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
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 well.
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 distributions.
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
- 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
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 example.
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
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 such.
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
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.