The tax question nobody has answered

Unclaimed Retirement Money Series · Post 5 of 6

Category: Retirement Plan Basics
Tag: Tax Planning

A retirement plan balance can leave an employer-sponsored plan, enter a state unclaimed property fund, and remain subject to questions that no single agency has answered from beginning to end.

For plan sponsors, the central issue is straightforward:

When retirement money moves from a plan to a state fund, what exactly is the tax event, who reports it, what does the participant or heir receive, and which rules apply when the money is later claimed?

The answer is partly clearer than it was several years ago, but important gaps remain.

This matters because an unclaimed account is not only an administrative problem. It may also create questions involving fiduciary duties, tax reporting, withholding, beneficiary rights, participant communications, and plan records.

What GAO-19-88 identified

In January 2019, the U.S. Government Accountability Office published GAO-19-88, Retirement Accounts: Federal Action Needed to Clarify Tax Treatment of Unclaimed 401(k) Plan Savings Transferred to States. The report examined retirement savings that had been transferred to state unclaimed property programs.

The report described circumstances in which accounts could become dormant, including:

  • The participant’s death.
  • The participant reaching the age at which required minimum distributions generally begin.
  • An uncashed distribution check.
  • A plan’s inability to locate the participant or beneficiary.

GAO reported that the tax treatment of transfers from employer retirement plans to state unclaimed property funds was unresolved at the time. Questions included whether the transfer was a taxable distribution, whether federal income tax withholding was required, and how the transaction should be reported to the Internal Revenue Service.

GAO also described uncertainty about whether ERISA preempted state laws that attempted to compel retirement plans to transfer plan assets to state unclaimed property programs.

That distinction remains important. A state law requiring the transfer of assets still held inside an ERISA plan may raise different issues from a voluntary transfer of an uncashed check after a distribution has already been made.

What has changed since the 2019 report

Some of the uncertainty identified by GAO has been addressed.

In November 2020, the IRS issued Revenue Ruling 2020-24, addressing certain payments from qualified retirement plans to state unclaimed property funds. The ruling generally treats the payment as a designated distribution to the participant for federal tax withholding and Form 1099-R reporting purposes.

The IRS’s Form 1099-R instructions also state that payments from qualified plans to state unclaimed property funds under escheat laws must be reported on Form 1099-R. The IRS Form 1099-R resource page provides the current form and instructions.

That guidance helps answer one part of the question:

A plan-to-state transfer may be treated as a reportable distribution in the year the plan transfers the money.

It does not answer every question that follows.

The later payment from the state may occur months or years after the plan transfer. The participant or heir may receive a different amount because of withholding, state procedures, or administrative costs. The recipient may also need to determine whether the amount can be rolled into another retirement arrangement and what documentation is required.

The tax treatment of the entire process is therefore not as simple as “the money went to the state, so the matter is closed.”

The open question: what happens at each stage?

A plan sponsor evaluating this issue may need to separate the process into three stages.

1. Money remains in the plan

Before any transfer occurs, the plan may still hold the participant’s account balance or an amount owed to a beneficiary.

This is where ERISA preemption questions can arise. GAO-19-88 discussed the Department of Labor’s position that ERISA generally preempts state laws that compel an ERISA plan to transfer plan assets to a state unclaimed property fund.

That does not necessarily resolve every situation involving a distribution check, a small cash-out, or a payment that is no longer considered a plan asset. The legal analysis can depend on the plan’s terms, the type of payment, the timing of the transfer, and applicable state law.

2. The plan transfers money to the state

The IRS guidance issued in 2020 generally treats certain qualified-plan payments to state unclaimed property funds as distributions to the participant.

That raises practical questions for the plan sponsor and its service providers:

  • Which person is treated as the recipient for tax reporting?
  • When is Form 1099-R issued?
  • What amount is reported as the gross distribution?
  • Is federal income tax withholding required?
  • How is the distribution coded?
  • What happens when the participant is deceased?
  • How are beneficiary or estate records handled?
  • What communications explain the tax reporting before the transfer occurs?

The answer may not be identical in every case. The plan document, the payment history, the participant’s status, the beneficiary designation, and the type of retirement plan can all matter.

3. The state later pays the participant or heir

The state’s later payment creates a second layer of uncertainty.

The plan may have already reported a distribution when the money was transferred to the state. The state may then pay the participant, beneficiary, or heir under its own unclaimed property procedures.

At that point, questions can include:

  • Is the state payment a new taxable distribution or the payment of an earlier reported distribution?
  • What tax form, if any, does the state issue?
  • Does the recipient receive the gross amount or an amount reduced by prior withholding?
  • Can the recipient roll the money into an IRA or another qualified plan?
  • How does the recipient document the original plan distribution?
  • What happens if the recipient is an heir who did not receive the original tax notice?

The IRS addressed one part of the rollover concern in Revenue Procedure 2020-46, also published in the November 2020 Internal Revenue Bulletin. That procedure added a distribution to a state unclaimed property fund as a reason that may support self-certification for a waiver of the 60-day rollover deadline.

That is meaningful guidance, but it is not the same as a complete rule for every participant, beneficiary, or heir. Whether a rollover is available may depend on the type of account, the recipient, the timing, the amount received, and the receiving arrangement.

What DOL Field Assistance Bulletin 2025-01 adds

On January 14, 2025, the Department of Labor issued Field Assistance Bulletin 2025-01.

The bulletin provides limited fiduciary enforcement relief for certain voluntary transfers from ongoing pension benefit plans to state unclaimed property funds. The relief applies when:

  • The payment is owed to a missing participant or beneficiary.
  • The plan is an ongoing pension benefit plan, which can include defined contribution plans such as 401(k) plans.
  • The present value of the participant’s or beneficiary’s nonforfeitable accrued benefit is $1,000 or less.
  • The plan fiduciary satisfies the conditions described in the bulletin.
  • The receiving state fund meets the bulletin’s requirements.

The $1,000 threshold is specified by the Department of Labor in FAB 2025-01, dated January 14, 2025. It is not a tax threshold and does not change federal tax rules.

The bulletin also states that an eligible state fund must hold the money for the benefit of affected participants, beneficiaries, and their heirs. It must allow claims to be made and paid in perpetuity, regardless of when the state received the property.

This is relevant to heirs of deceased participants. An heir may have a right to claim the property from the state even though the original participant is no longer living. The bulletin’s fiduciary relief, however, does not determine the heir’s income tax liability, the proper reporting recipient, or the availability of a rollover in a particular case.

FAB 2025-01 is a Department of Labor enforcement position. It is not an IRS ruling and does not provide tax advice.

Why this creates exposure for plan sponsors

For a plan sponsor, ambiguity can create exposure in several areas.

Fiduciary process

A decision to transfer an account or uncashed check may require a documented process. That process may include search efforts, review of plan terms, consistent treatment of similarly situated participants, and evaluation of the state program.

Tax reporting

A transfer may trigger Form 1099-R reporting and withholding obligations. Incorrect reporting can affect the participant, beneficiary, heir, plan administrator, and the sponsor’s records.

Beneficiary administration

A deceased participant’s account may involve a designated beneficiary, a surviving spouse, an estate, or another claimant. The identity of the proper recipient can affect both administration and tax reporting.

Participant communications

A participant may not understand that money can be reported as distributed when the participant never receives it directly. Clear notices can help explain the possible consequences, the intended transfer, and the process for making a claim later.

Record retention

Plan records may need to connect the original account, the transfer to the state, the tax reporting, the beneficiary determination, and any later claim. Gaps in that chain can make later questions more difficult to resolve.

A sponsor review worth putting on the calendar

The following topics may be appropriate for review with the plan’s own professionals:

  1. Plan language governing small distributions, missing participants, beneficiaries, and uncashed checks.
  2. State-law requirements affecting distributions or unclaimed property.
  3. ERISA preemption issues, particularly where a state attempts to compel a transfer from an ERISA plan.
  4. Search and notice procedures used before a transfer is considered.
  5. Form 1099-R and withholding procedures for payments sent to a state fund.
  6. Beneficiary and heir documentation when the participant is deceased.
  7. Rollover communications and records for money later claimed from the state.
  8. Coordination among the plan sponsor, plan administrator, recordkeeper, tax professional, and legal counsel.

Navigant Advisory Group LLC provides financial education and does not provide legal, tax, fiduciary, investment, recordkeeping, custody, or plan administration services. This article is educational information, not legal or tax advice. Legal, tax, and plan-specific questions belong with the plan sponsor’s own plan administrator, tax professional, or counsel.

The question is still worth asking

The IRS has clarified important aspects of plan-to-state transfers since GAO-19-88 was published in January 2019. DOL FAB 2025-01, dated January 14, 2025, provides additional fiduciary enforcement relief for certain voluntary transfers involving benefits of $1,000 or less.

Even so, the complete path from plan account to state fund to participant or heir still involves unanswered or fact-specific questions.

For plan sponsors, the next step may be a focused conversation, not a broad review of every retirement plan issue. A review of the transfer process, tax reporting, beneficiary records, state-fund requirements, and participant communications can help identify where the plan’s current approach needs clarification.

For more information about plan education and sponsor support, visit Navigant’s services for businesses or contact Navigant Advisory Group.

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