Administrator’s Notes:

Develop Procedure for Distributing Balances at Termination

By: Lynda J. Morrison, email lmorrison@cbginc.com

Maintaining accounts in a retirement plan for participants who have terminated employment can cause

significant problems which include increased administrative fees, both because of a higher number of participants and, in some cases, because the plan is required to be audited by an independent accountant if the plan has more than 100 participants. Also, maintaining accounts for terminated participants can cause substantial problems in the future when those participants are difficult to locate, especially if the balances are relatively small.

The good news is that this problem can be avoided. First, you should review the rules governing distributions to terminated participants. If a terminated participant’s account is less than $5,000, the plan document may (and should) provide that they will be cashed-out upon termination. If the document so provides, the employer should start the distribution process upon the participant’s termination by providing a notice a distribution form for the participant to complete (a participant must be afforded an opportunity to elect a direct rollover in lieu of a taxable cash distribution). If the employee fails to return the form within 30 days, the employer can process a cash distribution of the account and withhold applicable taxes. If the participant returns the form, the employer distributes the account accordingly.

If a terminated participant’s account exceeds $5,000, distribution cannot occur before normal retirement age without the participant’s consent. Even so, the employer can provide the notice and distribution form to the participant. However, if not returned, distribution cannot occur until normal retirement age, or until the participant consents to the distribution.

We encourage clients to establish a procedure that results in participants receiving the distribution paperwork upon termination of employment, preferably as part of an exit process.

Plan sponsors who have failed to distribute terminated participant balances have another headache with which to deal. If the terms of the plan provide that amounts will be distributed upon termination of employment, or within a reasonable time thereafter, failing to so distribute balances, even though not sought by the participants, violates the terms of the plan. Not operating a plan in accordance with its written terms violates the requirements necessary to constitute a tax-qualified plan. To resolve this violation, plan sponsors can utilize the Internal Revenue Service’s voluntary compliance program. The steps necessary to correct should be reviewed by counsel and may differ based on the facts. However, correction will generally require a notice to affected participants (generally those with account balances less than $5,000) affording them an opportunity to elect a direct rollover. Once the notice is provided and the election forms are either returned or not returned and sufficient time elapses, distributions can occur as discussed above.

Use of the IRS’ voluntary compliance program may or may not require the IRS approval and the payment of a user fee depending on the situation. Also, the plan sponsor may have difficulty locating some participants. The IRS also maintains a missing participant locator service that may be helpful.

Published: 10/24/2003