At some point, almost every
company that sponsors a retirement plan will experience the “fun” of
tracking down a missing participant in order to pay a benefit. Although
difficult to avoid completely, there are steps employers can implement as
part of normal operations that can greatly minimize the headache. One of the
most effective steps is to distribute benefits to former employees as soon
as possible after termination of employment, before they have an opportunity
to become missing.
Forcing Distribution of Small Balances
The IRS has rules in place that dictate when terminated participants
can/must take distributions of their account balances from defined
contribution plans. Embedded within those rules are certain options that can
facilitate the efficient payout of smaller balances to many former
Generally, participants who have vested account balances in the plan of
at least $5,000 are permitted to keep their money in the plan as long as
they wish, subject to required minimum distributions on attainment of age 70½.
Participants with balances below that threshold can be forced to take their
money out of the plan as long as they are given appropriate notice 30 to 60
days prior to the payment. The notification gives participants the option to
rollover their accounts into an IRA of their choice or to a new employer's
plan rather than receiving the payment in cash and incurring a tax
If the participant does not make such an election by the end of the
notice period, the employer automatically distributes cash and withholds the
appropriate taxes for balances below $1,000. For balances between $1,000 and
$5,000, the force-out is via an automatic rollover to an IRA established on
behalf of the participant.
When the mandatory distribution rules first took effect in 2005, there
were not many automatic IRA rollover options available in the marketplace.
As a result, many employers elected to reduce the cash-out threshold to
$1,000. Amounts below that level could be forced out via check with taxes
withheld but larger amounts could remain in the plan. Fast forward to the
present and there are numerous options for automatic IRA rollovers for
participants who do not respond to the notice. However, many plans still
provide for the lower cash-out limit. A plan amendment can increase the
limit to the maximum of $5,000 thereby allowing for the almost immediate
payout to a greater number of former employees.
If a terminated participant has a vested balance of less than $200, his
or her account can be forced out via a cash payment without having to go
through the notification process.
What if the Participant's Account Balance includes Rollovers?
Consider a participant who joins his or her company's 401(k) plan and
accumulates an account balance of only $1,500 before terminating employment.
However, the participant rolled $7,000 into the plan from a previous
employer's plan. That makes a total vested balance of $8,500 which is well
above the maximum allowable cash-out limit.
In recognition of this potential conundrum, the IRS created an option
that allows plans using the $5,000 cash-out limit to disregard unrelated
rollovers into the plan when determining whether or not a former employee
can be forced out. Plans with lower cash-out limits are not allowed to take
advantage of this rollover exclusion.
Check the Plan Document
Keep in mind that usually when the law provides options on how to handle
a certain situation, each plan document must specify which option will be
used for that particular plan. As a result, it is always important to check
the terms of the plan to make sure it contains the proper language
authorizing the preferred option. If not, it is often very straightforward
to amend the plan to elect a different option.
What about Larger Balances?
Participants with (non-rollover) vested balances exceeding $5,000 cannot
be forced out of the plan; however, there are steps employers can take to
encourage former participants to take distributions of their larger
balances. Sometimes simply including plan distribution forms along with
other termination paperwork on an employee's last day of work is enough of a
reminder to them to request payment. In addition, it is permissible to
charge regular plan fees to the accounts of former employees even if the
company pays the same expenses for active employees.
What if the Plan is Terminated?
Suppose that an employer decides to terminate its plan. The plan cannot
be completely wrapped up until all assets are distributed. Although the
cash-out rules described above provide a solution for smaller balances, they
do not typically apply to larger balances.
Fortunately, the Department of Labor has provided a solution for plans
that are completely terminating. In short, sponsors of terminating plans can
automatically rollover vested balances exceeding $5,000 as long as they
first take the following four steps to locate missing participants:
Certified Mail: Use certified mail to send out the required distribution paperwork,
special tax notice, etc.
Related Plan Records: Check other plan records as well as records for other company benefits
such as health insurance plans.
Designated Plan Beneficiary: Check with the participant's designated beneficiary to see if he or she
can provide contact information that may help locate the missing individual.
Letter Forwarding: Use the Social Security Administration (SSA) letter-forwarding service to
notify the former participant of the impending plan termination and provide
the distribution paperwork. Both the IRS and SSA had letter-forwarding services; however, the IRS
discontinued its service during 2012. The SSA service remains active but
there is one key difference. The IRS program was free for requests involving
fewer than 50 letters, whereas the SSA charges $35 per letter forwarded.
Plan sponsors should also consider using a commercial locator service or
a credit reporting agency. Fortunately, the reasonable fees for all of these
steps can be charged to the accounts of the missing participants being
What about Residual Balances?
From time to time, a former participant may receive a full distribution
only to have a residual amount hit his or her account. This may be due to a
the participant being eligible for an employer contribution that is not
deposited until after the close of the year. A safe harbor nonelective
contribution is one example. Sometimes, the residual amount is due to
investment earnings that are not posted to the account until after the
distribution is taken. Regardless of the source, any trailing amounts must
As long as the paperwork for the original distribution was signed or the
small balance forced out within 180 days, the residual can be processed
using the same instructions. For example, if the participant's original
paperwork requested a rollover to an IRA at a certain financial institution
and that paperwork was signed within 180 days, the residual distribution can
be rolled to that same IRA at the same financial institution without the
need for additional paperwork.
If more than 180 days has passed, the residual account balance is handled
as if no previous distribution has occurred. In other words, residuals below
the cash-out threshold are processed the same as any other small balance
requiring notification before forcing out the amount in question. If the
residual exceeds the cash-out limit, the participant has the option to keep
the money in the plan.
What Happens when a Participant Does Not Cash a Distribution Check?
An uncashed check is one that has not been returned (and was, therefore,
presumably received by the participant) but also has not been negotiated.
Dealing with these checks can be especially challenging and there is no
direct guidance on how to handle such situations.
Even if not cashed, the check proceeds are considered taxable income to
the participant and should be reported as such on Form 1099-R for the year
the distribution was issued. However, the dollars representing those
proceeds remain in the plan until the check is physically cashed. As a
result, plan fiduciaries remain responsible to prudently manage those
Many plans include provisions that allow such amounts to be forfeited. If
the participant comes forward in the future, the plan must make him or her
whole by reinstating the forfeited amount and paying the distribution.
A few years ago, it became popular practice to simply pay the entire
amount of the distribution to the IRS as income tax withholding. Although
very clean and efficient from the plan sponsor's perspective, the IRS issued
guidance indicating such practice was not acceptable. Therefore, sponsors
should no longer pursue 100% withholding as an option.
What Happens when the Distribution Fee Exceeds the Account Balance?
It is not uncommon for an employee to be eligible for a plan or to decide
to make deferrals for a very short period prior to terminating employment,
sometimes only a single pay period. In those situations, the participant's
vested account balance is usually a minimal amount; so minimal, in fact,
that the fee charged to process the distribution is greater than the
balance. The plan can adopt procedures that automatically charge the fee
against such accounts even though no actual distribution is paid.
For example, assume a plan's recordkeeper charges a fee of $85 to process
each distribution. The plan's administrative policy could provide that the
fee will automatically be charged to the accounts of all terminated
participant with vested balances below $85. The amounts charged are paid to
the recordkeeper as a fee and the accounts are eliminated.
Plan sponsors that choose to use this type of procedure should work with
their advisors and consultants to make sure the decision is properly
documented and communicated to employees.
As the saying goes, an ounce of prevention is worth a pound of cure. In
the case of small balances and missing participants, there are many steps a
plan sponsor can take to keep these potentially bothersome situations from
becoming big headaches.
Since many fees are based on participant counts and many plan notices
(participant fee disclosures, summary annual reports, etc.) must be provided
to former employees with balances, eliminating those balances can save the
plan/plan sponsor money. By being proactive in this area, sponsors can keep
their plans lean and running at peak efficiency.
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. Readers should not act or rely on any information in this
newsletter without first seeking the advice of an independent tax advisor such
attorney or CPA.