The Government Accountability Office (GAO) released a study recommending three ways the Internal Revenue Service (IRS) and the U.S. Department of Labor (DOL) could clarify the handling of transfers of millions of dollars in unclaimed savings from employer retirement plans to states. While the study and recommendations had a narrow focus, they build on an emerging consensus among states and regulators about how to manage the retirement benefits of lost participants.
The study (GAO‑19‑88), titled “Federal Action Needed to Clarify Tax Treatment of Unclaimed 401(k) Plan Savings Transferred to States,” was released to the public on February 19 after being commissioned by the U.S. Senate Finance Committee. It addressed, among other areas, the critical gray area of tax treatment for benefit distributions to states when account owners can’t be found.
The ultimate disposition of these balances now involves the benefits being transferred to a state (known as being “escheated”) after a few years, then being treated as a non-periodic distribution to the participant. The participant who subsequently reclaims the benefits from the state often is still disadvantaged financially, but is better off than suffering a total loss of the benefit.
Addressing lost participants is now being emphasized by each of the agencies overseeing retirement plan regulation: the IRS, DOL and the Pension Benefit Guaranty Corporation (PBGC). (See related August 2018 story.) Independent auditors increasingly are asking for documentation that a plan regularly attempts to find lost participants.
In Field Assistance Bulletin 2014‑01, the DOL identified specific steps plans should take to attempt to locate lost participants. These include using certified mail, looking at records for other company plans, contacting beneficiaries, using free electronic search tools and making other reasonable efforts. If these steps are not yielding results, part of making other reasonable efforts includes varying the approach, like switching to a different search database.
Note: One potential indicator that a defined contribution plan may have a problem with lost participants can be seen on the Form 5500 or Form 5500‑SF, if the number of participants with account balances listed is high relative to the number of active participants.
Mandatory Cash-Out Provisions
Many plans now include mandatory cash-out provisions through which smaller benefit amounts payable are transferred to an individual retirement account (IRA). These provisions generally are helpful to the plan sponsor, particularly in plan terminations. By following these steps, the plan can satisfy its obligations to the terminated participant. Finding or keeping track of the participant becomes the responsibility of the IRA provider.
Some plans also include provisions for automatically paying required minimum distributions (RMDs) to any participant eligible to receive one (generally age 70½ or older and either terminated or a 5-percent owner). Some recordkeepers include in their service agreements the proviso that automatic RMDs will be paid, regardless of the plan provisions. Both situations create a higher incidence of uncashed checks because the checks are written without confirming the participant’s address. Other plans may notify an RMD-eligible participant that a payout is required but the plan does not write the check until the participant confirms the payment instruction.
A mobile workforce, the emerging gig economy and plan rules to pay out small balances contribute to individuals accumulating several rollover and traditional IRAs over the course of a career. Commonly, only one or perhaps none of the IRAs is actively managed. Further, an individual aged 70½ or older can pick one of the IRAs from which his or her RMDs are paid. So the remaining IRAs can appear to the financial institution as inactive accounts.
Inactive IRAs also can appear to states as accounts subject to escheat to the state. Each state has its own rules for when escheat occurs. Typically, states wait until an individual reaches age 70½ or is reported as deceased to escheat an IRA.
For example, in 2016, Pennsylvania changed its standards regarding unclaimed property. A financial institution in Pennsylvania must report any account for which the institution has lost contact with the owner and the owner of the account has expressed no interest or activity for three years, which is a much shorter time period than most states are given to take action on an inactive account. This accelerated approach has drawn the attention of other states, which are expected to adopt similar, more aggressive standards in the future.
On May 29, 2018, the IRS published Revenue Ruling 2018-17 regarding withholding and reporting payments from IRAs to state unclaimed property funds. This ruling applies to IRAs and not to employer-sponsored plans, but could become a precedent that the IRS may use to apply to qualified retirement plans.
Under the ruling, a payment from an IRA to a state is considered a distribution from the IRA. The distribution is a non-periodic payment, subject to a 10-percent withholding for federal taxes. Furthermore, the payment is taxable for the owner of the IRA and is reportable on a Form 1099R. There is no special code on the Form 1099R for the payment; it is filled out as if the owner had received the payment. This could result in the owner’s being subject to early-distribution penalties. The effective date for these rules introduced in the 2018 Rev. Rul. is the earlier of when financial institution can implement the rules or January 1, 2019, but that date was extended to January 1, 2020, by IRS Notice 2018-90.
Tax Withholding Varies
As a result of the lack of clear guidance from the IRS and DOL, 401(k) plan sponsor practices for state transfers vary—some withhold taxes when moving the savings to states and some don’t, according to the report. This makes the IRS “less likely to collect federal income taxes that may be due if transfers are taxable events.”
Keep in mind that the payment to the state occurs in part because the financial institution lost contact with the owner. The owner likely will learn of the payment when the IRS comes asking why the taxable payment on the Form 1099R reported to the IRS was not reported by the owner. The owner can work with the IRS to address the tax issues and can reclaim the benefit from the state, but the owner will no longer have the money in a tax-exempt account.
Reclamation of unclaimed amounts from a state is not a reason for which the IRS allows an exemption from the 60-day rollover period. One of the recommendations in the GAO report is for the IRS to consider adding reclaimed benefits to the list of reasons for rolling over a retirement account after 60 days. This would allow the owner to restore the tax-exempt account status and avoid current taxation and penalties.
Another recommendation in the GAO report is for the IRS to clarify whether amounts transferred from employer‑sponsored plans to a state are distributions. These most likely will be uncashed checks. If they are classed as distributions, what are the withholding and tax-reporting requirements? Similarly, a third GAO recommendation in the report asks the DOL to specify the circumstances in which uncashed checks from active employer-sponsored plans can be sent to a state.
In comments on a draft of the report, the GAO noted, the IRS agreed with the GAO recommendations and said it would work with the DOL to address related issues.
How to Find Missing Benefits
An individual can check for benefits that may have been escheated to a state. The National Association of Unclaimed Property Administrators (NAUPA) has a website that links to each state’s unclaimed property sites. The PBGC and the National Registry of Unclaimed Retirement Benefits also have useful websites that individuals can use to search for escheated amounts.
Finding an unclaimed benefit, paying taxes and penalties, losing tax-exempt status, and getting little or no investment return do not sound like situations in the best interest of participants. There is a lot of opportunity for improvement in this process. In the meantime, claiming a “lost” retirement account from a state is better than losing the entire benefit.
To help avoid this gray area, employer-sponsored plans need to continue efforts to maintain contact with all participants, regulators need to sharpen their guidance, and individuals need to be diligent in tracking their retirement benefits.
|A. Paul Protos is president and cofounder of ATR Inc., a third-party administration and benefits consulting firm that provides services related to Forms 5500, plan documents, summary plan descriptions, recordkeeping services, and compliance/operational reviews. Protos has more than 40 years of benefits consulting and administration experience. He has achieved the enrolled retirement plan agent (ERPA) designation. Protos is the contributing editor of the Pension Plan Fix-It Handbook.|