A. Introduction

The field of employee benefits is one which applies to banks with or without trust departments. Employee benefit plans are vehicles for which the benefits promised by an employer are funded, administered, and provided to eligible employees or members. Individual Retirement Accounts (IRAs) established by individuals under certain provisions of the tax laws are also covered in this section.

Employee benefit plans represent a diverse field. Plans vary according to the types of benefits provided, the manner in which plan assets are administered, and the manner in which benefit amounts are provided to the employees/participants and their beneficiaries. Every bank offers various types of employee benefits to its employees and their beneficiaries. As such, portions of the material in this section of the manual are relevant to every bank supervised by the FDIC.

Bank trust departments may manage the bank's own employee benefit plan(s) for its own employees. The trust department may perform the same services for the bank's parent holding company and affiliates. In addition, the trust department may service employee benefit plans sponsored by outside corporations, unions, individuals, and government entities.

B. Scope of Bank Activity

C. Types of Benefits

One way of describing various types of employee benefit plans is to reference the types of benefits the plan provides. In general, there are two types of benefits: retirement and welfare.

Retirement plan benefits generally arise when an employee is qualified to retire, and often provide benefits to the employee's spouse and dependents. Some retirement plans involve the deferral of income for periods extending to the termination of employment, or beyond. Such plans usually cover key members of management. Retirement plans involve a number of different types of plans and funding arrangements. Although trust departments are generally more active in the retirement benefits field, examiners need to be aware of the general requirements for welfare benefit plans as well.

The term welfare benefits is used to describe non-retirement benefits. Welfare benefits may involve health and life insurance, scholarships and education assistance, day care centers, apprentice programs, prepaid legal services, vacation and sick-leave programs, and all other non-retirement benefits.

A second, and more common way of generically describing various types of employee benefit plans involves the method used to determine how assets are contributed to the plan. In this regard, there are two main types of pension plans: defined benefit and defined contribution plans.

Most plans operated by private employers are offered, at least in part, because contributions to the plan are tax deductible to the plan sponsor. In order to be tax deductible, an employee benefit pension plan must meet certain minimum standards and have certain provisions required by the Internal Revenue Service (IRS). As the tax laws and regulations tend to change often, the specific requirements, eligibility, conditions, and thresholds also are subject to change.

D.1. Defined Benefit Plans
A defined benefit plan is one which establishes a formula to define what the participant (employee) is entitled to receive. The formula is usually based on longevity and/or income. Most traditional pension plans use this approach, which often provides greater benefits the longer the employee stays with the plan sponsor. Employees/participants are entitled to the percentage of the benefits established under the plan. This entitlement is termed "vesting."

D.1.a. Defined Benefit Pension Plans
In this approach, the benefit payment is defined. The participant is entitled to whatever amount the formula results in, and has a claim against all of the plan's assets for payment of the vested benefit. The plan sponsor (employer or union) is responsible for ensuring that sufficient assets are in the plan to pay those defined benefits. The most common type of defined benefit plan is the traditional pension plan.

Pension plan benefits are generally paid out in the form of a life annuity beginning at the participant's normal retirement date. Other methods of paying benefits are installment payments and lump sum distributions, with options sometimes given to the participant. The Pension Benefit Guarantee Corporation (PBGC) insures the benefits of private defined benefit plans to the extent provided in Title IV of ERISA.

In private plans, it is common for retirement benefits payable under the pension plan to be set in conjunction with Social Security benefits. Benefits calculated in this manner are said to be integrated with Social Security retirement benefits. IRS regulations governing the integration of Social Security benefits are complex and designed to prevent discrimination in favor of highly paid employees.

Defined benefit plans are more expensive to administer and operate than defined contribution plans. Defined benefit plans involve projecting a host of variables to estimate the amount of benefits payable upon retirement and the amount of assets that must be contributed today to fund those benefits in the future. Actuaries are required to perform the projections. Due to the extra costs involved, defined benefit plans have become less popular, with many defined benefit plans terminated and replaced by defined contribution plans.

D.1.b. Cash Balance Plans
Another form of defined benefit plan is the "cash balance" plan. Cash balance plans are similar to traditional defined benefit pension plans in that: (a) they guarantee a specific benefit upon retirement which is not dependent upon the plan's investment performance; (b) retirement benefits are payable as an annuity with surviving spouse protection; (c) employers must follow minimum funding policies under ERISA, and (d) basic plan benefits are guaranteed by the PBGC up to limits set by law.

In recent years, this type of plan has become increasingly popular. Most of these plans have emerged as conversions from overfunded traditional defined benefit pension plans. Following conversion, plan assets remain intact. And employers cannot remove overfunded assets unless the plan has been terminated and full benefits under the terminated plan have been funded. Despite this protection, some conversions by high profile employers have attracted media attention. The focus of much of the attention, and controversy, surrounds diminished benefits for employees with long years of service. Unless employers take explicit steps to protect older employees with long company service, conversions from traditional pension plans (whose benefits are largely determined by years of service and final average pay) into cash balance plans, may impact these employees negatively.

Cash balance plans differ from traditional defined benefit plans in that they define benefits in terms of a stated "account balance," as opposed to a specific monthly benefit for life under traditional defined benefit pension plans. In this form of plan, employers credit a participant's account each year with a "pay credit" (typically based on a percentage of compensation) plus an "interest credit" (either a fixed rate, or a rate which is linked to an index, such as the one year treasury bill rate). When a participant retires under a cash balance plan, he or she is entitled to the balance of his or her vested benefit (similar to a defined contribution plan), which may be taken as an annuity or in a lump sum. This is opposed to retirements under traditional defined benefit pension plans, where retirees are entitled to lifetime monthly annuities based upon years of service and pay.

A transition device, called "wearaway," is sometimes offered to employees with long service when traditional defined benefit pension plans are converted to cash balance plans. Wearaway provides employees the option of receiving the greater of their frozen benefit under the phased out pension plan formula, or their total benefit under the cash balance formula. Employees near early retirement age may accrue little or nothing for a prolonged period under a cash balance plan until the phased out plan benefit is worn away. This is because the value of the traditional pension plan benefit may be far greater than future accruals under the cash balance plan. Furthermore, beginning balances under the cash balance plan may be set lower than the present value of the phased out plan's accrued benefit. This serves to worsen the wearaway effect. Some employers temper the adverse conversion impact on long service employees by: (a) "grandfathering" them under the older plan's benefit formula, (b) providing higher "pay credits," (c) setting their opening balances higher, or (d) permitting employees to choose between benefit formulas under the old or new plans.

Employer accruals under a typical cash balance plan remain relatively level, increasing only slightly toward the end of an employee's career. Employer accruals under a traditional defined benefit pension plan begin relatively low, but increase sharply as an employee approaches retirement. This tends to make cash balance plans less costly to fund and operate than traditional defined benefit pension plans. Unlike traditional pension plans, cash balance plans also typically eliminate early retirement options but permit participants to receive retirement benefits in a lump sum, which can be rolled over into an IRA or another employer's plan.

D.2. Defined Contribution Plans
A defined contribution plan is one which establishes a formula defining how much the plan sponsor will contribute to the plan. The formula may be based on the sponsor's profitability, on the amount of the participant's earnings, or on any number of other factors or combinations. In some plans, the sponsor determines the amount of contribution on a discretionary basis.

Profit sharing, employee stock ownership, thrift 401(k) and 403(b), Simplified Employee Pension (SEP)-IRA, Salary Reduction SEP (SARSEP), Savings Incentive Match Plan for Employees (SIMPLE), and other types of commonly encountered plans use the defined contribution approach. As with defined benefit plans, plan participants are entitled to their vested percentage of the benefits, as established under the plan.

In this approach, the contribution is defined; the benefit payment is not. The benefit amount is dependent on both the amount contributed and the success of the investment results. Under this approach, the participant is entitled only to the amount in his or her account, based on the varying amounts contributed and the investment return. The participant has a claim only on the assets of his or her account in the plan; there is no claim against all of the plan assets belonging to other plan participants. The PBGC does not insure the benefits of defined contribution plans.

In general, there are five basic types of plans or formulas for defined contribution plans: profit sharing, money purchase pension, target benefit, stock bonus, and employee stock ownership.

D.2.a. Profit Sharing Plans
A profit sharing plan is a qualified defined contribution plan which is also an Individual account plan. These plans are subject to ERISA. Plan assets are often invested wholly in the employer's stock. ERISA diversification requirements are not generally violated so long as the plan or trust instrument allows no more than 10% of the plan's assets to be invested in employer securities, except as provided in Section 407(a) of ERISA. Such plans are believed to foster productivity on the part of employees, who will own part of the company.

There are two types of profit sharing plans: current or deferred plans. In a current profit sharing plan, profits are paid directly to employees in cash, check, or stock as soon as profits are determined. Deferred profit sharing plans are more common. Deferred profit sharing plans are defined contribution plans operating under a written plan and qualified under the Internal Revenue Code (IRC) where the employer provides retirement benefits.

The employer's contribution to the plan each year can be either purely discretionary (nothing at all, if the employer wishes) or based on some type of predefined formula. If a formula is used, it typically relates the contribution to the employer's profits. The term profit sharing plan implies that an employer must have profits before any contributions are made to the plan. However, this requirement was eliminated under the Tax Reform Act of 1986. Contributions to profit sharing plans are not required to be based on an employer's profits according to Section 401(a)(27)(A) of the IRC.

The plan must provide a definite predetermined formula for allocating the contributions made to the plan among the participants. In addition, the plan must provide a predetermined formula for distributing the fund accumulated under the plan after a fixed number of years; attainment of a stated age; or upon the prior occurrence of some event such as layoff, illness, disability, retirement, death, or severance of employment.

Generally, contributions are allocated to participants in proportion to their compensation with subsequent allocations reflecting future contributions adjusted by the investment experience of the plan. Plan benefits consist of the amount accumulated in each participant's account including: (1) employer contributions,   (2) forfeitures from other employee's accounts, and (3) interest and capital gains. Many plans permit participants to borrow against their vested interest in the plan.

D.2.b. Money Purchase Pension Plans
A Money Purchase Pension Plan (MPPP) is a defined contribution plan which is also an Individual account plan. Employer contributions are usually determined based upon a percentage of compensation for specific Individuals. As with the profit sharing plan, benefits for each participant are derived from the amounts contributed to each Individual account. Unlike a profit sharing plan, forfeitures are not added to participants' accounts but are used to reduce the employer's contributions.

Money purchase pension plans differ from profit sharing plans in a number of ways:

• MPPPs must state a definite formula or approach for employer contributions; contributions may not be determined annually by the employer;

• MPPPs are subject to minimum funding requirements of the IRC;

• MPPPs must provide for a life annuity as a distribution option;

• MPPPs have different deduction limitations under the IRC than profit sharing plans; and

• MPPPs distributions are not permitted before retirement age, death, disability, or termination of either the plan or employment.
  

D.2.c. Target Benefit Plans
Target benefit plans are intended to provide a target benefit to each participant upon retirement. Employer contributions to each participant's account are established through a defined benefit formula. The amount of the contribution is determined by an actuary. The plan does not guarantee that the target benefit will be paid at retirement; its only obligation is to pay whatever can be provided by the amount in the participant's account depending on the actual investment results achieved by the fund. A life annuity must be one distribution option for the employee.

Target benefit plans are hybrids of a money purchase plan and a defined benefit plan. Target benefit plans are Individual account plans because contributions are allocated to each participant's Individual account.

D.2.d. Stock Bonus Plans
Stock bonus plans are identical to profit sharing plans and are usually established to permit employees to share in the ownership of the business and/or to reward meritorious service. Contributions, as with profit sharing plans, are not necessarily based upon profits and the benefits are distributable in cash or stock of the employer.

Generally, the plan must allow the participant to demand that the benefit be distributed in employer securities. If employer stock is not traded on an established market, the employee must have the right to require the employer to repurchase the stock under a fair market value formula.

D.2.e. Employee Stock Ownership Plans (ESOPs)
The information presented under this section will apply to both ESOPs sponsored by the bank for its own employees, and ESOPs found in the bank's trust department which are sponsored by different employers. In addition to the material presented under this heading, examiners should also refer to the following:  
(1) ESOP Plans - Employer Securities Investments - Prudence; (2) ESOP Plans - Employer Securities Investments - Valuation; and (3) ESOPs Loans to Plans - Section 408 Statutory Exemption. The pertinent areas related to ESOPs are noted below:

• ESOPs, In General
  
• Leveraged ESOPs
  
• Advantages and Disadvantages of ESOPs

D.2.e.(1). ESOPs, In General
An ESOP is an Individual account plan that is either a qualified stock bonus plan or a combination qualified stock bonus and qualified money purchase plan. ESOPs provide separate accounts for each participant. Benefits are based solely on amounts contributed to each Individual account including attributable income, expenses, gains and losses, and allocated forfeitures of other participants' accounts. ESOPs are defined in Section 407(d)(6) of ERISA, Department of Labor (DOL) ERISA Regulation 2550.407d-6, and Section 4975(e)(7) of the IRC. See Appendix E.

Congress has provided a number of tax incentives to encourage the formation and continuation of ESOPs. ESOPs operate primarily under IRS requirements but are also subject to certain ERISA provisions. Since tax incentives impact government revenues, the rules under which ESOPs operate are subject to change by Congress and implementing IRS regulations. Some ESOPs which reflect various statutory or regulatory approaches have special names: Tax Reform Act Stock Ownership Plans (TRASOPs), Payroll-deduction Stock Ownership Plans (PAYSOPs), etc.

Most ESOPs invest solely in the employer's stock. Since many companies are either closely-held or have a very limited market for their stock, valuing the stock can prove problematic and provide opportunities for abuse. The value of the employer's stock greatly impacts the employee's eventual benefits.

In reviewing the administration of an ESOP's investments, the examiner must be cognizant of the following facts pertaining to ESOPs. ESOPs:

• Are not exempt from ERISA's prudence and exclusive benefit rules; but
  
• Are exempt from ERISA's diversification rule; and
  
• May be exempt from prohibited transactions (purchases and sales of employer securities from the employer and/or parties in interest) if certain conditions are met. In general, refer to ERISA Section 408(e) and DOL ERISA Regulation 2550.408e. See Appendix E. Three main conditions for exemption require:
  • Not more than adequate consideration may be paid by the plan (see Definitions, ERISA 3(18);
    
  • No direct or indirect commissions may be paid; and
    
  • The investment meets the prudence requirement of Section 404(a) of ERISA.

As tax-qualified plans, ESOPs must follow applicable IRS requirements, in addition to ERISA provisions. Except as otherwise indicated below, IRS Regulation 54.4975-11 (see Appendix E) establishes most of the following operational requirements for ESOPs. An ESOP must:

• Be formally designated as an ESOP in the plan document.

• Be designed to invest primarily in qualifying employer securities. For leveraged ESOPs, investments are restricted to the employer's common stock or convertible preferred stock; stock rights, warrants, and options are not considered in the definition. For non-leveraged ESOPs, the definition also includes marketable bonds, debentures, notes, and similar marketable debt instruments of the employer.

The types of qualifying employer securities are covered by IRS Regulation 54.4975-12. DOL ERISA Regulation 2550.407d-5 defines the term qualifying. See Appendix E.

• Value employer securities in accordance with both IRS and ERISA requirements. The valuations affect purchases and sales of employer securities, market-value reporting on the Annual Report (Form 5500), allocations to participants' accounts, and distributions to participants.

ERISA Section 408(e)(1) and DOL ERISA Regulation 2550.408e require that transactions for employer securities involve no more than adequate consideration. This term is defined in ERISA Section 3(18).

Section (d)(5) of IRS Regulation 54.4975-11 requires certain steps when valuing employer securities by an ESOP. For securities traded on securities exchanges, the quoted prices may be used. If the stock is publicly traded, no appraisal is necessary. But if it is traded infrequently, an appraisal may still be needed. In general, employer securities which are not readily tradable on an established securities market must be valued by an independent appraiser.

• Valuations must be made in good faith and based on all relevant factors:
  
  • In any transaction between the ESOP and a disqualified person, the value of the securities must be determined as of the date of the transaction. In such transactions, an independent appraisal, by itself, does not automatically equal good faith.
    
  • For all other transactions, values must be determined as of the most recent valuation date under the plan. In such transactions, an independent appraisal will generally be deemed to be a good faith determination of value.
    

• Include a put option. IRC Section 401(a)(23) also states that, to be qualified, a stock bonus plan must include a put option for securities that are not publicly traded.

With a put option, an employee who is entitled to a distribution from an ESOP has the option of requiring the employer to repurchase employer securities from the employee's Individual account in the plan. If the securities are not readily tradable on an established market, the securities must be valued at a reasonable fair market value. Through this arrangement, the employee receives a cash distribution instead of an in-kind distribution of illiquid securities.

• Include a suspense account for which assets are added to and maintained.
  

In addition, an ESOP must (1) pass voting rights through to participants for those shares allocated to Individual accounts according to Security and Exchange Commission (SEC) Regulation 240.14c-7 and (2) meet stringent nondiscrimination tests as to employee participation according to IRS regulations.

ESOPs can acquire assets through: (1) an outright gift of cash or newly issued common stock to the plan, (2) a thrift arrangement under which employees contribute money (PAYSOPs), (3) a profit-sharing arrangement where the employer's annual contribution is a percentage of profits, or (4) a money purchase arrangement where a percentage of compensation is contributed each year irrespective of profits. Most ESOPs; however, obtain initial funding through loans and are termed leveraged ESOPs. Loans to ESOP plans must comply with IRS and Labor Department requirements. Refer to the Leveraged ESOPs caption below.

D.2.e.(2). Leveraged ESOPs
Since a majority of ESOPs are leveraged, the examiner needs to understand the concept of a leverage ESOP and the conditions that apply. A corporation creates an ESOP, alone or in addition to (sometimes referred to as piggyback) another qualified retirement plan. The ESOP applies for a loan. The lender is usually an independent third party, but it could be anyone, including a party in interest such as the plan sponsor or the bank.

A number of conditions apply to such loans when the loan is with or guaranteed by a party in interest. The ESOP loan should be primarily for the benefit of participants and beneficiaries. Demand loans are not permitted and the loan must be payable over a set period. Terms of the loan must be, at the time it is made, at least as favorable to the ESOP as those of a comparable loan negotiated at an arm's-length basis by independent parties. No more than a reasonable rate of interest may be charged. While the loan may be unsecured, most ESOP loans are secured. If collateral is given by the plan to a party in interest, it may consist only of qualifying employer securities.

Leveraged financing may operate in two different ways. In the first way, the company gives the lender a written guaranty promising that the ESOP will repay the loan and that, each year, the employer will contribute to the ESOP sufficient funds to permit the ESOP to make its annual repayment of the loan. In the second way, the company borrows money from a bank and lends the money to the ESOP under terms identical to those negotiated between the company and the bank (mirror loan). After one of the financing options is chosen, the ESOP takes the loan proceeds and purchases qualifying employer securities at a reasonable price. Purchases must meet the conditions of ERISA Section 408(e) to avoid violating prohibited transaction rules.

Company contributions to the ESOP, which are tax-deductible under IRC Section 404, are used to pay off the loan. The employer's entire plan contribution (used to pay back the loan) is deductible within the limits of the IRC. If the employer borrowed the money directly, only the interest paid on the loan, and not repayment of the principal, would be deductible. The payments release a proportionate amount of securities from the loan's collateral. The securities, which were held in a suspense account by the plan, can be allocated among the plan participants as portions of the loan are paid off.

D.2.e.(3). Advantages and Disadvantages of an ESOP
There are a number of factors that influence the decision to sponsor an ESOP. Many of the considerations are tax-oriented. The plan sponsor, participating employees, and other parties all derive various advantages and disadvantages from the operation of an ESOP.

Employer Considerations
The employer's advantages include the fact that ESOPs are believed to foster productivity on the part of employees who will own part of the company. An ESOP may also provide a means of raising capital internally without resorting to outside financing, which may be more expensive. If leverage for the ESOP is necessary, the lender may offer a lower interest rate to the plan since interest received on the loan may be non-taxable to the lender (see Lenders to ESOPs). In addition, an ESOP may be used to convert a public company to a private one or to resist an unwanted takeover. An ESOP used for such a purpose is subject to, among other things, the fiduciary responsibility and prohibited transaction provisions of Title I of ERISA, Protection of Employee Benefit Rights

Operating an ESOP also offers the employer a number of tax advantages. Tax deductions are available for stock or cash contributions to the plan, cash dividends paid to plan participants, and dividends used to repay the loan. Particularly noteworthy is that the employer's entire plan contribution (used to pay back the loan) is deductible within IRC Section 404 limits.

Disadvantages for the employer involve the dilution of ownership and/or control, and the difficulties and costs inherent in arriving at recurring fair market valuations for thinly-traded securities.

Employee Considerations
The primary consideration for most employees is that contributions made by the employer and accumulated earnings are tax-deferred. In addition, taxes on stock appreciation, when the stock is distributed, may be deferred by rolling the distribution over into an Individual Retirement Account (IRA). The fact that ESOPs offer employees a stake in the employer corporation through stock ownership has meant, in some situations, that employees have been able to save their jobs by purchasing a company or production facility which was scheduled for closure.

One significant disadvantage is that the employee bears all investment risk. In addition, the employee's investment is concentrated in one company's stock performance and valuations for the employer stock may be difficult to achieve. If the outlook for the employer's industry or for the employer itself is poor, the employee's retirement benefits may be threatened. Ownership of marginal or poorly managed companies, or those in declining industries, is of little value to employees and no foundation for careful retirement planning. As with any defined contribution plan, the employee's benefits are not insured by the PBGC.

When employees own stock in the employer, they exercise a certain amount of control over the employer. However, their influence may be limited as most ESOPs do not own a majority of the company's stock. Only shares allocated to Individual accounts have voting rights. And, the allocation of stock to Individual employees' accounts is a slow process in leveraged ESOPs. Voting rights are fully passed through only in publicly traded companies; in non publicly traded companies, only certain issues are voted on by participants. In a number of instances where an ESOP was formed to permit employees to purchase a facility from the employer, the employees owned a majority of the stock but management controlled voting authority. In effect, the employees may have little or no say in how the company they own is managed or operated.

To qualify for tax credit under IRC Section 409, ESOPs are required to pass the following voting rights on to Individual accounts holding allocated shares. IRC Section 409(e)(2) requires plans holding registered employer securities to permit plan participants to direct the plan on how to vote allocated securities. Where plans hold non-registered securities, IRC Sections 409(e)(3) and (5) require plans to permit plan participants to direct the plan on how to vote allocated securities with respect to corporate matters, such as: mergers, consolidations, recapitalization, reclassification, liquidation, dissolution, sale of substantially all assets of a business, or similar transactions. IRC Section 409(e) is located in Appendix E.

Lenders to ESOPs
Tax laws provide incentives for lenders to grant loans to ESOPs. Under IRC Section 133, 50% of the interest the lender earns from an ESOP loan is non-taxable income when certain conditions are met:

• The ESOP owns at least 50% of each class of the outstanding stock of the corporation issuing the stock (or 50% of all outstanding stock) immediately after the acquisition (there are some limited additional provisions for isolated situations);
  
• The term of the loan isn't for more than 15 years; and
  
• The participants can direct the plan how to vote the shares allocated to their Individual accounts and acquired with the exempt loan.

These loans carry normal credit risk to the lender; plan sponsors in weak financial condition may involve more than normal credit risk. If the employer is unable to make its contributions to the ESOP, the plan will be unable to repay the lender. If the lender exercises its rights as a secured lender (the employer stock collateral pledged by the ESOP and the employer guarantee), it may wind up owning and operating the company.

Company Shareholder Considerations
Generally, if an ESOP exists, shareholders of the employer have a ready market for their stock. In addition, if a shareholder sells his or her employer stock to the ESOP, any unrealized gain may be deferred. The shareholder may elect not to recognize the gain on the sale of stock to the ESOP if qualified replacement property is purchased within the replacement period. Refer to IRC Section 1042 regarding the Sales of Stock to Employee Stock Ownership Plans or Certain Cooperatives.

D.2.f. Thrift and Savings Plans
A thrift or savings plan is a defined contribution plan which is also a type of Individual account plan. These plans are employer sponsored and employee participation is normally voluntary. The plans permit the employee to make contributions, usually established as a percentage of pay. Employers normally make matching or partially matching contributions.

In many thrift and savings plans, employees can direct their plan assets into several pre-selected investment vehicles. Many corporate plans include employer stock as one of the investment options for these plans. An advantage to a plan where the employee decides how to invest funds in his or her plan account is that there is a reduced fiduciary liability for both the plan sponsor and any bank trustee. Self-directed thrift plans must generally comply with the requirements of DOL ERISA Regulation 2550.404c-1. This is discussed further in subsection H.5.c.(6), Individual Account (Section 404(c)) Plans.

Most thrift and savings plans are tax-qualified. Section 401(k) of the IRC, which originally was added in 1978, permits employers to establish tax-qualified cash or deferred profit sharing or stock bonus plans. Under such plans, taxes on amounts contributed by both the employer and the employee, as well as accumulated earnings are deferred. With a salary reduction-type arrangement, the employees receive less current cash income and pay correspondingly lower Federal income taxes. Essentially, what a salary reduction plan accomplishes is to permit employees to provide for their own retirement with pre-tax dollars, rather than after-tax dollars.

To qualify for the mentioned tax benefits, the IRS requires the plan document to cover a number of specific areas. Among these are nondiscrimination in eligibility for the plan, and provisions to assure that executives and highly-paid employees do not receive preferential treatment. Vesting, withdrawals, participant loans, distribution of benefits, and other requirements must be met. The IRS rules governing these matters are complex and are primarily a concern for the plan sponsor, not a bank fiduciary.

D.2.g. Welfare Benefit Plans
The more common types of employee welfare benefit plans and the related benefits include:

• Health Plans which provide for hospital expenses, diagnostic X-ray and laboratory fees, surgical and medical fees, medicine and drugs, major medical insurance, accidental death and dismemberment, and life insurance benefits. Such plans may also provide for dental care, visual care, psychiatric care, and preventive medical examinations.
  
• Disability Plans which normally provide benefits during periods of inability to work because of physical incapacity from illness or injury.

• Vacation and Holiday Plans which provide cash benefits to cover time off for vacation purposes.

• Apprenticeship, Educational, and Similar Plans which provide funds for retraining Individuals in the event of termination of a job in a particular industry, provide an opportunity to expand skills to improve job performance, or take on new responsibilities within or outside of the company.

• Multiple Employer Welfare Arrangements (MEWAs) which permit a pooling of employer contributions to purchase health insurance for their employees at favorable rates. Problems can arise because some suppliers offer attractively priced but unfunded "insurance-like" products without complying with state insurance laws. These suppliers claim their products are employee benefit "plans" and are, therefore, preempted from state insurance laws by ERISA. In doing so, they attempt to avoid state regulation and insurance reserve requirements. The following rules apply: (1) when a MEWA is covered by ERISA and fully insured (which rarely happens), state insurance laws may apply to the extent they provide specified levels of reserves and contributions to pay future benefits; (2) when a MEWA is covered by ERISA and not fully insured, any state insurance law "not inconsistent" with ERISA may also apply; (3) when a MEWA is not covered by ERISA, no preemption can be claimed. Refer to subsection L, Compliance with State Laws for additional comment on state law and MEWAs. [The term MEWA is defined for purposes of Title I of ERISA in Section 3(40)(A); section 514(b)(6) of ERISA addresses the issue of presumption with respect to MEWAs.]

Most single employer welfare plans are either insured plans or unfunded plans. The insured plans typically provide medical and/or life insurance. The unfunded benefit plans most common for single employers are vacation and sick leave plans. The establishment of a single trust, to which contributions are made and from which benefits are paid, normally involves multiple employer plans. Occasionally larger corporations may provide medical and life benefits on a self-insured basis. In these instances, a trust to which annual contributions are made may be established.

Since welfare benefits are normally included in group insurance programs, an examiner will infrequently encounter a trust department acting as trustee of a welfare benefit plan. However, trusteed welfare benefit plans are subject to the various provisions of ERISA in the same manner as pension benefit plans. Thus, when encountered in trust departments there must be a plan and trust document which defines the manner of contribution, provides the basis for payment of benefits, and describes the manner in which such plan funds are to be invested.

D.3. Abandonned Plans

The Abandoned Plan Program facilitates the termination of, and distribution of benefits from, individual account pension plans that have been abandoned by their sponsoring employers. The program was established pursuant to three final regulations and a related class exemption and is administered by Employee Benefits Security Administration national and regional offices.

Significant business events, such as bankruptcies, mergers, acquisitions, and other similar transactions affecting the status of an employer, too often result in employers, particularly small employers, abandoning their individual account pension plans (e.g., 401(k) plans). When this happens, custodians such as banks, insurers, mutual fund companies, etc. are left holding the assets of these abandoned plans but do not have the authority to terminate such plans and make benefit distributions – even in response to participant demands. In these situations, participants and beneficiaries have great difficulty accessing the benefits they have earned. In response, the Labor Department’s Employee Benefits Security Administration (EBSA) has developed rules to facilitate a voluntary, safe and efficient process for winding up the affairs of abandoned individual account plans so that benefit distributions are made to participants and beneficiaries. Information about the program is available under the Abandoned Plan Program section of EBSA’s Web site at www.dol.gov/ebsa.

Overview of Regulations

The regulations, 29 CFR Parts 2550 and 2578, establish standards for determining when a plan is abandoned, simplified procedures for winding up the plan and distributing benefits to participants and beneficiaries, and provide guidance on who may initiate and carry out the winding-up process.

Plan Abandonment

A plan generally will be considered abandoned if no contributions to or distributions from the plan have been made for a period of at least 12 consecutive months and, following reasonable efforts to locate the plan sponsor, it is determined that the sponsor no longer exists, cannot be located, or is unable to maintain the plan.

Determinations of Abandonment

Only a qualified termination administrator (QTA) may determine whether a plan is abandoned under the regulations. To be a QTA, an entity must hold the plan’s assets and be eligible as a trustee or issuer of an individual retirement plan under the Internal Revenue Code (e.g., bank, trust company, mutual fund family, or insurance company).

Termination and Winding-Up Process

The regulations establish specific procedures that QTAs must follow, including:

• Notifying EBSA prior to, and after, terminating and winding up a plan.
• Locating and updating plan records.
• Calculating benefits payable to participants and beneficiaries.
• Notifying participants and beneficiaries of the termination, their rights and options.
• Distributing benefits to participants and beneficiaries.
• Filing a summary terminal report.

A QTA is not required to amend a plan to accommodate the termination.

The regulations include model notices that the QTA may use.

Distribution Safe Harbor for Missing Participants

The regulations establish a fiduciary safe harbor for distributions from terminating individual account plans (whether or not abandoned) on behalf of missing participants.

In most cases, the account of a missing participant will be transferred directly to an individual retirement plan. In some cases, accounts of $1,000 or less may be distributed to a bank account or state unclaimed property fund on behalf of the missing participant.

Fiduciary Liability

QTAs that follow the regulations will be considered generally to have satisfied the prudence requirements of ERISA with respect to winding-up activities.

A QTA does not have an obligation to conduct an inquiry or review to determine whether or what breaches of fiduciary responsibility may have occurred with respect to a plan prior to becoming the QTA for such plan.

A QTA is not required to collect delinquent contributions on behalf of the plan, provided that the QTA informs EBSA of known delinquencies.

Since more than one entity may be holding assets of a plan, the regulations provide a safe harbor for other asset custodians who cooperate with the QTA.

Annual Reporting Relief

The regulations provide annual reporting relief, under which QTAs are not responsible for filing a Form 5500 Annual Report on behalf of an abandoned plan, either in the terminating year or any previous plan years; but the QTA must complete and file a summary terminal report at the end of the winding-up process.

Instructions on how to file the terminal report will be available under the Abandoned Plan Program section of EBSA’s Web site at www.dol.gov/ebsa.

Class Exemption

Accompanying the regulations is a class exemption, PTE 2006-06 (116KB PDF file - PDF Help), that provides conditional relief from ERISA’s prohibited transaction restrictions.

The exemption would cover transactions where the QTA selects and pays itself:

• For services rendered prior to becoming a QTA.
• To provide services in connection with terminating and winding up an abandoned plan.
• For distributions from abandoned plans to IRAs or other accounts maintained by the QTA resulting from a participant’s failure to provide direction.

D.4. Health Savings Accounts (HSAs)

Health Savings Accounts (HSAs) were created on December 8, 2003 under Title XII of the Medicare Prescription Drug, Improvement and Modernization Act of 2003," (MPDIMA of 2003) and updated under Title III of the Tax Relief and Health Care Act of 2006 (TRHCA of 2006).

In general, HSAs are tax-exempt trusts or custodial accounts created exclusively to pay for the qualified medical expenses of the account holder and his or her spouse and dependents. Individuals with a high deductible health plan (and no other health plan other than a plan that provides certain permitted coverage) may establish an HSA. However, individuals who may be claimed as a dependent on another person’s tax return are not eligible to open an HSA. HSAs provide tax-favored treatment for current medical expenses as well as the ability to save on a tax-favored basis for future medical expenses. Within limits, contributions to an HSA made by or on behalf of an eligible individual are deductible by the individual. Where the establishment of an HSA is voluntary on the part of an employee, and the employer does not influence or limit the investment or use of HSA funds, the HSA does not constitute "employee welfare benefit plans" for purposes of Title I of ERISA. Individuals may make tax deductible contributions to the HSA even if they do not itemize deductions; the individual’s employer can make contributions that are not taxed to either the employer or the employee; and, employers sponsoring cafeteria plans can allow employees to contribute untaxed salary through salary reduction. Individuals age 55 and older are also allowed to make additional catch-up contributions to their HSAs. Furthermore, certain credits on behalf of the individual by plan sponsors are permissible and not viewed as a prohibited transaction under ERISA or the Code. Amounts contributed to an HSA belong to the account holder and are portable. Earnings on HSAs are not taxable, and can grow tax-free through investment earnings. Unlike amounts in Flexible Spending Arrangements that are forfeited if not used by the end of the year, unused funds remain available for use in later years. Distributions from an HSA for qualified medical expenses are not includible in gross income. However, distributions from an HSA which are not used for qualified medical expenses are includible in gross income and subject to an additional 10 percent tax. The additional tax does not apply if the distribution is made after death, disability, or the individual attains the age of 65. After an individual has attained age 65 and becomes enrolled in Medicare benefits, contributions cannot be made to an HSA.

A high deductible health plan is a health plan that, for 2007, has a deductible that is at least $1,100 for self-only coverage or $2,200 for family coverage and that has an out-of-pocket expense limit that is no more than $5,500 in the case of self-only coverage, and $11,000 in the case of family coverage. Out-of-pocket expenses include deductibles, co-payments, and other amounts (other than premiums) that the individual must pay for covered benefits under the plan. A plan is not a high deductible health plan if substantially all of the coverage is for permitted coverage or coverage that may be provided by permitted insurance. A plan does not fail to be a high deductible health plan by reason of failing to have a deductible for preventive care.

Permitted insurance is: (1) insurance if substantially all of the coverage provided under such insurance relates to (a) liabilities incurred under worker’s compensation law, (b) tort liabilities, (c) liabilities relating to ownership or use of property (e.g., auto insurance), or (d) such other similar liabilities as the Secretary of Treasury may prescribe by regulations; (2) insurance for a specified disease or illness; and (3) insurance that provides a fixed payment for hospitalization.

Permitted coverage is coverage (whether provided through insurance or otherwise) for accidents, disability, dental care, vision care, or long-term care.

Health flexible spending arrangement (“FSAs”) and health reimbursement arrangements (“HRAs”) are health plans that constitute other coverage under the HSA rules. An individual who is covered by a high deductible health plan and a health FSA, or HRA, is generally not eligible to make contributions to an HSA. An individual is eligible to make contributions to an HSA if the health FSA or HRA is: (1) a limited purpose health FSA or HRA; (2) a suspended HRA; (3) a post-deductible health FSA or HRA; or (4) a retirement HRA.

Tax Treatment of and Limits on Contributions

Contributions to an HSA by or on behalf of an eligible individual are deductible (within limits) in determining adjusted gross income. In addition, employer contributions to HSAs (including salary reduction contributions made through a cafeteria plan) are excludable from gross income and wages for employment tax purposes. In the case of an employee, contributions to an HSA may be made by both the individual and the individual’s employer. All contributions are aggregated for purposes of the maximum annual contribution limit. Contributions to Archer MSAs (medical savings accounts for self-employed individuals and employees of small employers with 50 or fewer employees) reduce the annual contribution limit for HSAs. The maximum aggregate annual contribution that can be made to an HSA is the lesser of (1) 100 percent of the annual deductible under the high deductible health plan, or (2) (for 2007) $2,850 for self-only coverage and $5,650 for family coverage. The annual contribution limit is the sum of the limits determined separately for each month, based on the individual’s status and health plan coverage as of the first day of the month. The annual contribution limits are increased for individuals who have attained age 55 by the end of the taxable year. In the case of individuals and covered spouses who are age 55 or older, the HSA annual contribution limit is increased by catch-up contributions of $700 in 2006, $800 in 2007, $900 in 2008, and $1,000 in 2009 and thereafter. As in determining the general annual contribution limit, the increase in the annual contribution limit for individuals who have attained age 55 is also determined on a monthly basis. Contributions, including catch-up contributions, cannot be made once an individual is enrolled in Medicare. In the case of individuals who are married and either spouse has family coverage, both spouses are treated as having only the family coverage with the lowest annual deductible. The annual contribution limit (without regard to the catch-up contribution amounts) is divided equally between the spouses unless they agree on a different division (after reduction for amounts paid from any Archer MSA of the spouses). An excise tax applies to contributions in excess of the maximum contribution amount for the HSA. The excise tax generally is equal to six percent of the cumulative amount of excess contributions that are not distributed from the HSA. Amounts can be rolled over into an HSA from another HSA or from an Archer MSA.

Comparable Contributions

Section 306 of the TRHCA of 2006 requires employers to make available comparable contributions on behalf of all employees with comparable coverage during the same period. Contributions are considered comparable if they are either of the same amount or the same percentage of the deductible under the plan. If employer contributions do not satisfy the comparability rule during a period, then the employer is subject to an excise tax equal to 35 percent of the aggregate amount contributed by the employer to HSAs for that period. The comparability rule does not apply to contributions made through a cafeteria plan.

Taxation of Distributions

Distributions from an HSA for "qualified medical expenses" of the individual and his or her spouse or dependents are excludable from gross income. Qualified medical expenses include expenses for diagnosis, cure, mitigation, treatment, or prevention of disease. Qualified medical expenses do not include expenses for insurance other than for (1) long-term care insurance, (2) premiums for health coverage during any period of continuation coverage required by Federal law, (3) premiums for health care coverage while an individual is receiving unemployment compensation under Federal or State law, or (4) health insurance premiums for Medicare, other than premiums for Medigap policies. Qualified health insurance premiums include Medicare Part A and Part B premiums, Medicare HMO premiums, and the employee share of premiums for employer-sponsored health insurance. Distributions from an HSA that are not for qualified medical expenses are includible in gross income. Distributions includible in gross income also are subject to an additional 10 percent tax unless made after death, disability, or the individual attains the age of 65.

Health Flexible Spending Arrangements and Health Reimbursement Arrangements

Arrangements commonly used by employers to reimburse medical expenses of their employees include health flexible spending arrangements (“FSAs”) and health reimbursement accounts (“HRAs”). Health FSAs are typically funded on a salary reduction basis. If the health FSA meets certain requirements, the compensation that is forgone is not includible in gross income and reimbursements for medical care from the health FSA are excludable from gross income and wages. Health FSAs are subject to the general requirements relating to cafeteria plans, including a requirement that a cafeteria plan generally may not provide deferred compensation. This requirement is referred to as the “use-it-or lose-it-rule.” Until May of 2005, this requirement was interpreted to mean that amounts available from a health FSA as of the end of a plan year must be forfeited by the employee. In May 2005, the Treasury Department issued a notice that allows a grace period not to exceed two and one half months immediately following the end of the plan year during which unused amounts may be used. An individual participating in a health FSA that allows reimbursements during a grace period is generally not eligible to make contributions to the HSA until the first month following the end of the grace period even if the individual's health FSA has no unused benefits as of the end of the prior plan year. HRAs operate in a manner similar to health FSAs, in that they are an employer maintained arrangement that reimburses employees for medical expenses. Some of the rules applicable to HRAs and health FSAs are similar, e.g., the amounts in the arrangements can only be used to reimburse medical expenses and not for other purposes. Some of the rules are different. For example, HRAs cannot be funded on a salary reduction basis and the use-it-or lose-it rule does not apply. Rather, amounts remaining at the end of the year may be carried forward to be used to reimburse medical expenses in the next year. Reimbursements for insurance covering medical care expenses are allowable reimbursements under an HRA, but not under a health FSA. Subject to certain limited exceptions, health FSAs and HRAs constitute other coverage under the HSA rules.

Rollovers from Health FSAs and HRAs into HSAs for a Limited Time

Section 302 of the TRHCA of 2006 permits certain amounts in a health FSA or HRA to be distributed from the health FSA or HRA and contributed through a direct transfer to an HSA without violating the requirements for such arrangements. The amount that can be distributed from a health FSA or HRA and contributed to an HSA may not exceed an amount equal to the lesser of (1) the balance in the health FSA or HRA as of September 21, 2006 or (2) the balance in the health FSA or HRA as of the date of the distribution. Amounts contributed to an HSA under this section are excludable from gross income for tax purposes, are not taken into account in applying the maximum deduction limitation for other HSA contributions, and are not deductible. Contributions must be made directly to the HSA before January 1, 2012. The rollover is limited to one distribution with respect to each health FSA or HRA of the individual. This provision was designed to assist individuals in transferring from another type of health plan to a high deductible health plan. If an individual for whom a contribution is made under the provision does not remain an eligible individual during the "testing period," the amount of the contribution is includible in gross income of the individual. An exception applies if the employee ceases to be an eligible individual by reason of death or disability. The amount is includible for the taxable year of the first day during the testing period that the individual is not an eligible individual. A 10 percent additional tax applies to the amount includible. A modified comparability rule applies with respect to contributions under the provision. If the employer makes available to any employee the ability to make contributions to the HSA from distributions from a health FSA or HRA under this section, all employees who are covered under a high deductible plan of the employer must be allowed to make such distributions and contributions. The IRS issued guidance regarding rollovers from FSAs and HRAs into HSAs. See Internal Revenue Service Notice 2007-22.

Certain FSA Coverage Treated as Disregarded Coverage

Section 302 of the TRHCA of 2006 provides that, for taxable years beginning after December 31, 2006, coverage under a health flexible spending arrangement (“FSA”) during the period immediately following the end of a plan year during which unused benefits may be paid or reimbursed to plan participants for qualified expenses is disregarded coverage. Such coverage is disregarded if (1) the balance in the health FSA at the end of the plan year is zero, or (2) the entire remaining balance in the health FSA at the end of the plan year is contributed to an HSA.

Repeal of Annual Plan Deductible Limitation on HSA Contribution Limitation

Section 303 of the TRHCA of 2006 modifies the limit on the annual deductible contributions that can be made to an HSA. The maximum deductible contribution is not limited to the annual deductible under the high deductible health plan. The maximum aggregate annual contribution that can be made to an HSA in 2007 is $2,850 for self-only coverage and $5,650 family coverage.

Indexing of Cost of Living Adjustments

Section 304 of the TRHCA of 2006 provides that for adjustments made for any taxable year beginning after 2007, the Consumer Price Index for a calendar year will be determined as of the close of the 12-month period ending on March 31 of the calendar year for the purpose of making cost-of-living adjustments for the HSA dollar amounts that are indexed for inflation ( contribution limits and high-deductible health plan requirements).

Contribution for Months Preceding Month that Taxpayer is an Eligible Individual

Section 305 of the TRHCA of 2006 allows individuals who become covered under a high deductible plan in a month other than January to make the full deductible HSA contribution for the year. An individual who is an eligible individual during the last month of a taxable year is treated as having been an eligible individual during every month during the taxable year for purposes of computing the amount that may be contributed to the HSA for the year. For the months preceding the last month of the taxable year that the individual is treated as an eligible individual solely by reason of this section, the individual is treated as having been enrolled in the same high deductible health plan in which the individual was enrolled during the last month of the taxable year. If an individual makes contributions permitted by section 305 but does not remain an eligible individual during the "testing period," the contributions preceding the month in which the individual was an eligible individual are includible in gross income. An exception applies if the employee ceases to be an eligible individual by reason of death or disability. The "testing period" is the period beginning with the last month of the taxable year and ending on the last day of the 12th month following such month. The amount is includible for the taxable year of the first day during the testing period that the individual is not an eligible individual. A 10-percent additional tax applies to the amount in question.

Employer Comparable Contribution Requirements for Contributions Made to Nonhighly Compensated Employees

Section 306 of the TRHCA of 2006 provides an exception to the comparable contribution requirements which allows employers to make larger HSA contributions for nonhighly compensated employees than for highly compensated employees. Highly compensated employees are defined as under section 414(q) and include any employee who was (1) a five-percent owner at any time during the year or the preceding year; or (2) for the preceding year, (A) had compensation from the employer in excess of $100,000 (for 2007) and (B) if elected by the employer, was in the group consisting of the top 20 percent of employees when ranked based on compensation. The comparable contribution rules continue to apply to the contributions made to nonhighly compensated employees so that the employer must make available comparable contributions on behalf of all nonhighly compensated employees with comparable coverage during the same period.

Rollovers from IRAs into HSAs

Section 307 the TRHCA of 2006 permits a one-time contribution to an HSA of amounts distributed from an individual retirement arrangement (“IRA”). The contribution must be made in a direct trustee-to-trustee transfer. Amounts distributed from an IRA under this section are not includible in income, and are not subject to the 10 percent tax on early distributions. The amount that can be distributed from the IRA and contributed to an HSA is limited to the maximum deductible contribution to the HSA computed on the basis of the type of coverage under the high deductible health plan at the time of the contribution. The amount that can otherwise be contributed to the HSA for the year of the contribution from the IRA is reduced by the amount contributed from the IRA. No deduction is allowed for the amount contributed from an IRA to an HSA. Only one distribution and contribution may be made during the lifetime of the individual. However, if a distribution and contribution are made during a month in which an individual has self-only coverage as of the first day of the month, an additional distribution and contribution may be made during a subsequent month within the taxable year in which the individual has family coverage. The limit applies to the combination of both contributions. If the individual does not remain an eligible individual during the "testing period," the amount of the distribution and contribution is includible in gross income. An exception applies if the employee ceases to be an eligible individual by reason of death or disability. The amount is includible for the taxable year of the first day during the testing period that the individual is not an eligible individual. A 10-percent additional tax applies to the amount in question. Section 307 does not apply to simplified employee pensions (“SEPs”) or to SIMPLE retirement accounts. The IRS issued guidance on this matter in the form of a Service Notice on March 5, 2007.

DOL Guidance Regarding HSAs

The DOL has issued gudiance on several issues concerning HSA and the application of ERISA and the Internal Revenue Code to HSAs. In 2004, the DOL issued Field Assistance Bulletin 2004-01 which addressed the application of ERISA to HSAs established in connection with employment. DOL expanded on this guidance by issuing Q&As in Field Assistance Bulletin 2006-02. In addition, in 2004, DOL issued Advisory Opinion 2004-09A, which addresses the application of the prohibited transaction provision of IRC Section 4975 to certain contributions to HSAs.

Self-employed Individuals are permitted to establish tax-qualified pension and profit sharing plans for themselves and their employees. A self-employed Individual is a sole proprietor or partner who works in his or her unincorporated business. Such arrangements are normally designated as Keogh or HR-10 plans, trusts, or accounts. Sometimes Keogh accounts are termed Self-Employed Retirement Plans (SERPs). Keogh plans are generally comparable to corporate-sponsored defined contribution plans that are Individual account plans.

There are specific provisions in the IRC covering Keogh accounts. Only self-employed Individuals may deduct contributions to a Keogh plan. Participants may be permitted to make nondeductible contributions to a plan in addition to employer contributions. Even though these employee contributions may not be deductible, the earnings on them and the contributions by the employer are tax deferred until the Individual begins retirement withdrawals. Retirement withdrawals may commence upon attainment of age 59 1/2 but must commence by the end of the calendar year in which the Individual attains age 70 1/2. The owner-employee may contribute up to 25% of the first $150,000 of earned income or $30,000, whichever is less. In addition, the IRC requires that contributions, in the same percentage of compensation as for the owner-employer, be made on behalf of common law employees with three or more years of service. Plan participants rarely direct their own investments.

In self-employed retirement plans, the contribution is defined but the benefit payment is not. Benefits are subject to both the amount contributed and the success of the investment results. Under this approach, the participant is entitled only to the amount in his or her account, based on the varying amounts contributed and the investment return. The participant has a claim only on the assets of his or her account in the plan; there is no claim against all of the plan assets belonging to other plan participants. The PBGC does not insure the benefits of defined contribution plans. IRS Publication 560, Retirement Plans for the Self-Employed, provides more detailed information on both defined benefit and defined contribution Keogh plans.

A bank may serve as a trustee or custodian for Keogh or HR-10 plans. As trustee, the bank's responsibilities may range from ministerial functions to the exercise of broad discretionary duties. As custodian, responsibilities are essentially ministerial in nature. In either case, the bank's responsibilities will be governed by the instrument and ERISA.

• Keogh accounts which cover only the owner-employer, and no other employees, are subject to compliance with the prohibited transaction provisions of ERISA Section 406 and the parallel IRC Section 4975 (refer to subsection H.7, Prohibited Transactions - ERISA Section 406).
  
• Keogh accounts which cover both the owner-employer and other employees are subject to ERISA Sections 404 and 406, covering fiduciary responsibility and prohibited transactions (refer to subsection H.7, Prohibited Transactions - ERISA Section 406).
  
• IRC Section 408(m) indicates that if self-directed and Individual account plans invest in collectibles, the investment will be treated as a distribution. Collectibles include: stamps, coins, artwork, gems, antiques, etc. An exception is made for U.S. American Eagle gold coins, which are permissible investments (refer to Appendix E)

A bank may accept non-deposit self-directed Keogh custodial accounts without trust powers under Section 333.101(b) of the FDIC's Rules and Regulations, if the appropriate state authority also permits such accounts to be accepted without trust powers. Despite the fact that trust powers are not needed, banks accepting such accounts must implement appropriate controls. Refer to Section 2, subsection O, Self-Directed IRAs and Keogh Accounts.

Examiners should also be aware that Keogh accounts may not normally be invested in Collective Investment Funds (CIFs) without violating Federal securities laws. There are a few approaches where collective investments are possible, but with many restrictions. Refer to Section 7, subsection D.1, Keogh Account Usage Of Collective Investment Funds. Under certain conditions, banks may offer beneficiaries of Keogh accounts reduced or no cost banking services, refer to Section 5, subsection H.9.c. Receipt of Services by IRAs and Keogh Plans.

F. Individual Retirement Accounts (IRAs)

F.1. Operating/Filing Requirements
The IRS requires all IRAs to operate under either one of two versions of IRS Form 5305, or under a written agreement which incorporates the provisions of either of the versions of this form. The two forms are identical except for the interchangeability of the terms trust and custodian throughout the forms. As custodian, responsibilities are essentially ministerial in nature.

The examiner should note:

• Under IRC Section 408(h) - bank custodians of IRAs are considered trustees, hence fiduciaries.
  
  
• Under IRC Section 408(i) - IRA trustees are required to report contributions, distributions, and other matters required by regulation (including the fair market value of assets) to the IRS and the IRA owner on an annual basis. As the value of some types of assets, such as limited partnerships, is not easily ascertainable, the administration of some IRA accounts can be problematic.

In a 2-24-93 letter to Partnership Valuations, Inc., Annapolis, Maryland, the IRS indicated that trustees of IRAs were responsible for ensuring that IRA assets are properly valued on an annual basis, including assets which are "hard to value". It also stated that IRA trustees could not evade evaluation responsibility by having the IRA owner sign a release, indemnification or other instrument. The IRS indicated that IRA contributions, distributions, and valuations should be reported on IRS Form 5498 (Individual Retirement Arrangement Information) to satisfy annual reporting requirements. A copy of the 2-23-93 IRS Interpretive Letter EP:R:9 - Valuation of IRA Assets to Partnership Valuations, Inc. is located in Appendix E.  IRS Revenue Ruling 59-60 - Valuation of Non-Traded Assets, in Appendix E also provides general guidance on valuing non-traded assets.

F.2. Types of IRAs
In addition to IRAs for Individuals, a number of different variations now exist and are highlighted below:

• Rollover IRAs enable an employee to transfer, tax-free, lump-sum distributions from a previous employer's tax-deferred retirement plan to a new IRA. Rollovers may also be used to transfer funds from one IRA account to another IRA account. The transfer permits the employee to continue tax-deferred earnings.

When a lump-sum distribution from an employee benefit plan is "rolled" into an IRA, the entire distribution from the previous plan must be transferred to one or more rollover IRAs. In addition, if the funds being transferred originate from either a lump-sum distribution or represent the movement from an existing IRA account to a new IRA account, the transfer must be done directly from the previous plan or IRA to the rollover IRA. If the transfer is done by a check to the employee, the employee must:

• Pay 20% of the total amount to the government for Federal income taxes, which is withheld from the initial disbursement;
  
• Furnish the 20% that was withheld in order to avoid tax consequences since the entire amount of the initial distribution must be rolled into the new rollover IRA; and
  
• Place the total amount of funds into the rollover IRA by the 60th day after the day the distribution is received.

• Individual Retirement Annuity is an IRA which is established by purchasing an annuity contract or an endowment contract from a life insurance company. The annuity must be issued to the IRA owner, and either the owner or their surviving beneficiaries may receive benefits from the IRA. The entire interest in the contract must be nonforfeitable, it must provide that the owner cannot transfer any portion of it to any person other than the issuer, it must (for contracts issued after 11-6-78) have flexible premiums to permit annuities to change as the owner's compensation changes, it must limit annual contributions to the maximum amount permitted under Traditional IRAs discussed above, and provide for refunded premiums to pay for future premiums or to buy additional benefits before the end of the calendar year after the year the refund is received, and it must begin distributions by April 1 of the year the owner reaches age 70 1/2. IRS Publication 590, Individual Retirement Arrangements, provides further basic information on IRAs.
  
  
• Individual Retirement Bonds are IRAs which were funded through the purchase of Individual retirement bonds issued by the Federal government. The program was suspended after 4-30-82. It had the following characteristics: the bonds paid interest only until they were cashed in by the owner; no interest was paid on the bonds after the owner reached 70 1/2 years of age; upon the owner's death, the bonds stopped paying interest at the earlier of 5 years after the date of death or the date on which the owner would have reached age 70 1/2; and the bonds could not be sold, discounted, or used as collateral or security. IRS Publication 590, Individual Retirement Arrangements, provides further basic information on IRAs.

• Simplified Employee Pension (SEP)-IRA is a pension plan where the employer establishes an IRA account for the benefit of each covered employee. Employer contributions are excluded from an employee's income. In any year where the employer's contribution is less than the normal IRA maximum for Individuals (refer to Traditional IRAs above), the employee may contribute the difference. SEP-IRAs are much simpler and involve less administrative cost for the employer than do other types of retirement plans.  I RS Publication 560, Retirement Plans for the Self-Employed, provides information on SEP-IRA plans.

The Economic Growth and Tax Relief Reconciliation Act of 2001amended Sections 402 and 414 of the Internal Revenue Code, enabling individuals age 50 and over to make elective retirement plan deferrals (catch-up contributions) to 401(k) plans, SIMPLE IRA plans, simplified employee pensions (SEP), Section 403(b) arrangements, and Section 457 governmental plans effective for plan years beginning after December 31, 2001.  Refer to Section Q. Catch-Up Contributions for additional details.

• Salary Reduction Simplified Employee Pension Plan (SARSEP) is a type of defined contribution employee benefit plan established under the Tax Reform Act (TRA) of 1986. SARSEPs are sometimes referred to as elective deferral arrangements or as salary reduction arrangements. SARSEPs operate with pretax employee contributions, thus reducing the employee's income tax liability.

New SARSEPs could be adopted by employers through December 31, 1996. Beginning January 1, 1997, SARSEPs were replaced by Savings Incentive Match Plans for Employees (SIMPLEs), and no new SARSEPs may be established. SARSEPs adopted prior to 1997 can be continued with additional contributions made to them.

SARSEPs were available to employers with 25 or fewer employees, and with at least 50% of eligible employees participating in the plan. Employees contribute a percentage of their salary, thus reducing current income and current income taxes. Income and capital gains earned by SARSEPs are tax-deferred. The annual limit on salary contributions to a SARSEP is limited ($9,500 in 1996), with the limit indexed. In top heavy plans, the amount contributed for the highly compensated employees cannot be more than 125% of the average percentage of pay contributed by all non-highly-compensated employees.

IRS Publication 560, Retirement Plans for the Self-Employed, also provides information on SARSEP plans.

• Inherited Individual Retirement Accounts are subject to special rules. The IRA is included in the estate of the decedent who owned it. Unless the inheriting beneficiary is the decedent's surviving spouse, the beneficiary cannot treat the IRA as their own. Only the surviving spouse can elect to: make contributions to the IRA, including rollover contributions; rollover the inherited IRA into another IRA; and to delay receipt of distributions until (the surviving spouse reaches) age 70 1/2. All other inheriting beneficiaries must take distributions from the IRA, which is dependent upon the IRA owner's election at the time the IRA was opened and minimum distribution requirements. IRS Publication 590, Individual Retirement Arrangements, provides further basic information on IRAs.

• Roth Individual Retirement Accounts were introduced in 1998. Except for some special rules which apply only to Roth IRAs, these Individual retirement accounts are subject to the same IRS rules as are traditional IRAs. IRS Publication 590, Individual Retirement Accounts, extensively discusses all types of IRAs, and it should be used as general guidance when reviewing IRAs. Some of the basic Roth IRA rules follow:
  
  

1. A Roth IRA must be initially designated as a Roth IRA when it is established. Neither SEP-IRAs nor SIMPLE IRAs may be designated or operated as Roth IRAs.
    

2. Contributions to Roth IRAs are not tax deductible and are not reported on the individual's tax return:

   1. Roth IRA contribution limit:

                If contributions are made only to Roth IRAs, the contribution limit for 2003 for              individuals under age 50 is generally the lesser of:

   • $3,000 ($3,500 if the individual is 50 or older in 2003), or

   •  An individual's taxable compensation for the year.

   • These $3,000 and $3,500 amounts do not increase in 2004.

   2. Contributions to both traditional and Roth IRAs for same year:

                 If contributions are made to both a Roth IRA and a traditional IRA, the              contribution limit for 2003 is the lesser of:

   • $3,000 ($3,500 if the individual is 50 or older in 2003) minus all contributions (other than employer contributions under a SEP or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs, or

   •  An individual's taxable compensation minus all contributions (other than employer contributions under a SEP or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs.

If an individual's modified adjusted gross income is above a certain amount, contribution limits may be reduced and must be computed.  IRS Publication 590, Individual Retirement Arrangements, details how to calculate the reduced contribution limits.

3. An individual can contribute to a Spousal Roth IRA, provided:

   • The contributions satisfy the Spousal IRA limit (same as Traditional IRA Spousal Limit above),

   • A joint tax return is filed for the year, and

   • The couple's modified adjusted gross income is less than $160,000.

3. Contributions to Roth IRAs may continue even after the owner has reached 70 ½ years of age, there is no age limit for contributions.
    
4. A contribution to one type of IRA may be "recharacterized" as a contribution to a different IRA, but it must be performed in a trustee-to-trustee transfer.
    
5. Roth IRAs are not subject to any minimum distribution, and account balances can be left in the IRA as long as the owner lives.
    
6. Traditional IRAs, SEP-IRAs, and SIMPLE IRAs can be converted to Roth IRAs if the owner has a "modified adjusted gross income" of not more than $100,000 and (if married) files a joint return. Except for the one year waiting period, most rollover rules for traditional IRAs apply.
    
7. A Traditional IRA may be converted to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used. Most of the rules for rolloversapply to these rollovers. However, the 1-year waiting period does not apply.  Although the conversion of a Traditional IRA is considered a rollover for Roth IRA purposes, it is treated as a taxable distribution from the Traditional IRA.

8. Individuals who convert traditional IRAs to Roth IRAs, but who are ineligible to do so, are subject to a taxable distribution for the amount of the conversion, plus any additional taxes on early withdrawals. A Roth IRA conversion may be "re-characterized" by converting it back to a traditional IRA prior to the owner's tax return due date, including extensions.
    
9. For tax years 1998 and 1999, IRA owners were permitted to convert an amount from a traditional IRA to a Roth IRA, transfer that amount back in a "re-characterization," and then reconvert it back to a Roth IRA in a "re-conversion." After 1999, owners cannot convert and reconvert an amount during the same taxable year.
    
10. Qualified distributions from Roth IRAs are not taxable, if they are made after a 5 year period beginning with the first taxable year for which a contribution was made, and the distribution is:

    1. Made on or after the date the owner reaches age 59 ½,

    2. Made because of the owner's disability,

    3. At the owner's death, made to a beneficiary or the to the owner's estate, or

    4. One that meets the traditional IRA "First" home requirements, up to a lifetime limit of $10,000.

11. Distributions of regular contributions are not taxable.
     
12. If the owner of a Roth IRA dies, the minimum distribution rules that apply to traditional IRAs apply to Roth IRAs as though the Roth IRA owner died before his or her required "beginning date" (by April 1 of the year following the year in which the owner reaches age 70 ½ ).
     
13. Beneficiaries:

    1. Generally, upon the death of the owner, the entire interest in the Roth IRA must be distributed to a beneficiary by the end of the fifth year of the owner's death, unless the interest is payable to a designated beneficiary over his or her life expectancy.
    2. A beneficiary of a Roth IRA may aggregate an inherited Roth IRA with another Roth IRA, if: (i) either the beneficiary inherited the other Roth IRA from the decedent, or was the spouse of the decedent, (ii) the beneficiary is the sole beneficiary of the Roth IRA, and (iii) the beneficiary elects to treat it as his or her own IRA.
    3. If the sole beneficiary of a Roth IRA is the spouse, he or she can either delay distributions until the decedent would have reached age 70 ½ , or treat the IRA as his or her own.

14. Excess contributions are subject to a 6% excise tax.
     
15. Early withdrawals are subject to a 10% premature distribution tax in addition to other applicable taxes.
     

• Abusive Roth IRA Transactions - The Treasury Department issued Notice 2004-8 identifying and prohibiting certain abusive Roth IRA contribution transactions.  The notice was effective on the date of issuance, December 31, 2003.  The transactions in question are used to avoid Roth IRA contribution limitations and, in some instances, taxation as income or capital gains.  These and similar types of transactions subject the IRA to possible disqualification and/or excise tax as prohibited transactions under the IRS Code.

• Deemed IRAs (Traditional IRA and/or Roth contributions to an individual retirement account within a qualified employer plan).  The Economic Growth and Tax Relief Reconciliation Act of 2001 added IRC Section 408(q), creating "deemed IRAs" for plan years after 2002.  Contributions to deemed IRAs may only be made on a voluntary basis by the employee and are not deductible from income.  These contributions do not affect the dollar amount of employer based contributions under a qualified plan.  Deemed IRAs must be maintained in a separate account or annuity under the plan, and are subject to IRA rules, not qualified plan rules.  However, the plan may commingle deemed IRA assets with qualified employer plan assets for investment purposes.  The IRS issued Revenue Procedure 2003-13 outlining amendment guidance for existing qualified employer plans.  The revenue procedure also provides sample plan amendment language which allows qualified plans to include deemed IRAs.  For Deemed IRA purposes, the IRS has ruled that qualified employer plans include Section 401(a) defined benefit and defined contribution plans, Section 401(k) plans, Section 403(a) annuity plans and 403(b) plans, and Section 457 deferred compensation plans.  They do not, however, include Savings Incentive Match Plans for Employees of Small Employers (SIMPLE) IRAs.  Procedures for amending qualified employer plans are also provided in IRS Bulletin 2003-4.

• Group Trust Participation by Roth and Deemed IRAs - IRS Revenue Ruling 2004-67 extends the ability to participate in group trust investments described in Revenue Ruling 81-100 to Roth individual retirement accounts described in § 408A and deemed individual retirement accounts described in § 408(q).  (Note: investing IRAs in common or collective funds is prohibited under Federal securities laws, refer to IRS Revenue Ruling 81-100 in Section 7.)

• Coverdell Education Savings Accounts (ESAs) - referred to as Education IRAs until July 26, 2001 - are not Individual Retirement Accounts or retirement arrangements of any kind.  They are trust or custodial accounts established for the purpose of paying "qualified higher education expenses" (tuition, fees, books, supplies, equipment, and "contributions to a qualified state tuition program") of a designated beneficiary at an "eligible educational institution" (either an eligible postsecondary school - any college, university, vocational school, or other post secondary educational institution qualified to participate in student aid programs by the U.S. Department of Education; or an eligible elementary or secondary school - any public, private, or religious school that provides elementary or secondary education - kindergarten through grade 12 - as determined under state law.)

Earnings on investments grow tax free until distributed.  Upon distribution, if the withdrawals are less than the beneficiary's qualified higher education expenses, the withdrawals are tax free.  Any portion of a withdrawal which is greater than the beneficiary's educational expenses is taxable to the beneficiary. Taxable distributions are subject to a 10% tax in addition to other applicable income taxes.

To be treated as an ESA, the account must be designated as such when it is established.  Any Individual, including the designated beneficiary, can contribute to an ESA if the individual's modified adjusted gross income for the year is less than $110,000 ($220,000 for individuals filing joint returns).  Contributions are not tax deductible.  There is no limit on the number of ESAs which can be established for the same beneficiary, and there are no limits to the number of beneficiaries a contributor may contribute towards in the same year.  However, total contributions for the same beneficiary in any tax year cannot exceed $2,000.  Contribution limits are gradually reduced if a contributor's modified adjusted gross income is between $95,000 and $110,000 (between $190,000 and $220,000 if filing a joint return).  Excess contributions are subject to a 6% excise tax.  No contributions may be made to an ESA in any tax year in which the beneficiary receives a contribution toward a "qualified state tuition program."

Education IRA Account requirements:

1. The trustee or custodian must be a bank or an entity approved by the IRS.

2. The document must provide that the trustee or the custodian can only accept a contribution that:

   1. is in cash,
   2. is made before the beneficiary reaches age 18 (no contributions can be made to an ESA after the beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary (not defined as of 2004), and

   3. would not result in total contributions for the tax year (not including rollover contributions) being more than $2,000.

3. Money in the account cannot be invested in life insurance contracts.
4. Money in the account cannot be combined with other property except in a "common trust fund or common investment fund." (Note: investing IRAs in common or collective funds is prohibited under Federal securities laws, refer to IRS Revenue Ruling 81-100 in Section 7.)
5. Generally, the balance in the account must be distributed within 30 days after the beneficiary reaches age 30, or the death of the beneficiary.  Assets distributed upon the death of a beneficiary must either be made to the beneficiary's estate, or to a beneficiary named by the designated beneficiary. However, distribution is not required if the Education IRA is transferred to a surviving spouse or other family member under age 30.

IRS Publication 970,Tax Benefits for Education provides information on Education IRAs.

F.3. Bank Trustee and Custodial Responsibilities
As trustee, the bank's responsibilities may range from ministerial functions to the exercise of broad discretionary duties. In most instances, IRAs found in trust departments are subject to the investment direction of the Individual or possibly an investment advisor. However, the trust department may be given full discretion in the investment selection process. As custodian, responsibilities are essentially ministerial in nature. The examiner should note that IRC Section 408(h) considers bank custodians of IRAs to be trustees, hence fiduciaries (refer to Appendix E).

Whether acting as trustee or custodian, the bank's responsibilities and duties will be controlled by provisions of the instrument under which the relationship is established. Examiners should perform a careful review of this instrument in order to ascertain the degree of responsibility assumed by the bank and conformity with the duties imposed upon the institution under the agreement.

F.3.a. Self-Directed Custodial IRAs - Own Bank Deposits
The majority of IRAs serviced by banks are handled in the commercial department in a custodial capacity. These accounts are restricted to investments in own bank deposits. Unless state law provides to the contrary, trust powers for such accounts are not required, even if the account document indicates the bank is a trustee.

F.3.b. Self-Directed Custodial IRAs - Non Bank Deposits
A bank may accept non-deposit self-directed custodial IRAs without trust powers under Section 333.101(b) of the FDIC's Rules and Regulations, if the appropriate state authority also permits such accounts to be accepted without trust powers. Despite the fact that trust powers are not needed, banks which accept such accounts must implement appropriate controls. Refer to Section 2, subsection O, Self-Directed IRAs and Keogh Accounts for additional information.

F.4. Special Examination Application
There are several provisions involving IRA accounts which examiners should be aware of:

• According to Advisory Opinion 93-33A issued by the PWBA Office of Regulations and Interpretations of the US Department of Labor on December 16, 1993, pursuant to Regulation 2510.3-2(d), the DOL does not have jurisdiction over IRAs which are not part of an employer sponsored pension plan falling under Title I of ERISA. Nevertheless, under Presidential Reorganization Plan No. 4 of 1978, effective December 31, 1978, the DOL was given the authority to issue interpretations of section 4975 of the Internal Revenue Code (with certain exceptions, including sections 4975(a), (b), (c)(3), (d)(3), (e)(1), and (e)(7)) involving prohibited transactions of that section of the Code. Accordingly, employer sponsored IRAs are subject to ERISA and fall under DOL jurisdiction. Traditional or individual non-employer-sponsored/non-employer-contributed IRAs are not subject to ERISA and fall under the supervision of the Secretary of the Treasury. They are, however, subject to DOL interpretations of section 4975 of the Code with regard to prohibited transactions under that section of the Code. (Refer also to subsection H.7, Prohibited Transaction - ERISA Section 406)
  
  Several IRA-specific interpretations have been issued by the Labor Department, which has authority over ERISA and also to interpret IRC Section 4975. All of the Advisory Opinions (AOs) noted below deal with self-directed transactions.

  • AOs 88-9 and 88-28 deal with investment in the fiduciary bank's stock (or that of its holding company). These AOs include guidance on purchases of treasury stock and stock issued in an Initial Public Offering (IPO).
    
    
  • AO 88-18 deals with a loan from the IRA to a company where the grantor/customer has a substantial interest. Under the circumstances described, DOL concludes that a prohibited use of plan assets for the benefit of a disqualified person under Section 4975(c)(1)(D) or an act of self-dealing under Section 4975(c)(1)(E) is likely to result if the customer directs the IRA to lend funds to the company.
    
    
  • AO 89-3 deals with the investment of IRA assets in the stock of the company which employs the grantor/customer. In this case, the stock was purchased directly from the employer company. Under the circumstances described, particularly that the employer had no involvement with the establishment or maintenance of the IRAs, the employer company is not a disqualified person under Section 4975(e)(2); therefore, no prohibited transaction under Section 4975(c)(1)(D) exists. The AO cautions that a prohibited transaction may occur under other provisions of Section 4975.

• SEP-IRAs are subject to ERISA Sections 404 and 406, covering fiduciary responsibility and prohibited transactions.
  
  
• IRS Forms 5305 (the governing IRA document) prohibit the Individual sponsoring an IRA from borrowing from the account or from pledging the account as collateral for a loan.
  
  IRS Regulation 1.408-4 regarding the Treatment of Distributions from IRAs states that if the Individual establishing the account uses, directly or indirectly, any portion of the IRA as security for a loan, the amount used as collateral will be deemed a distribution for that tax year [IRS Regulations 1.408-1(c)(4) and 1.408-4(d)(2)]. The regulation requires the issuing of a W2-P to the borrower and to the IRS to report the distribution. If the distribution occurs prior to the Individual reaching age 59½, a premature distribution would take place, involving an IRS penalty equal to 10% of the pledged amount under IRS Regulation 1.408-1(c)(6).
  
  
• Section 408(m) of the IRC indicates that if an IRA invests in collectibles, the investment will be treated as a distribution. Collectibles include: stamps, coins, artwork, gems, antiques, etc. Both Section 408(m) and DOL Prohibited Transaction Class Exemption (PTE) 91-55 provide an exception for U.S. American Eagle gold coins, which are permissible investments.
  
• Group Trust/Collective Investment Funds - Examiners should be aware that IRAs of all types may not invest in OCC Regulation 9.18 Collective Investment Funds (CIFs) without violating Federal securities laws. A number of lawsuits have resulted from IRAs being placed in CIFs, and there is one instance of the SEC taking enforcement action against an FDIC-supervised bank for having done so. There are a few approaches where IRAs may be collectively invested, with many restrictions. The investments are usually confined to mutual funds, but never to Regulation 9.18 CIFs. (Refer to IRS Revenue Ruling 81-100 in Section 7

• ERISA Law and Internal Revenue Code Sections.

• Summaries of ERISA Regulations, Opinions, and Court Decisions, by ERISA Section.

• Implementing Labor and IRS Regulations.

• Interpretive Opinions, Technical Bulletins, Exemptions, etc.