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  • Cashing-Out Terminated Employees From Your Company’s Retirement Plan

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Cashing-Out Terminated Employees From Your Company’s Retirement Plan

  • Posted on November 1, 2017 by Legacy Retirement Solutions

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We live in a society that has a transient workforce.  According to the Bureau of Labor Statistics, the average person will have 10 different jobs before reaching the age of 40.  What this means in the world of retirement plans is that plan sponsors need to be prepared for the impact that employee turnover has on the administration and operation of their retirement plans.  In this regard, every retirement plan sponsor should have a written procedure detailing how to deal with an employee’s termination of employment.  However, for purposes of this article, we are going to focus only on one aspect of the employment termination process as it relates to defined contribution retirement plans (“Plans”).  More specifically, this article examines the involuntary cash-out provisions included within most Plans.

Although not required to do so, many Plans offer immediate distributions of retirement plan assets to terminating employees.  Former employees generally appreciate these provisions because they permit the departing employee to take control of his or her retirement plan savings by rolling such amounts over to a new employer’s retirement plan or an “individual retirement account” (“IRA”) or by receiving a taxable distribution of such amounts.  Plan sponsors also benefit from allowing immediate distributions upon plan termination because it allows a plan sponsor to eliminate the costs and on-going fiduciary obligations that it has in connection with the now former employee’s retirement assets.  The remainder of this article assumes that the Plan at issue allows for immediate distributions upon termination of employment.

In order to facilitate and encourage plan distributions upon termination of employment, a plan sponsor should immediately provide terminated participants with a notification that explains the right to a receive a distribution from the plan and provides at least a 30-day window for such individual to voluntarily undertake this transaction. However, what happens when a participant neglects to exercise that right and, by default, such participant’s account balance remains in the Plan.  Fortunately for those plan sponsors that want to reduce fiduciary exposure and operational costs of the Plan, there is a way to force distributions in relation to certain small account balances that remain after a participating employee terminates service with the plan sponsor.  This provision is called a “cash-out” provision.

In general, the Internal Revenue Code requires that a retirement plan participant must provide consent before a plan sponsor can distribute his or her account balance.  However, the cash-out rule is an exception to the requirement that a plan sponsor obtain participant consent before processing a distribution from the Plan.  Since a plan sponsor is not required to employ a cash-out provision, it is important to verify the provisions of the specific Plan at issue before attempting to effectuate a cash-out distribution.  Notwithstanding, most Plans are designed to include some variation of such a provision.

With a properly implemented cash-out provision, a plan sponsor can forcibly distribute the account balance of a terminated participant if the value of his or her account is no greater than $5,000.  It is permissible for a plan sponsor to select a cash-out threshold of less than $5,000.  However, in general, if the value of the forced distribution is greater than $1,000, such distribution must be made in the form of a direct rollover to an IRA.  Also, in certain circumstances, it is permissible to ignore rollover contributions into the plan for purposes of calculating whether the cash-out threshold is exceeded.

It is important to understand that, generally, when a cash-out provision is implemented within a Plan, it obligates the plan sponsor to routinely distribute all accounts that fit into the parameters of the cash-out provision, without exception.  Presumably some plan sponsors are unaware of the existence of a cash-out provision within their Plan or, possibly, some plan sponsors simply neglect to periodically distribute terminated participant accounts that qualify for such treatment.  Consequently, at times, plan sponsors fail to distribute small account balances in accordance with the Plan’s cash-out provisions.  Unfortunately, a failure to follow the terms of a cash-out provision would constitute a failure to follow the terms of the Plan which is a tax-qualification defect.  Although this type of tax-qualification defect can be corrected under the “Employee Plans Compliance Resolution System” (“EPCRS”) as sponsored by the Internal Revenue Service (“IRS”), it is always better to avoid the failure in its entirety.

As suggested above, a plan sponsor’s failure to periodically exercise a cash-out provision can result in a tax-qualification defect.  However, the IRS has not provided clear guidance on how frequently this process must occur in order to avoid a tax-qualification defect.  As with most issues, the terms of the Plan document should be consulted in order to determine whether they impact this analysis.  In the event that the terms of the Plan are silent on this issue, small account balances subject to a cash-out provision should be “swept” out of the Plan with a short, regularly recurring frequency.  Despite the lack of specific IRS guidance on this topic, it appears clear that this should occur at least annually.

 

As much as we hope this article helped you to better understand this topic, it is not to be construed as financial, tax or legal advice.  Therefore, if you believe that the issues discussed herein may apply to your (or your client’s) company, be sure to further discuss it with a qualified retirement plan professional.  For more information about this topic, please contact our marketing department at 484-483-1044 or your administrator at Legacy.

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