I received a letter from a company I left in July 2004 about paying back money put into a 401k plan.
A paragraph reads: Based on your date of Hire of 1/2/02 and your date of termination
Of July 31, 2004, you were credited with 3 years service. YOur vested percentage was forty percent and your vested balance is $$$$. Our record indicate that you received a plan distribution in the amount of (total money) and resulting in an overpayment of $$$$.

My old boss allowed me 2 years ago to rollover the money to an IRA. Without mentioning a word of overpayment. Now 3 years later he wants me to pay back the excess.
The letter states it is due to IRS regulations.

Should cash out the IRA and pay the excess? I am puzzled and wonder if this is legal since 3 years have past.

Any info would be appreciated.

First, your boss can't give you 2 years to rollover the funds. IRS rules give you 60 days from date of distribution. Now your boss might have allowed you to delay your distribution, that he could do. But that might be the cause of the problem. The plan admin looked at the date of the request for distribution NOT the date of termination and based vesting on that.

When did you actually receive the distribution? Essentially if they did overpay you because of a mistaken vesting, then you owe them back the money. However, I don't think you will incure any IRS penalities if you wityhdraw the overpayment from the IRA.