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Sooner or later, every retirement plan will have to deal with participantswho have terminated employment but still have balances in the plan. In mostcircumstances, the plan document provides guidance on how to proceed; however,there are a number of factors that can make the determination a little morecomplex than what it seems at first blush.

Why do we Care?

Before exploring the options for handling former participant balances, it ishelpful to understand several aspects of plan maintenance that may steeremployers in one direction or another.

Count the Cost

Many plan service providers set their fees in whole or in part based on plansize. This may include total assets, the number of participants, average accountbalance or some combination of these factors. Understanding how fee schedulesare structured is one factor in determining the most appropriate policy fordealing with former plan participants. For example, if fees decrease as planassets increase, it might make sense to design the plan to minimize outflows toterminated participants. On the other hand, if fees increase as average accountbalances decrease and many former participants have below-average balances,taking steps to expedite distributions may be the more appropriate course ofaction.

Stand and be Counted

The number of participants is used to determine another critical thresholdfor retirement plans--the plan audit threshold. Generally, plans with more than100 participants on the first day of any plan year are required to engage anindependent qualified public accountant to audit the plan's financial statementsand attach the audit report to Form 5500. Former participants with remainingbalances are counted for purposes of the 100-participant threshold.

Since it is not uncommon for the cost of a plan audit to reach five figures,plan sponsors often seek to delay being subject to the requirement as long aspossible. One way to do this is, to the extent possible, to design the plan sothat former participants can/must have their balances distributed to them assoon as possible following termination of employment.

Tell the Participants

Anyone who works with retirement plans on a semi-regular basis is quite awareof the seemingly endless number of disclosures that must be provided toparticipants, including the Summary Plan Description, Summary AnnualReport and many others. A number of these disclosures include informationdescribing the rights of anyone with a balance in the plan, so they must beprovided to former employees as well.

While the IRS and Department of Labor (DOL) both allow certain documents tobe provided via electronic means such as e-mail, the requirements for doing socan be daunting with respect to former employees who no longer access a companye-mail account as part of their jobs. Plan options that allow for immediatedistributions can minimize the burden of providing many of these disclosures toformer employees.

Tell the IRS

Participant disclosures are not the only concern. Plans that include formeremployees with remaining balances are required to file a form with the IRS eachyear. Prior to 2009, this information was required to be attached to Form 5500;however, after a temporary suspension of this reporting requirement, it is nowsatisfied by filing Form 8955-SSA directly with the IRS each year.

The form lists the name, social security number and vested account balancefor terminated employees. The IRS shares this information with the SocialSecurity Administration so that it can notify recipients of social securitybenefits that they may be entitled to additional benefits from a formeremployer's retirement plan. As a result, plans must not only report participantswhen they terminate, they must also monitor prior years' forms and "un-report" terminees once they receive distributions.

What are the Options?

Plan sponsors have a fair degree of flexibility in designing their plans todeal with former participants with balances; however, once the design isdetermined, sponsors must consistently follow the provisions they put in place.

Small Balances

IRS and DOL rules allow plans to force distributions to former participantswith vested account balances of less than $5,000 after providing them with atleast 30 days advance notice of their right to request a cash distribution or arollover to an IRA or a new employer's plan.

Due to concern that automatically cashing out former employees could causethem to prematurely spend amounts they had set aside for retirement, the rulesrequire employers to establish rollover IRAs on behalf of former participantswith balances between $1,000 and $5,000 who do not respond to the advancenotice. Those with less than $1,000 can be cashed out with the appropriate taxeswithheld. These rules leave sponsors with several plan design options.

1. Force out all vested balances below $5,000 with those from $1,000 to $5,000 going to IRAs and those below $1,000 being paid in cash;
2. Force out all vested balances below $5,000 with all of them going to IRAs;
3. Force out all balances below $1,000 with all of them being paid in cash; or
4. Eliminate forced distributions altogether.

When the rules for automatic IRA rollovers were first effective in 2005, veryfew providers were set up to accept them, causing many employers to elect option3 or 4, above. However, the marketplace has adapted, and many providers are nowable to accommodate automatic rollovers. Therefore, plan sponsors are able toelect options 1 or 2, above, without taking on substantial administrativeburden.

The timing of forced distributions is a critical element to consider. Notonly do plan documents specify the threshold, e.g. $5,000, but they also specifythe timeframe in which distributions are processed. For example, many plansprovide that participants are eligible to take distributions as soon as possiblefollowing termination of employment.

Combining this provision with the forced distribution provision may requirethat former employees with balances below the threshold be provided theapplicable notices very soon after termination with the forced distributionsbeing processed 30 to 60 days later. Since some recordkeepers are only set up toprocess these "sweeps" quarterly, semi-annually or annually, sponsors shouldcoordinate their plan provisions to avoid inadvertently delaying forceddistributions in violation of plan terms.

Larger Balances

Terminated employees with vested balances exceeding $5,000 generally cannotbe forced out of a plan; however, plan sponsors can provide them with theapplicable notices and forms to communicate distribution options. There is oneimportant exception to this general rule. Any portion of a participant's accountthat was rolled into the plan from an IRA or an unrelated employer's plan can bedisregarded for purposes of the $5,000 forced distribution limit. Consider thisexample.

Joe Participant has terminated employment and has a total vested accountbalance of $14,000 as follows:

If the $9,500 rollover balance is disregarded, Joe's vested balance is only$4,500; therefore, if the plan document is written to require forceddistribution to former employees with balances below $5,000, Joe's entireaccount balance can be processed under those rules.

Fees

IRS and DOL guidance allows plans to charge certain fees to participantaccounts. This includes not only ongoing plan management expenses but alsodistribution fees. However, the plan document must include language authorizingthe charges and the method of allocating the expenses must be disclosed toparticipants, usually in the Summary Plan Description. For example, the plan mayprovide that general management expenses are allocated proportionately based onaccount balance while distribution fees are charged directly to the accounts ofthe participants requesting the distributions.

Residual Distributions

From time-to-time, a former employee takes a full distribution of his or heraccount before all contributions or investment gains are allocated. This mayoccur, for instance, in a safe harbor 401(k) plan for which the employerallocates a 3% nonelective contribution at the end of the plan year. Since thesecontributions cannot be subject to a last day of employment rule, anyparticipant eligible at any point during the year is entitled to thecontribution even if he or she terminated employment earlier in the year.

So, what happens to the residual account balance generated by thecontribution? The answer depends somewhat on timing. As described above,terminated participants must be provided with a distribution notice at least 30days in advance of a distribution. The notice is considered "stale" after 180days. Therefore, if the residual contribution is credited to the participant'saccount fewer than 180 days after the date the notice was provided, the plan canissue a distribution of the residual using the same method as the initialpayment, e.g. cash distribution, rollover to IRA, etc.

If it has been more than 180 days, the account is subject to the distributionrules in the same manner as if there had been no previous distribution paid. Inmany such situations, the residual balance will be below the forced distributionthreshold and can be processed as such.

What about Plan Terminations?

When an employer elects to terminate its plan, all participants are entitledto take distributions regardless of their employment status. Generally speaking,the distributions are processed according to the rules outlined above. But, whathappens when participants with more than $5,000 do not make a distributionelection? What happens if notices to former employees are returned due toinvalid addresses?

Fortunately, the DOL has provided guidance on how to handle these situations.If plan sponsors follow a four-step program but are still unable to obtain anelection from participants, the accounts in question can be rolled over usingthe automatic rollover rules regardless of balance. The four steps are asfollows:

• Use certified mail for the initial distribution notice;
• Check other plan records as well as those for other company benefit programs;
• Check with a designated plan beneficiary; and
• Use one of the governmental letter-forwarding services.

A fifth step that may be employed is to hire a locator service specializingin finding missing account holders. The expenses for all of these steps can beallocated to the accounts of the missing participants.

Conclusion

There are many options available to employers to address the account balancesof former employees, and there is no "one size fits all" solution. As with mostplan-related decisions, the appropriate solution depends on an employer'sspecific facts and circumstances as well as the capabilities of the variousservice providers involved.

Although there is flexibility in how the plan is designed to accommodatethese situations, the actual plan operation must adhere to the provisionswritten in the plan documents. Sponsors should work with knowledgeable providerswho can coordinate the efforts of all parties involved to develop a practicaland workable solution.

The information contained in this newsletter isintended to provide general information on matters of interest in the areaof qualified retirement plans and is distributed with the understanding thatthe publisher and distributor are not rendering legal, tax or otherprofessional advice. You should not act or rely on any information in thisnewsletter without first seeking the advice of a qualified tax advisor suchas anattorney or CPA.

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