IRS issues regulations and safe harbor notice on new rollover and withholding rules.

The IRS has just released Temp. Regs. Sec. 1.401(a)(31)-1T on the new directed rollover and withholding rules for distributions from qualified retirement plans and tax-sheltered annuities. These regulations provide guidance on how to implement the new directed rollover and mandatory 20% withholding requirements that become effective for certain distributions made after Dec. 31, 1992. The Service has also released a safe harbor notice that may be used to explain these new rules to recipients.

Under the Unemployment Compensation Amendments Act of 1992, the rollover rules for distributions from qualified retirement plans and tax-sheltered annuities have been expanded and simplified. Any part of the taxable portion of a plan distribution may be rolled over to another qualified plan or individual retirement account (IRA), other than certain periodic payments and required minimum distributions from tax-sheltered annuities.

Beginning in 1993, a qualified retirement plan or annuity must permit participants to elect to have any qualified rollover distribution transferred directly to an eligible transferee plan or IRA specified by the participant. Also effective for distributions made after Dec. 31, 1992, income tax withholding is imposed at a rate of 20% on any distribution that is eligible to be rolled over but is not transferred directly to an eligible transferee plan or IRA. Recipients may no longer elect out of withholding for such distributions.

To ensure that recipients of plan distributions are aware of the new rollover and withholding rules, plan administrators must provide a written explanation of the plan's distribution options (including the direct rollover option) within a reasonable period of time before making a distribution eligible for rollover treatment. The notice must explain the new rollover and withholding rules as well as the rules on averaging treatment and the exclusion of net unrealized appreciation on distributions of employer securities.

Certain corrective distributions are not considered eligible rollover distributions and are thus not subject to the mandatory 20% withholding requirement. These include corrective distributions of excess deferrals, excess contributions and excess aggregate contributions, as well as deemed distributions on the default of a participant loan and for the costs of life insurance coverage (P.S. 58 costs).

The regulations clarify that for plan qualification purposes, a directed rollover is a distribution and rollover, and not a transfer of assets and liabilities. Thus, spousal consent must be obtained for those plans subject to the survivor benefit rules. Similarly, a transferee plan is not required to provide the same optional forms of benefits that were provided under the transferor plan.

The regulations permit a directed rollover to be accomplished by any reasonable means of delivery to the transferee plan. The delivery of a check to the transferee plan by the employee is specifically permitted, provided the check is made out in a manner that will ensure that it is negotiable solely by the recipient plan's trustee.

Under the regulations, directed rollovers may be made to any qualified trust or IRA. (The new law would seem to limit eligible transferee plans to qualified defined contribution plans.)

An employer cannot preclude a recipient from dividing an eligible rollover distribution by electing to make a directed rollover of part of the distribution and to receive cash for the balance. However, a plan can impose a $500 minimum on the portion that is to be directly rolled over. In addition, a plan does not have to allow employees to have directed rollovers made to more than one transferee plan.

A plan administrator may prescribe reasonable procedures for a recipient to elect a directed rollover, including requiring the recipient to provide a statement from the designated transferee plan that it is an IRA or qualified plan and that it will accept a direct rollover. However, a plan cannot require the recipient to obtain a letter from a lawyer that the transferee plan is a qualified plan or IRA.

Plans may establish default procedures for when a recipient fails to make an affirmative election. However, a distribution may not be made under any default procedure unless the recipient has received a timely explanation of the directed rollover option. Plans may establish a deadline after which a recipient may not revoke an election.

A rollover notice must generally be given no less than 30 days and no more than 90 days before the distribution is made, along with a general description of the plan's distribution options and other rights under the plan. For involuntary cashouts of less than $3,500 and for distributions to participants who have reached a plan's normal retirement age, employees may waive the application of the 30-day time period by affirmatively making an election to either make or not make a direct rollover. The IRS has released a safe harbor notice that will satisfy this requirement.

The regulations confirm that the 20% withholding is required on distributions of property other than employer securities. If the cash in a distribution is not sufficient to satisfy the withholding rules, the plan administrator or payor must either sell the property or receive enough cash from the employee to pay the required withholding. As under current law, employer securities need not be sold to satisfy withholding.

Amounts directly rolled over must be reported on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. It is anticipated that new coding will be added to Form 1099-R to identify directed rollovers. Like all rollovers to IRAs, directed rollovers must be reported to the IRS by the IRA trustee or custodian on Form 5498, Individual Retirement Arrangement Information.

Under narrow circumstances, an employer need not withhold 20% of any distribution made during the first three months of 1993, provided the withholding is "made up" prior to Dec. 31, 1993. This relief is limited to situations in which immediate compliance with the new rules would result in undue hardship for the payor and only if there is reason to expect that there will be subsequent distributions to the employee during 1993 from which the additional amounts can be withheld.

Penalties for failure to withhold from eligible rollover distributions made after Dec. 31, 1992 and before July 1, 1993 will automatically be abated if the plan administrator or payor has acted diligently and in good faith in attempting to comply with these new withholding rules.

Plan amendments to comply with these rules do not have to be made before the last day of the 1994 plan year (or, if later, the last day by which Tax Reform Act of 1986 amendments must be made), provided the plan is operated in accordance with the new rules and the amendment applies retroactively to Jan. 1, 1993.

Procedures for directed rollovers should be promptly put in place to avoid potential plan disqualification and delays in making distributions. Because these new rules apply to distributions made as of Jan. 1, 1993, a rollover notice should be promptly provided to participants who have separated from service or who are otherwise entitled to distributions.