Best practices for mandatory retirement plan distributions
As plan sponsors wrap up their annual plan coverage and discrimination testing, the updated census gives them the perfect opportunity to clean up their plan by making mandatory distributions to certain terminated participants with balances still in the retirement plan.
Where allowed by the plan’s document, force out procedures can have several benefits for plans. For example, distributing small balances can simplify plan administration by reducing the number of participants who require annual disclosures and notices. This may also increase average account balances plan-wide, which could yield better pricing from vendors.
Mandatory distributions involve the forced distribution of terminated participant balances that fall below the threshold designated by plan document to a regulatory maximum of $5,000. Accounts between $1,000 and $5,000 must be rolled over into an IRA, and accounts less than $1,000 can be distributed via check with the standard taxes applied. Plan documents can elect to have all accounts below $5,000 rolled over automatically into an IRA, but more typically accounts below $1,000 are distributed by check.
To force terminated participants from the plan, the plan sponsor will first need to send the targeted participants a distribution notice giving them 30 days to decide what to do with their funds. This notice should include information on the options available to them, such as IRA rollovers or cash distributions minus applicable taxes or penalties, and what will happen with their funds if they do not act by the designated deadline. Along with this notice, plan sponsors should include distribution forms and disclosures such as the special tax notice.
Plan sponsors will also need to select an IRA trust provider for the accounts that end up being rolled over into IRAs. Many recordkeepers are happy to provide this service and there are third party trust providers available in the marketplace as well. When selecting the trust provider, plan sponsors should consider the cost to administer the IRA, the investment that the funds will be placed in, and the strength and reputation of the provider. Cost and the investment vehicle go hand in hand. Since the investment vehicle is a money market fund, the yield on the fund needs to be adequate to cover the administration costs of the new account. For example, if there is a $5,000 account rolled over into an IRA and money market vehicle yielding 0.50% and there is an annual administration fee of $40, then the account would lose $15 in the first year.
Ideally, terminated participants will make their own election regarding their funds. However, for the ongoing administration and health of the plan, it is prudent to implement mandatory distributions. Ideally, a plan sponsor will include the force-out process as a part of its termination process and provide an outbound participant with the notices and paperwork necessary to make an election at the time of termination.