As a result of the fiscal cliff tax legislation recently passed by Congress, employers who have or add a “designated Roth account” option to their existing 401(k), 403(b) or governmental 457 plans plan can permit employees to transfer any existing pre-tax account balances (including pre-tax employee deferrals) into a designated Roth account.

Overview
A designated Roth account can be used by individuals if their retirement plan offers this option.  A designated Roth is a separate account in a 401(k), 403(b) or governmental 457 plan to which an employer allocates an employee’s designated Roth contributions and their gains and losses. Instead of making elective, pre-tax contributions to his regular account, the employee directs that part or all of the contribution be made to an after-tax designated Roth account within the plan.

Eligibility to Make Roth Contributions
Unlike a Roth IRA, there is no income limitation on annual contributions to a designated Roth account. Workers of all income levels are eligible to contribute to such retirement accounts.

Rollovers
Under the new legislation, a designated Roth account may accept an in-plan Roth rollover (IPRR) of any pre-tax account whether or not the account is otherwise currently distributable. Under prior law the IPRR had to be from an account that was currently distributable so in most cases employee deferrals could not be transferred to a Roth account.

Taxation
Employees who elect to do an IPRR will be liable for federal income tax on the amount rolled over in the year of the rollover. Federal income isn’t payable on those contributions when they are distributed. If the distribution is a “qualified distribution”, earnings also are tax-free. A qualified distribution is one made: (a) after 5 years has elapsed; and (b) on or after he attains age 59 1/2; because of death or disability.

Implementing Roth Accounts and/or In-Plan Roth Rollovers
Adding a designated Roth account and/or IPRR option to a 401(k) plan provides employees enhanced flexibility in planning for retirement. The designated Roth account option may be an ideal alternative for employees who expect to be in a higher tax bracket when the funds are withdrawn or who wish to pass these funds on to their heirs.

If you are interested in learning more about how your plan may implement designated Roth accounts and /or IPRR’s, contact your Plan Account Manager.

In a recent case, the United States Court of Appeals for the Third Circuit held that a non-fiduciary who knowingly participates in a fiduciary’s breach of one of ERISA’s prohibited transaction provisions may be subject to the disgorgement of the profits he earned even though that planner was not subject to ERISA’s prohibited transaction rules.

The pertinent facts in the case of National Security Systems, Inc. v. Iola, are as follows:

A financial planner induced a number of his clients to become participating employers in a tax avoidance scheme involving an ERISA welfare plan to which large, purportedly tax deductible, contributions would be made. A company established by the promoter of the scheme (who was unrelated to the financial planner) selected insurance policies that would by purchased by the plan and received commissions from those insurance companies. The company in turn shared those commissions with the financial planner.

The Internal Revenue Service audited the clients, disallowed the deduction for the contributions to the plan, and assessed penalties against the clients. The clients later brought suit against various parties involved with the scheme, including the financial planner.

The trial court held that the financial planner, although not a fiduciary or even subject to ERISA’s prohibited transaction rules, could be held liable for knowingly participating in a fiduciary breach. The financial planner’s receipt of insurance company commissions from the promoter’s company (who was a fiduciary by virtue of its selection of the insurance polices for the plan) was sufficient to impose liability when he had knowledge of the transactions in question. As a fiduciary it was prohibited from receiving compensation from any third party (i.e., the insurance company) dealing with the plan with respect to the income or the assets of the plan. Therefore, the court ordered that the planner disgorge the profits he made from recommending the plan to his clients.

On appeal, the financial planner argued that the Supreme Court and the Third Circuit Appeals Court had previously held that only non-fiduciaries who are “parties in interest” under ERISA’s prohibited transaction rules might be subject to liability for knowingly participating in a fiduciary’s breach. (Presumably, the planner was not a party-in interest because he did not service the plan; he only recommended the proposed plan to the client.)

The Appeals Court rejected this argument. It held that the holding of the Supreme Court Decision cited by the planner was not dependent on the status of the defendant as a party-in-interest. ERISA is broad enough that any person who knowingly participates in a fiduciary breach may be held liable. While an earlier Third Circuit case implied that one had to at least be a party-in interest to be liable for participating in a fiduciary breach, that language was not central to the decision in that case and would not be followed, especially where it is inconsistent with a Supreme Court decision.

This decision does not apply to all fiduciary breaches; it is limited to breaches of fiduciary duty that constitute prohibited transactions. Nevertheless, advisors need to be cautious in recommending any plan or program promising extraordinary tax benefits without conducting a thorough due diligence investigation. Likewise, clients need to approach these programs with caution and seek independent advice before investing. The type of welfare plan recommend by the planner was widely criticized at the time as not complying with the law.

A recent case weighed in on the issue of whether one plan fiduciary may seek contribution from other fiduciary for claims of breach of fiduciary duty. The issue is one that has divided federal courts.

Participants in an employee stock ownership plan brought a class action suit against the officers and directors of the plan’s sponsoring employer for breach of fiduciary duty under the Employee Retirement Income Security Act (ERISA). Specifically, they allege that those defendants failed to act solely in the interest of the participants and beneficiaries of the plan, and to exercise the required skill, care, prudence, and diligence in administering the Plan. The defendants asserted a claim against three of the plaintiffs since that they were members of the plan administrative committee. As members of the administrative committee they were also plan fiduciaries; therefore, if there were fiduciary violations, those committee members should bear a portion of that liability.

This case was brought in a Florida federal court. Neither the Supreme Court nor the governing Appeals Court has ruled on the issue of whether an ERISA fiduciary has the right to seek contribution and indemnity from another fiduciary. Other appellate and district courts are split on the issue, leaving it unresolved in many federal courts.

The court found no specific statutory right of contribution under ERISA. That said, the court determined that Congress expects courts to fill in gaps in ERISA’s fiduciary rules through their own holdings. Law that develops through court decisions is referred to as “common law”. Therefore, is “appropriate to develop a federal common law of rights and obligations under ERISA-regulated plans.”

In this case the court looked to the law of trusts to decide this case. They concluded they could look to trust law to fill in gaps in the ERISA statutory schemed unless Congress’ failure to deal with the issue was intentional. The court looked at a decision in New York which applied this rationale to the right of contribution issue. In that case, an appellate court held “the right of action” for contribution and indemnity represents a fundamental principle of equity jurisprudence which “is [nothing] more than a procedural device for equitably distributing responsibility for plaintiff’s losses proportionally among those responsible for the losses.”

It should be noted that courts that reached the opposite conclusion determined that the failure of Congress to deal with this issue was not inadvertent. In enacting ERISA, Congress was concerned with protecting plan participants and beneficiaries; not fiduciaries.

Until the Supreme Court settles the issue, liability of co-fiduciaries for contribution will be determined based where the case originates. Nevertheless, prudence dictates that if you share fiduciary duties with others you need to satisfy yourself that actions carried out by your co-fiduciaries are prudent and in accordance with ERISA.

Plan Disbursement to Former Spouse Procured by Her Fraud Not an Impermissible Forfeiture

In an interesting Federal Appellate Court decision, it was held that a plan participant had no recourse against the Plan where his former spouse fraudulently procured a distribution of his Plan account balance.

Personal Background.

Mr. Foster was employed by PPG from October 1988 to October 20, 1999. While employed by PPG, Mr. Foster participated in the employer’s 401(k) employee stock ownership plan When Mr. Foster separated from PPG employment, he did not elect to withdraw his money from his Plan account, but rather deferred receipt of his benefits, thereby remaining a Plan participant.

Mr. Foster was married from 1993 until July 27, 2004, when the couple divorced. During their marriage, the Fosters lived together in the marital residence. When Mr. Foster left his employment with PPG in 1999, he still resided at the marital residence, and this address remained on file with PPG as his permanent address. In early July 2004, prior to the finalization of the divorce, Foster moved out of the marital residence, but Foster did not change his permanent address on file with PPG and the Plan until September 21, 2005. His wife, who we shall call “Ms. Foster”, continued to live at the marital residence. At no time between July 2004 and September 2005 did Foster file an official change of address form with the U.S. Postal Service or otherwise notify PPG or the Plan of his change of address.

Plan Account Access.

PPG had implemented automated systems for Plan participants to access their accounts, and notified Plan participants of how to use these systems. In March 2005, PPG mailed information on how to establish a new User ID and password, marked “To Be Opened By Addressee Only,” to the marital residence. Ms. Foster received the document and used the information it contained, along with Foster’s Social Security number, to attempt to gain access to Foster’s account online. In accordance with its procedures, PPG processed the password reset request and sent it to the “permanent address on file,” i.e., the marital residence. On May 8, 2005, armed with the new password and Foster’s Social Security number, Ms. Foster created a User ID, password, answers to security questions, and beneficiary designation on Foster’s account, changed the mailing address on the account to her P.O. box, and requested a withdrawal of $4,000, to be directly deposited to an account in her name. By September 13, 2005, Ms. Foster had emptied the entire account. Mr. Foster did not learn of the withdrawal until he received a 1099-R form in January 2006.

Dealings With PPG.

Mr. Foster sought to have his account restored on the basis that the withdrawal was not authorized by him. PPG refused claiming they had proper security measures in place to ensure the safety of participants’ assets in the Plan. Mr. Foster then filed suit against PPG and the Plan. The trial court ruled against him and an appeal followed.

Denial of Claim for Benefits was not Forfeiture of Benefits

An employee’s right to his or her “normal retirement benefit” is nonforfeitable upon the attainment of normal retirement age. However, the court noted that the forfeiture rules of ERISA do not entitle a participant to a fixed amount of benefit regardless of any and all later-occurring conditions, including the theft of funds in the situation presented here. The rules limiting forfeiture of benefits do not operate as a guaranty of benefits in all situations. The employee’s right to claim benefits was not abrogated by the plan. The fact that his claim, after full and fair review, was denied (in large measure due to his failure to maintain a current address with the employer), the court concluded, did not constitute a forfeiture.