Over the last 35 years, the DOL has made repeated administrative pronouncements that ERISA generally preempts state unclaimed property law.1 That broad interpretation of preemption will now be reevaluated by the DOL as a result of recommendations found in a GAO report released on February 19, 2019. The report, Retirement Accounts: Federal Action Needed to Clarify Tax Treatment of Unclaimed 401(k) Plan Savings Transferred to States (the Report), was presented to the Ranking Member of the U.S. Senate Finance Committee. In the Report, the GAO explores the escheat and tax treatment of unclaimed retirement funds. Based on the findings, the GAO has issued recommendations to both the IRS and the DOL, which could result in (1) a requirement for holders to report uncashed 401(k) distributions from active plans as unclaimed property, and (2) a change to the tax treatment of 401(k) funds reported as unclaimed property.
Findings
The Report details information gathered by the GAO including information on (1) how much in retirement savings is transferred to states as unclaimed property and what happens to those savings once transferred and (2) the steps the IRS and the DOL have taken to oversee these transfers and what improvements are needed.2
The GAO investigation uncovered some surprising statistics. Although one might have expected that most reported retirement funds would originate from unclaimed individual retirement accounts (IRAs) that are not covered by the DOL’s preemption position, that was not the case. The GAO found that during a sampled time period, the majority of retirement funds transferred to the states as unclaimed property included amounts from 401(k) plans. Digging deeper, however, the study revealed that most of the 401(k) funds reported as unclaimed property were from terminated 401(k) plans, because funds from terminated 401(k) plans can fall outside the scope of the DOL’s preemption position. Such funds can be transferred to the states as unclaimed property if a terminating 401(k) plan sponsor first takes certain steps to contact the owners, as outlined in federal guidance.
Other interesting statistics found in the Report are:
- Assets and uncashed checks from employer retirement plans were the most common form of retirement savings transferred to states as unclaimed property.
- Because most of the reported 401(k) funds were from terminated plans, individuals who were younger than 70½ were most affected.
- Some providers reported that they only transfer 401(k) funds to states when plans terminate.
- Transfers from IRAs only accounted for 16 percent of the retirement savings accounts transferred to the states responding to the survey.
- Most of the unclaimed savings from IRAs transferred to the states were for individuals older than 70½.
Against this backdrop, the GAO explored the following issues:
- Escheatment of uncashed 401(k) distribution checks from active plans
According to the Report, DOL guidance to date indicates the DOL’s view to be that ERISA preempts state law as it relates to requiring a plan to transfer unclaimed amounts held in plan accounts to the state. However, the DOL has not specified whether uncashed 401(k) plan distribution checks can be transferred to the states as unclaimed property under ERISA. Retirement plan service providers reported that it was not clear whether these checks are preempted under ERISA or reportable as unclaimed property if unclaimed for the duration of the dormancy period. According to the GAO, a clarification would help both states and retirement plan service providers to better navigate the available options for managing these checks.
- Tax reporting and withholding requirements when escheating 401(k) funds
Currently, there is no clarity for plan service providers on the application of tax reporting and withholding requirements to transfers of unclaimed savings from active 401(k) plans to the states. Just last year, the IRS provided guidance on the tax reporting and withholding requirements for transfers from IRAs,3 but it has not done the same for the reporting of funds from 401(k) plans. Current federal law allows individuals with account-based plans, like 401(k) plans, to defer any income tax on their plan contributions and any market gains on their account balances until the funds are distributed.
According to the GAO, if transfers of funds from 401(k) plans to the states were treated as distributions (similar to the IRS treatment of transfers of unclaimed IRA savings to the states), then 401(k) plan service providers would be responsible for issuing a Form 1099-R and remitting income tax withholding to the IRS on any tax-deferred amounts when they transfer any amounts to the states as unclaimed property. However, if this withholding doesn’t occur, the IRS may be less likely to collect federal income taxes that may be due as a result of these tax-deferred funds being distributed to the states.
- Providing a mechanism to roll over funds from a terminated retirement plan reclaimed from a state after escheat
The IRS has not taken steps to ensure that participants in terminated retirement plans can transfer amounts reclaimed from a state back into a retirement account on a tax-deferred basis. When an individual who was a participant in a plan that was terminated reclaims funds that had been escheated to a state, the GAO believes that the individual should have the option to roll over the reclaimed funds into a qualified retirement account to allow taxes on those funds to continue to be deferred. However, current IRS procedures do not allow this option, unless it is exercised within 60 days of funds being received by the owner. Under the IRS’s “self-certification” procedures, an individual may submit a letter to a plan administrator or IRA trustee requesting to roll over savings into a retirement account after the 60-day rollover deadline, provided they missed the deadline for certain reasons and meet other conditions. The pre-approved reasons for missing the 60-day deadline include financial institution error, post office error, and the death of a family member, but do not include any potential delay associated with the need to reclaim funds from a terminated plan that were escheated to a state. Therefore, the GAO states that the IRS should modify its procedures to allow individuals to roll over amounts escheated from a terminated retirement after the 60-day deadline to ensure that individuals who reclaim their savings from a state can complete a roll over.
GAO recommendations
The GAO made the following three recommendations.
- The Secretary of Labor should specify the circumstances, if any, under which uncashed distribution checks from an active retirement plan can be transferred to a state as unclaimed property.
- The IRS Commissioner and the Department of the Treasury should consider clarifying whether transfers of unclaimed savings from employer-based plans (such as 401(k) plans) to states are distributions and, what, if any, tax reporting and withholding requirements should apply to such transfers.
- The IRS Commissioner and the Department of the Treasury should consider adopting rules that would permit rollovers of amounts previously escheated to a state from a terminated retirement plan, if such amounts are reclaimed by plan participants. These rules should be in a form consistent with the rules adopted on the taxation of transfers of unclaimed retirement savings.
In response to the recommendations, the DOL stated it “plans to continue to evaluate whether there are circumstances in which the transfer of uncashed distribution checks from an ongoing plan to the states advances the goal of reuniting missing participants with their savings.”4 DOL officials are considering the appropriate prioritization of such guidance within the context of a broader range of missing participant issues raised by various stakeholder groups, such as search requirements and updating plan records.
In its formal response, the IRS stated that it will work with the Department of Treasury to clarify the issues concerning tax reporting and rollover issues, and has agreed to take the actions recommended by the GAO.
Reed Smith takeaways
The GAO’s report was thorough and the specific recommendations will inevitably lead to some changes to the escheat and taxation of 401(k) plan balances and distributions. The DOL’s agreement to review its position with respect to uncashed 401(k) distributions could result in a carve out of the ERISA preemption as it applies to 401(k) plans. Based on the DOL’s broad application of the ERISA preemption of unclaimed property laws, many holders have not historically reported uncashed 401(k) plan distributions. Indeed, a change in position by the DOL could alter how holders address uncashed 401(k) distribution checks. Although the DOL has agreed to review the issue, if the review results in a carve out from the DOL’s preemption position for uncashed distribution checks, this would be a dramatic departure from the clear position DOL has taken in the past. Further, carving out such an exemption would also be contrary to case law, which supports the DOL’s broad preemption position.5 We will continue to monitor developments.
Holders reporting terminated 401(k) plans will most likely see changes regarding withholding and tax reporting. It would not be surprising if the requirements mirror those in the recent IRS Revenue Ruling placing the burden of withholding and reporting on the holder, not the states.
- See ERISA Op. Ltr. 79-30A (May 14, 1979); ERISA Op. Ltr. 78-32A (Dec. 22, 1978); ERISA Op. Ltr. 94-41A (Dec. 7, 1994).
- To identify the amount of retirement savings transferred to states and what happens to those savings once transferred, the GAO interviewed federal and state officials, industry representatives, and other stakeholders, and surveyed all 50 states and the District of Columbia (and received 22 responses). GAO also surveyed 401(k) plan service providers and IRA trustees regarding the volume of retirement savings transferred to states and their federal tax reporting and withholding practices for those transfers.
- See IRS Revenue Ruling 2018-17.
- GAO Report at pg. 44.
- See Commonwealth Edison Co. v. Vega, 174 F.3d 870 (7th Cir. 1999 (ERISA preemption applied to funds in a self-funded plan because placing a state administrator instead of a plan administrator in possession of plan assets is “precisely what ERISA bars”); Gobeille v. Liberty Mutual Insurance Co., 136 S. Ct. 936 (2016) (ERISA preemption applies self-insured employee health plan because the preemption clause of ERISA was meant to be construed broadly).
Client Alert 2019 - 048
