Sooner or later, every
retirement plan will have to deal with participants who have
terminated employment but still have balances in the plan. In most
circumstances, the plan document provides guidance on how to proceed;
however, there are a number of factors that can make the determination
a little more complex than what it seems at first blush.
Why do we Care?
Before exploring the options for handling former participant
balances, it is helpful to understand several aspects of plan
maintenance that may steer employers in one direction or another.
Count the Cost
Many plan service providers set their fees in whole or in part
based on plan size. This may include total assets, the number of
participants, average account balance or some combination of these
factors. Understanding how fee schedules are structured is one factor
in determining the most appropriate policy for dealing with former
plan participants. For example, if fees decrease as plan assets
increase, it might make sense to design the plan to minimize outflows
to terminated participants. On the other hand, if fees increase as
average account balances decrease and many former participants have
below-average balances, taking steps to expedite distributions may be
the more appropriate course of action.
Stand and be Counted
The number of participants is used to determine another critical
threshold for retirement plans--the plan audit threshold. Generally,
plans with more than 100 participants on the first day of any plan
year are required to engage an independent qualified public accountant
to audit the plan's financial statements and attach the audit report
to Form 5500. Former participants with remaining balances are counted
for purposes of the 100-participant threshold.
Since it is not uncommon for the cost of a plan audit to reach five
figures, plan sponsors often seek to delay being subject to the
requirement as long as possible. One way to do this is, to the extent
possible, to design the plan so that former participants can/must have
their balances distributed to them as soon as possible following
termination of employment.
Tell the Participants
Anyone who works with retirement plans on a semi-regular basis is
quite aware of the seemingly endless number of disclosures that must
be provided to participants, including the Summary Plan
Description, Summary Annual Report and many others. A number of these
disclosures include information describing the rights of anyone with a
balance in the plan, so they must be provided to former employees as
While the IRS and Department of Labor (DOL) both allow certain
documents to be provided via electronic means such as e-mail, the
requirements for doing so can be daunting with respect to former
employees who no longer access a company e-mail account as part of
their jobs. Plan options that allow for immediate distributions can
minimize the burden of providing many of these disclosures to former
Tell the IRS
Participant disclosures are not the only concern. Plans that
include former employees with remaining balances are required to file
a form with the IRS each year. Prior to 2009, this information was
required to be attached to Form 5500; however, after a temporary
suspension of this reporting requirement, it is now satisfied by
filing Form 8955-SSA directly with the IRS each year.
The form lists the name, social security number and vested account
balance for terminated employees. The IRS shares this information with
the Social Security Administration so that it can notify recipients of
social security benefits that they may be entitled to additional
benefits from a former employer's retirement plan. As a result, plans
must not only report participants when they terminate, they must also
monitor prior years' forms and "un-report" terminees once they receive
What are the Options?
Plan sponsors have a fair degree of flexibility in designing their
plans to deal with former participants with balances; however, once
the design is determined, sponsors must consistently follow the
provisions they put in place.
IRS and DOL rules allow plans to force distributions to former
participants with vested account balances of less than $5,000 after
providing them with at least 30 days advance notice of their right to
request a cash distribution or a rollover to an IRA or a new
Due to concern that automatically cashing out former employees
could cause them to prematurely spend amounts they had set aside for
retirement, the rules require employers to establish rollover IRAs on
behalf of former participants with balances between $1,000 and $5,000
who do not respond to the advance notice. Those with less than $1,000
can be cashed out with the appropriate taxes withheld. These rules
leave sponsors with several plan design options.
Force out all vested balances below $5,000 with those from
$1,000 to $5,000 going to IRAs and those below $1,000 being paid in
Force out all vested balances below $5,000 with all of them
going to IRAs;
Force out all balances below $1,000 with all of them being paid
in cash; or
Eliminate forced distributions altogether.
When the rules for automatic IRA rollovers were first effective in
2005, very few providers were set up to accept them, causing many
employers to elect option 3 or 4, above. However, the marketplace has
adapted, and many providers are now able to accommodate automatic
rollovers. Therefore, plan sponsors are able to elect options 1 or 2,
above, without taking on substantial administrative burden.
The timing of forced distributions is a critical element to
consider. Not only do plan documents specify the threshold, e.g.
$5,000, but they also specify the timeframe in which distributions are
processed. For example, many plans provide that participants are
eligible to take distributions as soon as possible following
termination of employment.
Combining this provision with the forced distribution provision may
require that former employees with balances below the threshold be
provided the applicable notices very soon after termination with the
forced distributions being processed 30 to 60 days later. Since some
recordkeepers are only set up to process these "sweeps" quarterly,
semi-annually or annually, sponsors should coordinate their plan
provisions to avoid inadvertently delaying forced distributions in
violation of plan terms.
Terminated employees with vested balances exceeding $5,000
generally cannot be forced out of a plan; however, plan sponsors can
provide them with the applicable notices and forms to communicate
distribution options. There is one important exception to this general
rule. Any portion of a participant's account that was rolled into the
plan from an IRA or an unrelated employer's plan can be disregarded
for purposes of the $5,000 forced distribution limit. Consider this
Joe Participant has terminated employment and has a total vested
account balance of $14,000 as follows:
If the $9,500 rollover balance is disregarded, Joe's vested balance
is only $4,500; therefore, if the plan document is written to require
forced distribution to former employees with balances below $5,000,
Joe's entire account balance can be processed under those rules.
IRS and DOL guidance allows plans to charge certain fees to
participant accounts. This includes not only ongoing plan management
expenses but also distribution fees. However, the plan document must
include language authorizing the charges and the method of allocating
the expenses must be disclosed to participants, usually in the Summary
Plan Description. For example, the plan may provide that general
management expenses are allocated proportionately based on account
balance while distribution fees are charged directly to the accounts
of the participants requesting the distributions.
From time-to-time, a former employee takes a full distribution of
his or her account before all contributions or investment gains are
allocated. This may occur, for instance, in a safe harbor 401(k) plan
for which the employer allocates a 3% nonelective contribution at the
end of the plan year. Since these contributions cannot be subject to a
last day of employment rule, any participant eligible at any point
during the year is entitled to the contribution even if he or she
terminated employment earlier in the year.
So, what happens to the residual account balance generated by the
contribution? The answer depends somewhat on timing. As described
above, terminated participants must be provided with a distribution
notice at least 30 days in advance of a distribution. The notice is
considered "stale" after 180 days. Therefore, if the residual
contribution is credited to the participant's account fewer than 180
days after the date the notice was provided, the plan can issue a
distribution of the residual using the same method as the initial
payment, e.g. cash distribution, rollover to IRA, etc.
If it has been more than 180 days, the account is subject to the
distribution rules in the same manner as if there had been no previous
distribution paid. In many such situations, the residual balance will
be below the forced distribution threshold and can be processed as
What about Plan Terminations?
When an employer elects to terminate its plan, all participants are
entitled to take distributions regardless of their employment status.
Generally speaking, the distributions are processed according to the
rules outlined above. But, what happens when participants with more
than $5,000 do not make a distribution election? What happens if
notices to former employees are returned due to invalid addresses?
Fortunately, the DOL has provided guidance on how to handle these
situations. If plan sponsors follow a four-step program but are still
unable to obtain an election from participants, the accounts in
question can be rolled over using the automatic rollover rules
regardless of balance. The four steps are as follows:
Use certified mail for the initial distribution notice;
Check other plan records as well as those for other company
Check with a designated plan beneficiary; and
Use one of the governmental letter-forwarding services.
A fifth step that may be employed is to hire a locator service
specializing in finding missing account holders. The expenses for all
of these steps can be allocated to the accounts of the missing
There are many options available to employers to address the
account balances of former employees, and there is no "one size fits
all" solution. As with most plan-related decisions, the appropriate
solution depends on an employer's specific facts and circumstances as
well as the capabilities of the various service providers involved.
Although there is flexibility in how the plan is designed to
accommodate these situations, the actual plan operation must adhere to
the provisions written in the plan documents. Sponsors should work
with knowledgeable providers who can coordinate the efforts of all
parties involved to develop a practical and workable solution.
The information contained in this newsletter is
intended to provide general information on matters of interest in the
area of qualified retirement plans and is distributed with the
understanding that the publisher and distributor are not rendering
legal, tax or other professional advice. You should not act or rely on
any information in this newsletter without first seeking the advice of
a qualified tax advisor such as an attorney or CPA.