New retirement plan distribution rules.

The Unemployment Compensation Amendments Act of 1992 (the "Act"), which was signed into law on July 3, 1992, made substantial changes to the qualified retirement plan distribution rules by liberalizing certain restrictions on the rollover of distributions and by requiring either mandatory withholding or direct plan-to-plan transfer of distributed funds. In October 1992, the IRS issued temporary regulations and Notice 92-48, which provide guidance on the distribution provisions of the Act. (Note: The new rules call plan-to-plan transfers "direct rollovers.") The new rules generally apply to qualified plan distributions made after Dec. 31, 1992.

Distribution traps removed

In general, a distribution from a qualified retirement plan that is rolled into an individual retirement account (IRA) or into another qualified plan account within 60 days is not subject to tax. Previously, however, there were traps for the unwary; certain distributions were ineligible for rollover treatment, and thus were subject to income taxes at the time of the distribution, as well as a 10% excise tax if the distribution constituted an early withdrawal. For instance, a distribution of less than one-half of a participant's profit-sharing account balance was ineligible to be rolled over into an IRA.

The Act removes these distribution traps, but still prevents the rollover of distributions that consist of a series of substantially equal payments over the life of a participant (or the life of a participant and beneficiary); also, payments made over a specified period of 10 years or more may not be rolled over. In addition, required minimum distributions paid to participants who have attained age 70 1/2 are not eligible. The committee reports to the Act clarify that single sum payments - for example, a lump-sum payment of a portion of a participant's accrued benefit at retirement - will be allowed rollover treatment even though the balance of the benefit will be paid in equal monthly payments.

Beware: required direct rollover transfer or mandatory 20% withholding

Under prior law, distributions were typically made to the participant, who in turn would either elect to roll over the funds or retain the funds and pay the taxes due. The Act adds a new plan qualification requirement specifying that qualified plans must allow direct rollover of distributions otherwise eligible for rollover treatment. Direct rollovers may be made to an IRA, certain annuities, and to qualified defined contribution plans that allow for the receipt of rollover contributions. Rollover amounts not directly transferred through a direct rollover are subject to mandatory 20% income tax withholding. (Under prior law, a participant could elect to have no withholding made.) In addition, Sec. 403(a) annuities and Sec. 403(b) tax-sheltered annuities (but not IRAs) are subject to the mandatory 20% withholding requirement unless a direct rollover transfer is made under rules similar to those applying to qualified plans.

Most plan participants would be wise to take advantage of the requirement that plans offer direct rollovers. However, for participants who have not decided whether to elect rollover treatment at the time of the distribution, the 20% withholding requirement will accelerate a participant's distribution planning. Example: Plan participant P terminates his employment at age 40 and takes a distribution of his entire $50,000 accrued benefit. P will then receive a check for $40,000, with the remaining $10,000 applied to income tax withholding. If P eventually decides to roll over the distribution, he may face a problem. In order to defer taxation on the entire $50,000, P must come up with $10,000 out-of-pocket to supplement the $40,000 distribution that he received. If P cannot or does not wish to add the $10,000 to his rollover, he will be subject to income taxes and the 10% excise tax on the $10,000 (i.e., in effect, the withholding).

As a planning technique, participants changing jobs and desiring maximum flexibility could have their retirement funds directly transferred through a direct rollover to a "rollover IRA." Funds can then be left in the IRA, transferred later to a new employer's qualified plan or distributed to the participant at any time without withholding.

Plan administrators will be responsible for providing notification to participants of the direct rollover rules and the mandatory withholding requirements. Notice 92-48 provides a model of "safe harbor" notice for plan participants. In general, notification must be made during a 60-day period beginning 90 days before the expected distribution.

It should be noted that bills have been introduced in Congress that would repeal or modify these plan distribution provisions. However, legislative changes are unlikely since the withholding provisions are projected to provide a substantial portion of the revenue necessary to finance the unemployment benefit extension.

At the time of a direct rollover, a participant's entitlement to certain rights and options, such as the right to a joint and survivor annuity form of benefit, will expire; transfers will generally be treated like distributions (i.e., a transfer of funds to the participant, followed by a rollover). This is good news for transferee plans that might otherwise be required to provide rights and options not otherwise provided by their plan. As was true under old law, however, plans do not have to accept direct rollovers. (If a plan refuses to accept transfers, the participant has the option of designating another plan or IRA that will accept transfers or the distribution will be subject to the new mandatory withholding rules.)

Practically speaking, participants and other recipients will have to establish IRA accounts or coordinate a rollover into a qualified defined contribution plan before a direct rollover may be made. Many plan administrators may wish to verify that a rollover account has been established with an IRA sponsor or that a qualified plan trustee will accept a transfer. However, the Act allows the administrator to rely on participant information and does not require independent verification.

Qualified plan documents will have to be amended to incorporate the new direct rollover rules by the last day of the plan year that begins in 1994. Tax-sheltered Sec. 403(b) annuities maintained by governmental entities are prohibited by some state laws from making direct rollovers. In those cases, the effective date of the direct rollover and mandatory withholding rules is delayed until the earlier of 90 days after state law is amended to allow for direct rollovers, or Jan. 1, 1994. From Bruce R. Delbecq, J.D., CPA, Southfield, Mich.