement plan to another. It most commonly occurs when an individual changes jobs and transfers vested retirement funds from the former employer to the new employer or to an IRA.
Technically, of course, the individual's receipt of the funds from the first retirement plan is a distribution that would normally mean that the individual would have to pay taxes on the money received. However, if certain conditions are met, the individual will be allowed to roll the money over without paying taxes.
Tax free rollovers. For the rollover to be tax free, the transfer must be to an "eligible retirement plan" and it must be made within 60 days of the day it is received. An eligible retirement plan is generally any of the following:
- an IRA
- a qualified employer's retirement plan (such as a 401(k))
- a qualified annuity
The rollover can be split up among, for example, several IRAs or it can be split up among each of the plans listed above, as long as all the transfers are done within 60 days of receipt.
Tip: There is a automatic (default) rollover rule for qualified retirement plans. The rule applies to mandatory distributions of more than $1,000 from a qualified retirement plan.
Under the requirements, mandatory distributions from a retirement plan, including governmental and church plans, must be paid in a direct rollover to an individual retirement plan unless the distributee elects to have the amount rolled over to another retirement plan or to receive the distribution directly. A mandatory distribution is a distribution that is made without the participant's consent and is made to a participant before the participant attains the later of age 62 or normal retirement age. However, a distribution to a surviving spouse or alternate payee does not count as a mandatory distribution.
The plan administrator must notify a distributee in writing when a distribution will be paid in a direct rollover to an IRA. In the meantime, contact your plan administrator if you have any questions about the mechanics of the automatic rollover provision.
Rollover restrictions. Certain types of plans face restrictions on how they may be rolled over. Most notably, SIMPLE plan accounts may be rolled over only into an IRA or another SIMPLE plan. However, distributions from the IRA form of SIMPLE accounts that an employee has participated in for at least two years can be rolled over into other types of retirement plans, such as employer qualified plans and deferred compensation plans of exempt employers, organizations and public schools.
Retirement plan terminations
A plan termination refers to the situation where an employee decides to discontinue a qualified retirement plan.
If you offered a defined contribution plan, such as a 401(k) plan, there isn't too much to worry about when the time comes to discontinue the plan. The plan administrator will see that each employee receives the proper amount in his or her account.
Defined benefit plans, on the other hand, may cause you some concern because the rules are such that some of the benefits can be unfunded (in other words, someone is entitled to benefits but the money hasn't actually been paid to the plan yet). So the following rules concern only defined benefit plans.
Your defined benefit plans are supposed to be permanent. Generally, a plan that has been in operation for at least five years will be treated by the IRS as permanent. If you need to terminate your plan, you should have valid business reasons for doing so.
In some cases, the IRS will question whether a termination was for a valid business reason. If the IRS determines that the plan was never intended to be permanent, it may retroactively disqualify the plan, resulting in dire tax consequences to your business and to the participants.
Types of terminations. There are a few different types of terminations:
- If the assets you have in the plan are sufficient to pay all the benefits that are owed, the termination is referred to as a standard termination.
- If there are not enough assets to pay benefits, and the termination is initiated by the employer because of financial hardship, the termination is referred to as a voluntary termination.
- If there are not enough assets to pay benefits, and the termination is initiated by the Pension Benefit Guaranty Corporation, which insures defined benefit plans, the termination is referred to as an involuntary termination.
Excise taxes. There are also steep excise taxes that may apply if you discontinue a plan that is overfunded and hope to pull cash out of the plan to use for other purposes. If you are considering such a step, you'll need to consult a pension specialist who can help you determine whether this is actually possible in view of the potential tax liability.
Fiduciary and recordkeeping, reporting and disclosure responsibilities
Administering retirement plans involves various fiduciary responsibilities, as well as recordkeeping, and reporting and disclosure requirements.
Fiduciary responsibilities
A retirement plan administrator has a fiduciary responsibility to the plan participants, which means that the administrator must manage the retirement plan for the exclusive benefit of plan participants. Specifically, this means that plan assets must be invested so that:
- The cost of plan assets does not exceed fair market value at the time of purchase.
- A fair return commensurate with the prevailing market rate is received.
- Sufficient liquidity to permit distributions is maintained.
- Safeguards are adopted to ensure the diversity to which a prudent investor would adhere.
Are you a fiduciary? Generally, since you'll be sponsoring the plan, you'll be liable as a fiduciary. There are, however, two ways to escape liability for investment decisions. The first is to contract with a qualified investment adviser and turn over all investment decisions to that person or organization. You'd still be liable for the adviser you selected, if that selection is made carelessly, but at least you would not be liable for the investments themselves.
The Pension Protection Act of 2006, allows qualified fiduciary advisers to offer personally tailored investment advice to employees even if the adviser is affiliated with the investment funds offered. However, the adviser must meet disclosure, qualification, and other self-dealing safeguards. As an employer you are not required to monitor the specific advice given, but you are required to prudently select and monitor the advice provider.
The other way to be relieved of fiduciary liability is to allow your employees to direct their own investments (e.g., through a mutual fund company). There are a number of special requirements you would have to meet, but if you comply with those requirements, your employees will be responsible for their own investment decisions.
Basically, the liability question comes down to the relationship between the parties. If you want to turn over everything to the administrator and have it decide if a claim is covered by the plan, the administrator would be a fiduciary to the plan. On the other hand, if you want to retain control and determine eligibility for benefits, while the administrator just handles the paperwork, the administrator will be a nonfiduciary service provider. The usual case falls somewhere in between, and that's fertile ground for lawsuits.
Recordkeeping requirements
For each participant, you should be able to provide the following information to your administrator:
- date of birth
- date of hire
- hours of service for each year of employment based on plan year
- any break in service, termination of employment, suspension, layoff and rehire, change of position or status, and re-employment dates, if any
- employee contributions on a pre-tax and after-tax basis for each year of participation
- allocation of assets to the proper investment vehicle
- salary of each year of employment based on the plan year
- Social Security wage base for each plan year
- employer matching contribution, if any
- marital status of employee
- completed beneficiary designation
- employee category or location, if it affects determination of a benefit
Reporting and disclosure requirements
Reporting and disclosure laws under ERISA require you to provide information about your retirement plan to the federal government and to each participant and beneficiary at certain times. The reporting and disclosure laws, however, do not apply to any welfare plan with fewer than 100 participants.
Even though your plan may be exempt from the reporting and disclosure requirements, you should still expect your administrator to provide plan participants with the appropriate information. You should make sure that:
- They receive the explanatory material.
- It is written clearly and is easy to understand.
- There is language assistance for those who do not understand English.
- Charges are reasonable for copies of the material.