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
employees.
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 liability.
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 located.
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 be handled.
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 assets.
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.
Summary
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.
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