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
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
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
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
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
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
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
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
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
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
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.
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.