When a participant terminates employment with a company and leaves a vested account balance in the plan, several options are available. The terms of your plan document will control the participant’s decision.
Generally, when a participant’s vested account balance is $5,000 or less, the plan can require the participant to take a distribution. The payout may be in the form of a cash distribution or by rolling the balance into an IRA or a new employer’s plan. If the participant’s balance is less than $1,000, you can cash out the balance and withhold the appropriate taxes.
You must give the participant at least 30 days’ notice of the right to request a distribution. If the participant doesn’t respond to the advance notice, the plan sponsor must establish a rollover IRA for former participants with balances between $1,000 and $5,000.
Balance of more than $5,000
You can’t require terminated employees to take a distribution from account balances larger than $5,000. But, when determining the $5,000 limit, you can disregard any portion of a participant’s account that was rolled into the plan from an IRA. And you can provide participants with the same distribution notices and forms.
If the vested account is more than $5,000, participants can leave the money in the plan and the account will continue to grow tax-free. Participants don’t have to pay taxes on the money. Plans generally charge a fee for keeping a terminated employee’s account balance open, and may restrict a participants’ ability to transfer money among the plan’s investment options. Your distribution notice should indicate that plan fees and investing flexibility may differ if the participant chooses to roll the account into an IRA or another employer’s plan.
Plans generally allow terminated employees to take a lump sum distribution, but the participant will owe at least 20% automatic withholding tax on the distribution. Generally, participants should consider this option only if there is a financial emergency.
Deciding what to do with terminated employees’ account balances can be complex. When drafting or revising your plan document, consider the following:
Plan provider costs. Plan providers can base fees on total plan assets, the number of participants, the average account balance or a combination of these. If fees decrease as plan assets increase, design the plan to minimize distributions to terminated participants. But if fees increase as average account balances decrease, and many of the terminated participants have smaller account balances, then consider designing the plan to expedite distributions as soon as possible.
Participant disclosure requirements. Government regulations, such as ERISA and Sarbanes-Oxley, require plan sponsors to annually provide several disclosures to participants — including former employees with account balances. These disclosures include participant statements, changes in providers or investments offered, the summary plan description (SPD), the summary annual report, blackout notices, and notice of submission to the IRS. By drafting your plan document to allow for immediate distributions, you can minimize the burden of providing these disclosures to former employees with account balances.
IRS disclosure requirement. Plans that retain former employees’ account balances must annually file Form 8955-SSA directly with the IRS. The form lists the name, Social Security number and vested account balance for terminated employees.
The IRS gives the information to the Social Security Administration so it can notify Social Security recipients that they may also be entitled to additional benefits from a former employer’s retirement plan. In addition to reporting participants when they terminate, plans must report when terminated participants receive a distribution.
Timing the distribution. When drafting or reviewing your plan document to meet your specific needs, consider timing forced distributions to coordinate with the record keeper’s processing deadlines. For example, many plans provide that participants are eligible to take distributions as soon as possible following termination of employment, but some record keepers are set up to process the distributions only quarterly, semiannually or annually.
Getting it right
Be sure to check your plan document for the rules pertinent to your plan. Getting the payout right can avoid extra costs for the plan.