A client of mine has an ESOP that is making annual payments to a number of terminated participants. They send out a mailing each year advising the participant of the upcoming payment, and asking if it should be paid in cash or rolled over.

The question is this - if the participant does not respond to the mailing, and the payment amount is over $1000 (the plan has not amended for automatic rollover) can they pay that to the participant less the 20% tax?

No, not since EGTRRA. See IRC §401(a)(31) (pasted in part below):


(31) Direct transfer of eligible rollover distributions.

(A) In general. A trust shall not constitute a qualified trust under this section unless the plan of which such trust is a part provides that if the distributee of any eligible rollover distribution—
(i) elects to have such distribution paid directly to an eligible retirement plan, and
(ii) specifies the eligible retirement plan to which such distribution is to be paid (in such form and at such time as the plan administrator may prescribe),
such distribution shall be made in the form of a direct trustee-to-trustee transfer to the eligible retirement plan so specified.

(B) Certain mandatory distributions.
(i) In general. In case of a trust which is part of an eligible plan, such trust shall not constitute a qualified trust under this section unless the plan of which such trust is a part provides that if—
(I) a distribution described in clause (ii) in excess of $1,000 is made, and
(II) the distributee does not make an election under subparagraph (A) and does not elect to receive the distribution directly,
the plan administrator shall make such transfer to an individual retirement plan of a designated trustee or issuer and shall notify the distributee in writing (either separately or as part of the notice under section 402(f) ) that the distribution may be transferred to another individual retirement plan.
(ii) <A name=TCODE:8467.14>Eligible plan. For purposes of clause (i) the term “eligible plan” means a plan which provides that any nonforfeitable accrued benefit for which the present value (as determined under section 411(a)(11) ) does not exceed $5,000 shall be immediately distributed to the participant.

Document Header:
Internal Revenue Code
Current Code
Subtitle A Income Taxes §§1-1564
Chapter 1 NORMAL TAXES AND SURTAXES §§1-1400T
Subchapter D Deferred Compensation, Etc. §§401-436
Part I PENSION, PROFIT-SHARING, STOCK BONUS PLANS, ETC. §§401-420
Subpart A General Rules §§401-409A
§401 Qualified pension, profit-sharing, and stock bonus plans.

Selected Text Starting At: 401(a)(31)

Here's RIA's analysis of this provision of EGTRRA:


New Law. Congress believed that pre-2001 Act law law did not adequately encourage rollovers of involuntary distribution amounts. Failure to roll over these amounts can significantly reduce the retirement income that would otherwise be accumulated by workers who change jobs frequently, Congress said. By making a direct rollover the default option for involuntary distributions, Congress hopes to increase retirement savings. (Com Rept, see ¶5074)

Thus, under the 2001 Act, in order to remain qualified, an “eligible plan” (defined below) will have to provide that if: (1) a distribution of a nonforfeitable accrued benefit of less than $5,000 but more than $1,000 is made, and (2) the distributee does not make an election to have the distribution paid directly to another qualified plan or IRA, and does not elect to receive the distribution directly, the plan administrator will make the transfer to an IRA of a designated trustee or issuer, and notify the distributee in writing, either separately or as part of the section 402(f) notice, that the distribution may be transferred without cost or penalty to another IRA. (Code Sec. 401(a)(31)(B)(i) as amended by 2001 Act §657(a)(1))

For this purpose, an “eligible plan” is a qualified plan which provides that any nonforfeitable accrued benefit for which the present value (determined under Code Sec. 411(a)(11) ) does not exceed $5,000 shall be immediately distributed to the participant. (Code Sec. 401(a)(31)(B)(ii) )

In other words, the 2001 Act makes a direct rollover the default option for involuntary distributions that exceed $1,000 and that are eligible rollover distributions from qualified retirement plans. The distribution must be rolled over automatically to a designated IRA, unless the participant affirmatively elects to have the distribution transferred to a different IRA or a qualified plan, or to receive it directly. (Com Rept, see ¶5074)

RIA viewpoint: Pamela D. Perdue, author of WG&L's Qualified Pension and Profit Sharing Plans, Second Edition, and a counsel to the firm of Summers, Compton, Wells & Hamburg in St. Louis, MO, specializing in the taxation of pension and profit-sharing plans, cautions that some plans will find compliance with this provision easier said than done. To date, many employers find that financial institutions are not particularly eager to establish IRAs for missing or otherwise non-cooperative individuals.

Document Header:
Checkpoint Contents
Federal Library
Tax Legislation
Complete Analysis of the Economic Growth and Tax Relief Reconciliation Act of 2001
Organization of the Complete Analysis
Analysis
Chapter 400 Pension and IRA Provisions
422 Qualified plans must provide that involuntary cash-outs of more than $1,000 (but less than $5,000) will be automatically rolled over to IRA unless distributee elects otherwise


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Thank you for the excellent response, that is what I was thinking. I have a follow up question, and I apologize, I am new to ESOP administration. It seems that these payments are required to be made to these terminated participants on a 5 year schedule. If the plan is not amended for automatic rollover, and the participant does not respond to the mailing requesting rollover information. what is the Plan Administrator to do? I don't think it would be permissible to not make the payment, but per the document, there is no provision for forcing out balances over $5000.

Could the PA rely on the prior year instructions if it is not the participant's first year? What if this is the first of the 5 payments.

Thanks for your help!

It would make sense to indicate in the distribution form for payment #1 that this is the first of many payments, and we will assume your election on this payment #1 distribution form will continue for all following distributions unless you indicate something different--or, you even could indicate that the election for payment #1 is irrevocable for the remaining payments thereafter. Since this is a series of distributions which is known by the participant when the distribution commences, you are not required to have specific permission for each payment--think annuity payments--or must you receive a new distribution election form each year in this situation since the payments may not be regular?