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Small Balance Cash-Outs: The One Provision that Doesn’t Make Sense

Does your retirement plan have a mandatory cash-out provision for account balances of $5,000 or less, where terminated employees automatically receive a distribution unless they elect otherwise? This provision, when properly administered, greatly minimizes the number of missing participants in a plan, since people are less likely to remember that they have $1,000 in a retirement account than when they have $100,000. Additionally, cleaning up small balance accounts increases a plan’s average account balance size, making the plan more attractive to recordkeepers from a pricing perspective.

While small balance cash-out provisions are a good idea, many plan sponsors sabotage the potential benefits by also including a provision that distributes balances of $1,000 or less to participants via paper checks. Here’s why this is a terrible idea:

  • Participants with balances of $1,000 or less are the most likely to be missing (as individuals with more money tend to keep their addresses updated), so a significant number of these checks are returned to the plan
  • Gen Z people - the ones who are more likely to be the owners of these small balance accounts - are less accustomed to receiving paper checks (I can count on one hand the number of paper checks I’ve received in the last few years, and I’m 51!)
  • With so much junk mail, there is the possibility that a check could simply be discarded
  • The paper check is subject to ordinary income taxes (20% of which is withheld up front), plus a 10% tax penalty if the recipient is under 59½ (most are), making that small check even smaller

So why do plan sponsors do this? Well, many years ago, the only way to cash out balances of $5,000 or less at termination of employment was to issue checks. But that changed in 2005, when the IRS provided guidance making it mandatory for any automatic cash-outs greater than $1,000, but less than $5,001, to be rolled over to an IRA. Unfortunately, many plan sponsors did not realize that distributions of $1,000 or less could also be rolled over, provided that the IRA provider would accept these rollovers (note that some plan sponsors responded to this new guidance by lowering their cash-out thresholds from $5,000 to $1,000, but they were in the minority). So, while plan sponsors rolled over $1,001-$5,000 balances to an IRA upon employment termination, they continued to issue paper checks for balances of $1,000 or less.

Fast forward to 2019, and, due to inertia, most plan sponsors are still issuing paper checks for cash-outs of $1,000 or less. And, if a plan’s current IRA rollover provider does not accept rollovers of $1,000 or less, I recommend finding another IRA rollover provider who does!

Can you think of a good reason to send paper checks to terminated employees with retirement account balance of $1,000 or less? I would love to hear from you on LinkedIn, Twitter or at info@cammackretirement.com!

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.

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