SECURE 2.0, RISE & SHINE and EARN Act surprises: How the “small” pension cash-out limit could change

Pending retirement proposals in both the House and the Senate would allow the statutory “small” pension plan cash-out limit to increase to $6,000 or $7,000 from $5,000, where it has been since August 6, 1997.

Wouldn’t it be great if the outcome of the increase in the limit has a benefit to both plan sponsors and the participants who have earned these vested pension obligations? In some cases, we think it can!

The questions and answers below illustrate a few of the favorable and perhaps not-so-favorable outcomes that could result from the passing of these proposals.

Q: I am a PARTICIPANT in a pension plan—defined benefit (DB) or 401(k)/403(b)/457(a) savings plan—and I just received notice that the value of my pension benefit will be “cashed out” by my former employer. Is this good or bad for me?

A: Dear participant, here are a few considerations:

• In some cases, you get to decide by telling your former employer not to make a distribution. Your former employer may still be able to override your choice.
• At the very least, the former employer now knows they have an accurate address (electronic or street) at which they can reach you when you want it cashed out.
• If your former employer sends you a check from the DB plan or the savings plan, and you deposit the distribution, you will likely have to pay federal income and state (where applicable) income tax on it this year.
• If you are younger than 59½, look for an additional income tax penalty for early withdrawal of pension funds.
• If you need cash to pay personal expenses (common debts, medical bills, etc.) or anything of your choice, you have it now, even if you must pay taxes on it.
• If your former employer rolled it into an IRA at a qualified IRA administrator, you will not have to pay taxes now, but you need to note it when you file your income tax return.
• If you had planned on receiving a “monthly pension paycheck” (which is what a DB plan typically provides), the cash-out eliminates that.
  • Monthly Social Security benefits will still be paid to you if you qualify, but some of the Social Security could be taxable and many recipients’ have their Medicare Part B premiums deducted from that monthly amount.
• Interest rates used to calculate cash-out distributions from DB plans generally change at least once a year. If there is a measurable increase or decrease in the interest rate(s) used for these calculations, then the value of the cash-out can change dramatically from year to year. As a result of the recent increase in interest rates, DB plan cash-outs that are paid in 2022 will probably be worth more than if they are paid in 2023.

Q: I am an EMPLOYER and I plan to cash out what I am legally allowed to do for our defined benefit plan or our savings plan. While I hope that Congress agrees to pass the increase in the small amount limits, I am not sure if this good or bad for our company or the former employee.

A: Dear employer, here are a few considerations:

• Most actions you take are aspects of a fiduciary obligation under the ERISA rules, meaning the action is taken with the best interest of the participant in mind.
  • The selection of the qualified savings plan administrator for any rollovers (even if it is your administrator today) is one of those obligations.
• Every distribution made will require sending notification to the former employee, and a tax notice the following January to the participant (Form 1099-R).
• If the distribution is from a DB plan, your per participant “annual Pension Benefit Guaranty Corporation (PBGC)” premiums for the cashed-out participants cease.
• The DB plan could look “smaller” and may make funding, accounting, and variable rate PBGC insurance cost volatility less material.
  • You may choose to assess the DB plan “duration” which may or may not measurably change for these proposed “small cash outs” increases; duration is particularly sensitive to changes in discount rates.
• If the distribution is from a savings plan, you will have to inspect whether the account balances were in the tax-deferred or the Roth plan options (if you have a Roth option). Any rollover to an IRA will have to be the same, i.e., tax-deferred or Roth.
• The obligation of finding the owner of the distribution demonstrates to the U.S. Department of Labor that a diligent effort has been made to minimize having “missing participants.”
• If the plan’s recordkeeping fee is based on the assets, the recordkeeping fee should decrease when the assets under management decrease.
• If the plan’s recordkeeping fee is based on a “per participant fee,” then the recordkeeping fee should decrease when the plan makes these statutory distributions to the owner of these small balances.
• The interest rates used to calculate the distributions for the DB plan generally change at least once a year. If there is a measurable increase or decrease in the interest rate(s), the value of the lump sum will change dramatically.

The takeaway

Perhaps all that can be reasonably concluded is that an increase in the small cash-out limit could result in both good and adverse outcomes, for participants and employers. For employers, there is a lot of plan administration to execute, and remembering the importance of meeting fiduciary obligations is key. For participants, it is imperative to understand the taxes and penalties associated with a benefit cash-out, as well as the impact that spending it now could have on their retirements.

Current tax law allows qualified retirement plans to set this threshold anywhere from $1 to $5,000 as follows:

Below is a summary of what Congress is proposing prior to the Senate convening to vote in the summer of 2022. We note that the proposals are silent on any change to the no-more-than-$1,000 current law:

The changes in the proposals above would be applicable to savings plans and defined benefit plans. We have ignored proposed effective dates for the changes because there is no firm commitment from the Senate to aggregate their proposals. The Senate is expected to move forward on this debate, but we may have to wait until after the November 2022 midterm elections.

Please contact your Milliman consultant to discuss the implications this topic may have on your plan.