New Rollover Rules Require Revision of Participant Notices

February 8, 2008

In the twisted realm of employee benefits law, even a minor change in the rules can cause unexpected inconvenience and exposure to liability for employers. Such is the case with a recently effective rule that permits employees to roll over retirement plan distributions to a Roth IRA. This seemingly innocuous change will require employers to revise the notices that they must distribute to all employees who receive retirement plan distributions that are eligible for rollovers.

New Rules On Rollovers to Roth IRAs

Roth IRAs are after-tax retirement savings accounts. A distribution from a Roth IRA is tax-free if it meets certain requirements regarding (i) the duration of the account, and (ii) the age of the owner. Under prior law, an employee who received a distribution from an “eligible retirement plan” (which includes tax-qualified plans such as 401(k) plans and pension plans, 403(b) plans, and governmental 457(b) plans) could not roll over the account directly to a Roth IRA unless the distribution came from a Roth account. Instead, the employee had to roll over the account to a traditional, pre-tax IRA and then “covert” the traditional IRA to a Roth IRA.

To convert a traditional IRA to a Roth IRA, the employee must include the taxable amount of the IRA (which, unless the plan permits non-Roth after-tax contributions, is generally the entire balance) in gross income.

The Pension Protection Act of 2006 simplified the treatment of Roth IRAs. Effective January 1, 2008, an individual may roll over a balance from an eligible retirement plan directly to a Roth IRA. The tax treatment of this direct rollover is identical to the treatment of a rollover to a traditional IRA followed by a conversion to a Roth IRA.

Effect on Employers

The elimination of an unnecessary step in rollovers to Roth IRAs is a logical and useful simplification of existing law. However, this otherwise welcome change has an unexpected consequence: Most employers will have to revise the notices that they give employees who are eligible for rollover distributions.

Under Internal Revenue Code Section 402(f), employers must provide a written explanation (a “402(f) Notice”) to each employee who is eligible for a rollover distribution that informs them of the employee’s ability to make such a rollover, and the tax consequences of electing a distribution versus a rollover. Employers must now revise these 402(f) Notices to inform employees that direct rollovers to Roth IRAs are permissible.

Because many 402(f) Notices specifically state that direct rollovers to Roth IRAs are not possible or that employees may rollover a distribution only to traditional IRAs, employers should carefully review their 402(f) Notices for inaccurate or misleading language. Failure to deliver a correct 402(f) Notice could subject an employer to IRS penalties or even a lawsuit from an employee who missed his or her opportunity to make a direct rollover to a Roth IRA.

To avoid allegations of providing nonconforming tax information, plan sponsors often use a prototype 402(f) Notice that the Internal Revenue Service (the “IRS”) published many years ago. Unfortunately, this format is woefully out of date, and the IRS has recently announced that it will issue an updated document in the near future. In the interim, plan sponsors are responsible for providing correct information to employees.

Many plan sponsors have outsourced responsibility for providing 402(f) Notices to plan administrators or trustees. Because liability for providing inaccurate 402(f) Notices falls on plan sponsors and other named fiduciaries, those plan sponsors should contact the responsible outside party and seek confirmation that the 402(f) Notices have been updated to reflect the Roth IRA rollover and other recent changes.