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Plan Overdraft Services

“A bank serves as the trustee of my client’s retirement plan. It offers overdraft protection services to the plan. Wouldn’t that be an extension of credit to a plan and, therefore, considered a prohibited transaction?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with an advisor in Hawaii is representative of a common inquiry related prohibited transactions.

Highlights of Discussion

A bank’s provision of overdraft protection services to a qualified retirement plan may be exempt from the prohibited transaction rules, provided the bank complies with the requirements of Department of Labor Advisory Opinion (DOL AO) 2003-02A and Prohibited Transaction Class Exemption 80-26 (PTE 80-26).

Overdrafts in a plan may occur as the result of securities transactions or check clearings. The covering of overdrafts in these scenarios represents the lending of funds from a depository institution (e.g., a bank or other financial institution) to an ERISA plan. Under the rules of the Employee Retirement Income Security Act of 1974 (ERISA), the depository institution is considered a “party in interest” either because it is a fiduciary to the plan (e.g., bank-owned deposits in the plan or a provider of trustee services to the plan). ERISA Secs. 406(a)(1)(B), 406(a)(1)(D) and 406(b)(2) prohibit interest free loans and other extensions of credit from parties in interest to employee benefit plans.

The Department of Labor (DOL) recognized that most plan overdrafts are short-lived and not abusive. As a result, the DOL provided relief for such transactions in PTE 80-26. PTE 80-26 covers loans or other extensions of credit used for the payment of ordinary operating expenses of the plan, or for a period of no more than three days for a purpose incidental to the ordinary operation of the plan. In order to qualify for the PTE, the overdraft coverage arrangement with the plan must meet the following requirements.

  • The financial institution may not charge the plan interest or any other fee, and the plan cannot receive a discount for payments made in cash;
  • The proceeds of the loan or extension of credit are used only for 1) the payment of ordinary operating expenses of the plan, including the payment of benefits in accordance with the terms of the plan and periodic premiums under an insurance or annuity contract, or 2) for a period of no more than three business days, for a purpose incidental to the ordinary operation of the plan;
  • The loan or extension of credit must be unsecured;
  • The loan or extension of credit may not be made, directly or indirectly, by an employee benefit plan.

The DOL provided further clarification on the topic in an advisory opinion issued February 10, 2003, which specifically discusses the provision of overdraft protection services in connection with securities and other financial market transactions. In DOL AO 2003-02A, the DOL opined that, under certain circumstances, the extension of an overdraft to a plan in connection with the settlement of a securities or other financial market transaction would satisfy the requirements for the exemptions provided in ERISA Sections 408(b)(2) and 408(b)(6).

Conclusion

The covering of overdrafts in a qualified retirement plan by a financial institution that occur as the result of securities transactions or check clearings could be a prohibited transaction. Fortunately, the DOL has provided relief in PTE 80-26 and AO 2003-02A.

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Two Plans–Two Limits?

“My client is a fireman who participates in the department’s 457(b) plan. He also runs his own electrical business. Can he set up a 401(k) plan and contribute to both plans?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with an advisor in Massachusetts is representative of a common inquiry related to multiple retirement plans.

Highlights of Discussion

This is an important tax question that your client should discuss with his tax professional to make sure all the facts and circumstances of his financial situation are considered. Generally speaking, however, the IRS rules would allow your client to contribute to both his 457(b) plan and 401(k) plan up to the limits in both.

For 2020, 457(b) contributions (consisting of employee salary deferrals and/or employer contributions combined) cannot exceed $19,500, plus catch-up contribution amounts if eligible [Treasury Regulation Section (Treas. Reg. §1.457-5)]  and 457(b) contribution limit].  The same maximum deferral limit applies for 401(k) plans in 2020 (i.e., $19,500, plus catch-up contributions). The catch-up contribution rules differ slightly between the two plan types.

401(k) and 457(b) Catch-Up Contribution Rules

401(k) 457(b)
Age 50 or Over Option

 

Employees age 50 or over can make catch-up contributions of $6,500 beyond the basic 402(g) limit of $19,500 for 2020.

 

Age 50 or Over Option

 

Employees age 50 or over can make catch-up contributions of $6,500 beyond the basic 457 deferral limit of $19,500 for 2020.

 

Special “Last 3-Year” Option

 

In the three years before reaching the plan’s normal retirement age employees can contribute either:

 

•Twice the annual 457(b) limit (in 2020, $19,500 x 2 = $39,000),

 

Or

 

•The annual 457(b) limit, plus amounts allowed in prior years not contributed.

 

Note:  If a governmental 457(b) allows both the age-50 catch-up and the 3-year catch-up, one or the other—but not both—can be used.

Since 2002, contributions to 457(b) plans no longer reduce the amount of deferrals to other salary deferral plans, such as 401(k) plans. A participant’s 457(b) contributions need only be combined with contributions to other 457(b) plans when applying the annual contribution limit. Therefore, contributions to a 457(b) plan are not aggregated with deferrals an individual makes to other types of deferral plans. Consequently, an individual who participates in both a 457(b) plan and one or more other deferral-type plans, such as a 403(b), 401(k), salary reduction simplified employee pension plan (SAR-SEP), or savings incentive match plan for employees (SIMPLE) has two separate annual deferral limits.

Another consideration when an individual participates in more than one plan is the annual additions limit under IRC Sec. 415(c),[1] which typically limits plan contributions (employer plus employee contributions for the person) for a limitation year [2] made on behalf of an individual to all plans maintained by the same employer. It this situation, the annual additions limit is of no concern for two reasons:  1) there are two separate, unrelated employers; and 2) contributions to 457(b) plans are not included in a person’s annual additions [see 1.415(c)-1(a)(2)].

Conclusion

IRS rules would allow a person who participates in a 457(b) plan and a 401(k) plan to contribute the maximum amount in both plans. However, it is important to work with a financial and/or tax professional to help determine the optimal amount based on the participant’s unique situation.

[1] For 2020, the limit is 100% of compensation up to $57,000 (or $63,500 for those > age 50).

[2] Generally, the calendar year, unless the plan specifies otherwise.

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Reduction in Workforce and Partial Plan Terminations

“My client had a 35 percent reduction in workforce in January 2020. Does that automatically mean the business suffered a partial plan termination?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with an advisor in Massachusetts is representative of a common inquiry related to reductions in workforce.

Highlights of Discussion

Not necessarily; it all depends on the facts and circumstances, and whether those terminated employees are rehired by the end of 2020.

The IRS presumes there is a partial plan termination when an employer reduces its workforce (and plan participation) by at least 20 percent during the plan year. This presumption is rebuttable, however. The IRS makes it clear that an actual determination of a partial plan termination is based on all the facts and circumstances of a particular scenario [Treasury Regulation § 1.411(d)-2(b)]. The IRS’s Revenue Ruling 2007-43 provides further guidelines to help determine if a partial plan termination has occurred. For additional coverage, please see RLC’s related Case of the Week.

The most recent guidance on this issue comes from the IRS’s Coronavirus-related relief for retirement plans and IRAs questions and answers, Q&A 15 (added July 2020). As a result, for purposes of determining whether a partial termination of a retirement plan occurred during the 2020 plan year, the IRS will not treat plan participants who were furloughed as having an employer-initiated severance from employment during the year if the business rehires them by the end of 2020. If that is the case, then immediate vesting of employer contributions would not apply.

Determining whether a plan is partially terminated is important because the IRS requires that all participants covered under the portion of a plan that is deemed terminated become 100 percent vested in matching and other employer contributions if the contributions were subject to a vesting schedule [IRC §411(d)(3) and Treasury Regulation 1.411(d)-2]. That could be very expensive, and something to think about if rehiring is a viable option.

Conclusion

The determination of whether or not a partial plan termination has happened depends on the facts and circumstances that occur over (at least) a full plan year. Although not binding legal authority, the IRS’s FAQ on rehires during 2020 provides plan sponsors insight into how the IRS will view such activities this year.

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Plan Permanency

“I have a client who set up a defined benefit plan last year and now, because of a financial downturn in his business, wants to terminate the plan. Does the IRS require an employer to maintain a defined benefit (DB) or defined contribution (DC) plan for a certain number of years?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with an advisor in Michigan is representative of a common inquiry related to plan permanency.

Highlights of Discussion

  • While the IRS does not require that a plan sponsor maintain its plan (DB or DC) for a certain number of years, it does state in its Treasury regulations, “The term ‘plan’ implies a permanent, as distinguished from a temporary, program,” [Treasury Regulation 1.401-1(b)(2)].
  • The regulation goes on to say, although the plan sponsor may reserve the right to change or terminate the plan, and to discontinue contributions thereunder, the abandonment of the plan for any reason other than business necessity within a few years after it has taken effect will be evidence that the plan, from its inception, was not a bona fide program for the exclusive benefit of employees in general. The IRS, in such an instance, could deem the plan was never qualified and, consequently, revoke its tax-favored status—making the plan’s assets immediately taxable to participants, and any tax deductions taken null and void.
  • For a bit more insight, the IRS has ruled in Revenue Ruling 72-239 that a plan that has been in existence for over 10 years can be terminated without a business necessity. In IRS Revenue Ruling 69-25, the IRS provided that if a plan is terminated within a few years of its inception and there were no unforeseeable, negative developments in the business that made it impossible to continue the plan, then this is evidence that the employer did not intend the plan as a permanent program. The employer can rebut this presumption by showing that it abandoned the plan as a result of an unforeseeable business necessity. Business necessity, in this context, means adverse business conditions, not within the control of the employer, under which it is not possible to continue the plan, including bankruptcy or insolvency, and discontinuance of the business, along with merger or acquisition of the plan sponsor, as long as the merger or acquisition was not foreseeable at the time the plan was created.
  • In the end, the IRS will judge a plan as permanent or temporary based on the facts and circumstances of the surrounding case. The IRS’s Employee Plans Guidelines for Plan Terminations at 7.12.1.3 outlines what examiners will consider for permanency requirements and what reasons for termination will be considered valid for business necessity.
  • The regulation further states, “In the event a plan is abandoned, the employer should promptly notify the district director, stating the circumstances which led to the discontinuance of the plan.”
  • A plan sponsor’s decision to terminate and reasons for terminating its qualified retirement plan should be thoroughly documented and retained.

Conclusion

Employers who have established or who may be contemplating establishing a qualified retirement plan must be aware that the IRS expects the arrangement will be a permanent one.  And although plan sponsors reserve the right to terminate their qualified retirement plans, the IRS views “business necessity” as the only legitimate reason for plan abandonment.

 

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