New "Automatic Rollover" Rule for Qualified Plans

by David Roth

July 2005

A qualified retirement plan may not distribute the account of a plan participant whose vested account balance exceeds $5,000 unless it first obtains the consent of the plan participant. Prior to March 28, 2005, such a plan could distribute the account of a participant whose vested account balance was less than $5,000 without obtaining the participant's consent. However, as is typical in this area of the law, the rules have changed.

Effective March 28, 2005, new tax law [IRC §401(a)(31)(B)] prohibits the automatic cash-out of any plan participant with an account balance between $1,000 and $5,000 without the participant's consent, unless the employer unilaterally rolls the account balance over into an IRA for the participant's benefit. This new law is known as the "Automatic Rollover" rule, and applies to any plan distribution that occurs after March 28, 2005. Plan documents must be amended in compliance with the Automatic Rollover rule by the last day of the plan year following the March 28, 2005 effective date. Thus, a calendar year plan must be amended on or before December 31, 2005.

Generally, plan sponsors may take one of two approaches to comply with the Automatic Rollover rule. The first approach involves amending the plan to lower the amount of any distribution requiring participant consent from $5,000 (the prior limit) to $1,000 (the new limit). This approach is likely the easiest to implement, although it does preclude the automatic cash-out of any account balance that exceeds $1,000. A second approach involves amending the plan to require an automatic rollover (into an IRA) of any account balance between $1,000 and $5,000, provided the participant does not consent to a different form of distribution. This approach would require the plan sponsor to locate and make arrangements with an IRA custodian willing to accept these automatic rollovers, which could be more difficult than it sounds. Nevertheless, this approach might be attractive for plan sponsors who have a relationship with a financial institution that offers IRA rollovers as part of its routine service. This approach might also be attractive to larger plan sponsors who have trouble locating plan participants after they have terminated employment.

For our current retirement plan clients, we have begun the process of amending plan documents to comply with the new Automatic Rollover rule, incorporating the first approach noted above. However, all sponsors must operate their plans in compliance with the new rule after March 28, 2005.