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Prevent Problems by Using Auto Rollover IRAs for Force-Outs Below $1,000

by | Feb 28, 2024

Have you done something for a long time without really thinking about it, and when you finally do you realize you could be doing it better? Most service providers and plan sponsors continue to pay force-out distributions of less than $1,000 in cash via checks without recognizing there is a more efficient solution.

Using checks to pay force-outs can result in unfavorable fiduciary and tax consequences. All uncashed checks are a fiduciary risk because they remain plan assets, and there is an ongoing responsibility to search for the missing participants. In addition, using checks for force-out distributions of $1,000 or less can result in unwanted taxable income and potential penalties for participants.

Just because it has always been done this way doesn’t mean there isn’t a better alternative. Address both the fiduciary risk and unwanted taxable income by using the automatic rollover IRA for all force-out distributions – from $1 to $7,000.

Fiduciary Risk

A fiduciary is obligated to satisfy certain responsibilities in administering the plan, including resolving uncashed checks and locating missing participants. Failure to fulfill those responsibilities can result in legal liability.

Uncashed Checks Are Still Plan Assets

When a cash distribution occurs, plan assets are typically transferred into a general checking account maintained by a custodian or recordkeeper for all client plans. If that check goes uncashed, the funds usually remain in the general account. However, according to the Department of Labor (DOL) uncashed distribution checks remain plan assets protected under ERISA.

The most common reason for an uncashed check is when the participant has not requested a distribution, such as a force-out. Uncashed or stale checks pose unique fiduciary risks, including:

  • Failure to locate participants associated with the uncashed checks may violate the duty to act prudently in the participant’s best interest.
  • Uncashed checks no longer accrue earnings from participant-directed investments; meaning the fiduciary is responsible for the investment, or lack thereof, of those plan assets. A fiduciary should consider whether lost earnings are due for checks that remain uncashed for long periods of time.
  • Without active accounts, participants are not receiving any notices or statements regarding plan information or changes.
  • A substantial number of stale uncashed checks is considered a red flag, demonstrating a potential problem with missing or non-responsive participants, and increasing the chance of a DOL investigation.

There is no need for a fiduciary to take on these risks for force-out distributions. By using an automatic rollover IRA for balances below $1,000, the funds sent to the IRA are no longer considered plan assets, thus reducing fiduciary responsibility.

Locating Missing Participants

The DOL considers it a fiduciary obligation to search for missing participants. Uncashed checks may be a warning sign of potential issues related to missing participants receiving their benefits. This is why the DOL issued guidance on locating former participants. Failure to follow these steps may result in fiduciary liability.

When processing checks for force-out distributions below $1,000 the plan sponsor / fiduciary is responsible for finding the former participants associated with uncashed checks. The DOL recommends using up to nine methods in attempting to locate missing participants. Further, the DOL wants these searches to regularly continue until the participant is found.

In the alternative, using an automatic rollover IRA for balances below $1,000 has the following benefits:

  • DOL guidance allows the use of the participant’s most recent mailing address in the employer’s records.
  • Plan sponsor/fiduciary is considered to satisfy notice requirements even if they are returned as undeliverable.

It is unnecessary for a plan sponsor/fiduciary to take on the responsibility of locating missing participants for force-out distributions below $1,000. However, you can avoid the administrative headache and potential fiduciary liability by using an automatic rollover IRA for all account balances of $7,000 or less.

Tax Consequences

Completing the force-out with a cash distribution for balances below $1,000 may expose the participant to unwanted taxable income and penalties. It also has the perception that the plan sponsor doesn’t care about the participant or his/her account balance even if it is small.

Unwanted Taxable Income

The following example demonstrates how a cash force-out distribution can be detrimental to a participant. Ashli, age 25, fails to timely return a distribution election for her $800 account balance because she doesn’t want to deal with it now. A check for the force-out distribution is processed for $640 (mandatory federal withholding of 20%) in November 2023. Now Ashli is forced to deal with it. She has $800 in taxable income in 2023 and will likely have to pay the 10% early withdrawal penalty.

This scenario can be avoided by using an automatic rollover IRA for balances below $1,000. If Ashli failed to timely return the distribution election, her total account balance of $800 would be rolled over to an IRA in November 2023. For 2023, a Form 1099-R is generated to report the $800 rollover from a qualified plan to an IRA, continuing the deferral of income taxes. Ashli can now deal with it when she wants, including possibly waiting until she satisfies an exception to the early withdrawal penalty.

Recognizing and Reporting Taxable Income

This distinction can be even more critical for checks processed late in the year due to the determination of which tax year the income will be recognized. Returning to Ashli, assume that she failed to timely return a distribution election for her $800 account balance because she had moved. A check is processed for $640 (mandatory federal withholding of 20%) in November 2023. Ashli fails to cash the check and it becomes stale. Ashli provides an updated address in August 2024. A new check is cut for $640 and cashed by Ashli in September 2024. In what year is Ashli’s account balance considered taxable income?

According to IRS Revenue Ruling 2019-19, it is taxable to Ashli in 2023. The failure of a participant to not cash a check by the end of the year issued does not change the tax withholding or reporting requirements for the plan sponsor. Unless the service provider allows exception processing, Ashli will need to amend her 2023 individual tax return to include the taxable income even though she didn’t cash the check until September 2024.

This scenario can also be avoided by using an automatic rollover IRA for balances below $1,000. In November 2023, Ashli’s total account balance of $800 would be rolled over to an IRA – instead of issuing a check – continuing the deferral of income taxes. When she provides an updated address in 2024 to the auto rollover IRA provider, she can take a distribution which would then be treated as taxable income in 2024. Ashli avoids the frustration of amending a tax return and the service provider and plan sponsor avoid having to deal with an unhappy Ashli.

Choose the Better Alternative!

Optimizing the plan’s automatic rollover IRA feature reduces fiduciary risk and avoids unnecessary tax consequences for participants. The ability to avoid these problems with small balances becomes even more critical as SECURE 2.0 changes like long-term, part-time (LTPT) eligibility and mandatory automatic enrollment take effect. These changes are likely to result in more small balances being left behind when employees leave.

When a better solution exists, we shouldn’t keep doing it the old way just because. Avoid the administrative burden and fiduciary risk by using an automatic rollover IRA for all account balances – from $1 to $7,000.


About The Author

Brian Furgala is Senior Director, Retirement Services Strategy for PenChecks Trust, a leader in outsourced retirement plan distribution processing and Automatic Rollover/Missing Participant IRAs and related services. His broad experience as an ERISA attorney and senior executive for several leading retirement plan service providers gives him a unique perspective on the industry.


The views expressed in this article are those of the author and do not necessarily represent the views of PenChecks Trust®, its subsidiaries or affiliates.
 

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