Operational failure of involuntary cash-outs and rollovers

[30Rock]

What is the correction if a plan uses a $1,000 cash-out threshold but the plan in operation has been involuntarily cashing out participants with account balances between $1-$5,000? And yes an IRA agreement was in place, however the plan document was not amended to permit these mandatory cash-outs/rollovers. It appears to have been going on for several years and has not been identified as an inadvertent failure. Thank you!

[Peter Gulia]

Before too hastily assuming that the plan was administered other than according to the written plan’s provisions, consider looking carefully to find all possibly relevant writings and evaluating whether some writings amended what otherwise would be “the” plan documents.

Although ERISA calls for a plan to be written, it need not be one fully integrated exclusive writing. And nothing in ERISA commands that an amendment be made with the same formality as the writing the amendment would change. Several courts’ decisions observe that a written plan might comprise several formal and informal writings.

Many plans do not restrict what kind of writing amends a plan. (One would read, carefully, the documents governing the plan to confirm the absence of a restriction that would make a less-formal writing insufficient to amend the plan.)

For example, a written agreement with a default IRA provider might state that the plan provides an involuntary distribution of a balance that’s no more than $5,000 (or the applicable limit on an involuntary distribution before the participant’s normal retirement age). Such an agreement might have been signed, ratified, or otherwise adopted by a person who or that had authority to amend the plan.

Likewise, communications to participants might have stated the cash-out provision, and might have been signed, ratified, or otherwise adopted by a person who or that had authority to amend the plan. A signature can be using on or in a writing a person’s name, including a corporation’s or other organization’s name, with an intent to adopt the writing. Under Federal law, an electronic signature can be as simple as sending an email with the sender’s intent to adopt the text the email delivers.

A plan sponsor might want its lawyers’ reading and advice about whether the sponsor amended the plan to change the involuntary-distribution threshold, and (if the sponsor did) when the amendment took effect.

This is not advice to anyone.

[30Rock]

Thank you that is helpful. 

[Paul I]

@30Rock there is set of administrative steps that a plan must take to administer the cash-outs properly.  If the plan has in fact followed those administrative steps, that will help support a position that the plan was operating intentionally to apply the cash-out rules.  You do not appear to have an issue with cash-outs for participants with vested balances of $1,000 or less. 

For cash-outs of vested balances that are over $1,000 and under the $5,000 (or $7,000 or some other lower limit), the plan should have sent a notice or letter to the participant and the 402(f) notice that the participant needed to take action before a specified deadline (typically at least 30 days).  This should include an explicit statement that the balance will be rolled over to an IRA if the participant does not respond by that deadline.

If these administrative steps are followed and everyone elects a direct distribution, there is no issue.  If these administrative steps were not followed, then the plan has an operational issue regardless of what are the plan provisions.  If nothing else, the plan should begin operating according to the cash-out rules.

As far as any sort of correction, it is hard to overlook the fact that the participants received their vested account balance.  These are not overpayments.

It is hard to overlook that each participant had the opportunity on their own initiative to rollover the distribution to an IRA within 60 days.  

It is hard to overlook that participants who did not rollover paid taxes on the distribution. If any amounts were returned to the plan so the plan can make a rollover to an IRA, the participant would have to file an amended tax return to try to recoup the taxes they paid previously.

It is hard to overlook that the amounts in question are relatively small.

The plan should consider all of the above in formulating a "correction". 

None of this is intended to imply that the plan should brush aside the issue.  The plan should acknowledge any operational error and take immediate steps to operate the plan correctly.

 

[30Rock]

Yes, it appears letter to participants was issued with the 402(f) notice.  I think we are trying to determine if we can retroactively amend the plan back to 2015 to match plan operations. However, this type of retroactive amendment does not clearly fall into an EIF and the "not less than favorable rule" under SECURE 2.0 and IRS Notice 2023-43. Then there is always the option to just fix it prospectively. Apparently 6 participants were affected by the incorrect cash-out.

[Artie M]

As always, what follows are just my thoughts…. Worse even because I am eating lunch and going to try to type this…

Assuming the Plan was not amended as laid out by the prior posters, this is an operational failure (i.e., a failure to operate the plan in accordance with its terms) and the general rule for self- correcting an operational failure is to fix what was done in the plan’s operation by correcting the mistake to match the plan’s terms.  The other alternative that can be used to self-correct under limited circumstances is to retroactively amend the plan so that its provisions match the way the plan was operated.

Self-correction through retro amendment under the circumstance you describe doesn’t appear to be permitted.

Essentially any failure that qualifies as an “EIF” can be self-corrected at any time and regardless of its significance.  My colleagues and I have batted around what exactly is an EIF and defining it is not all that simple.  Under the statute the only failures that are definitely not EIFs are egregious failures, failure involving the diversion or misuse of plan assets, and abusive tax avoidance.  The IRS adds to that list of non-EIFs, at least until it issues further guidance, significant failures in terminated plans, failures in orphan plans, written plan document failure in a startup plan, and any failure corrected by plan amendment that is less favorable for a participant than the original terms of the plan (there are others but not applicable to qualified plans).

So the failure you describe is not an EIF if corrected through a plan amendment.  So, it may still be an EIF, unless or until it is corrected through a retroactive amendment.  (Strange in that the failure might qualify for a retroactive amendment, until it is actually retroactively amended.)

If it is an EIF, it may still be self-corrected under the principles of the SECURE Act (just not through a retroactive amendment).

Under the guidance, with any potential self-correction, the key is determining whether the procedures a plan has in place, if any, are “reasonably designed to promote and facilitate overall compliance in form and operation with applicable Code requirements” and that they’ve been “routinely followed, and [the failure] must have occurred through an oversight or mistake in applying them” (emphasis added).

Arguably, the procedures you have described appear to meet those rules but for the fact that the plan limit is $1,000 and not a higher amount.  Arguably, the cash-outs you describe meet “applicable Code requirements” as it appears that the maximums used would be permitted under the Code.  I say, arguably, because it is also a requirement of the Code to follow the terms of the plan.  However, failure to follow the terms of a plan cannot disqualify a failure from being an EIF because every operational failure is a failure to follow the terms of the plan.  You indicate that notices are and were sent, there is an IRA agreement in place, etc.  Those seem to indicate reasonable procedures that were mistakenly applied… so why can’t this be an EIF?

Also any involuntary cash out in excess of $1,000 would appear (at least to me) to constitute an “overpayment” as described in SECURE 2.0.  Notice 2023-43 states that an “inadvertent benefit overpayment” for these purposes “is an [EIF] that occurs due to a payment made from [certain plans that include a qualified plan] that exceeded the amount payable under the terms of the plan or a limitation provided in the Code or regulations.  An inadvertent benefit overpayment also includes a payment made before a distribution is permitted under the Code or under the terms of the plan” (emphasis added).  (Just because the amounts were vested doesn’t mean they weren’t overpayments.  Most defined benefit overpayments are vested.)  If any of these distributions were involuntary cash-outs in excess of $1,000, including an involuntary rollover to an IRA (and even if the amount was vested), they were payments that “exceeded the amount payable under the terms of the plan” and they were payments that were “made before a distribution is permitted… under the terms of the plan.”

It does not seem unreasonable to self-correct the involuntary cash-outs that were made under the circumstances that you describe through the SECURE 2.0 rules applicable to EIFs that are inadvertent benefit overpayments, provided, they are not self-corrected through a retroactive amendment.

So it doesn’t seem unreasonable to apply any of the corrective steps permitted to be used under SECURE 2.0 under your circumstances.  Along with that, the plan would be amended prospectively to increase the involuntary cash out amount.

Of course, the last alternative is to simply submit this under VCP, proposing the correction of the failure through a retroactive amendment and then see what the IRS says. Of course, the plan sponsor would have to pay the VCP fee ($1,500-$3,500 plus attorney’s/advisors’ costs).

[30Rock]

I agree with what you are saying - 1. I do not feel comfortable about the retro amendment because I cannot state for sure no one was treated less favorably, and 2. I was also considering the overpayment corrections which still allow attempts to recoup however if the participant does return the funds, we likely will turn around and cash-out them out on the next cash-out/sweep especially since the cash-out threshold is now $7,000. But, since they normally do not return the overpayment, at least the fiduciary would be on record of making the attempt to recoup and correct the failures. And, under SECURE 2.0 you no longer have to attempt to recoup, so the plan sponsor could document this as a self-correction under the overpayment provisions of SECURE 2.0.

Any thoughts?

[G8Rs]

Here's another approach.

If the plan allows distributions upon termination of employment, then don't you have a failure to obtain consent rather than an overpayment? Rev. Proc. 2021-30 only addresses consent failures in a J&S plan. But if you're comfortable in crafting self-correction where nothing is prescribed, this would seem to help. Try to get consent to the distribution, and if they don't, then oh well. 

.07 Failure to obtain participant or spousal consent for a distribution subject to the participant and spousal consent rules under §§ 401(a)(11), 411(a)(11), and 417. (1) The permitted correction method is to give each affected participant a choice between providing informed consent for the distribution actually made or receiving a qualified joint and survivor annuity. In the event that participant or spousal consent is required Page 94 of 140 but cannot be obtained, the participant must receive a qualified joint and survivor annuity based on the monthly amount that would have been provided under the plan at his or her retirement date. This annuity may be actuarially reduced to take into account distributions already received by the participant. However, the portion of the qualified joint and survivor annuity payable to the spouse upon the death of the participant may not be actuarially reduced to take into account prior distributions to the participant. Thus, for example, if, in accordance with the automatic qualified joint and survivor annuity option under a plan, a married participant who retired would have received a qualified joint and survivor annuity of $600 per month payable for life with $300 per month payable to the spouse for the spouse’s life beginning upon the participant’s death, but instead received a single-sum distribution equal to the actuarial present value of the participant’s accrued benefit under the plan, then the $600 monthly annuity payable during the participant’s lifetime may be actuarially reduced to take the singlesum distribution into account. However, the spouse must be entitled to receive an annuity of $300 per month payable for life beginning at the participant’s death.

[30Rock]

That could be another approach. And if they do not consent there is no repercussion but what if they want to return it to the plan since they did not consent? I am just looking for the one-off instance that could happen.

[G8Rs]

I wouldn’t allow them to roll it back in. As you pointed out, it will just be cashed out again when the plan is amended. 

[30Rock]

Yes makes sense. Thank you all!