401(k) Partial Plan Termination Explained | Lord Abbett
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Retirement Perspectives

Plan sponsors should monitor if a company is reducing headcount, which could affect the status of a firm’s qualified retirement plan.

The economic headwinds facing business owners due to COVID-19 are leading many companies to reduce costs, which frequently includes a variety of maneuvers including employee furloughs and/or reducing headcount. But companies may not realize that reducing the number of employees may result in a 401(k) partial plan termination.

The termination of a qualified retirement plan (i.e., 401(k)) generally happens when a company’s finances are strained and the cost of maintaining its retirement plan becomes burdensome. If an employer initiated a partial plan termination" concerning its 401(k) or similar type of qualified retirement plan, affected participants who left during the applicable period (both those who severed employment voluntarily and involuntarily) must be made 100% fully vested in all employer contributions (match, profit-sharing). However, vesting does not need to be accelerated for participants not affected (those participants that remain employed).

Failure to fully vest the affected participants could result in distributed amounts being less than the amount accrued. Paying out affected participants less than the amount they rightly deserve could potentially cause the IRS to disqualify the plan if the affected participants are not made whole. In other words, without proper oversight, a partial plan termination could result in the entire retirement plan being disqualified by the IRS. If a qualified retirement plan is disqualified by the IRS, the plan’s trust ceases to be tax exempt. In other words, the 401(k) becomes taxable. In addition, employer tax deductions for making plan contributions will be impacted.

Generally, participants must include as income the vested amounts the employer contributed in the years the plan is disqualified. Therefore, those contributions will be subject to immediate (current) federal income tax. In addition, distributions from a plan that has been disqualified are not considered eligible rollover distributions. Consequently, distributions cannot be rolled over to an IRA or new employer plan. Instead, distributions are generally taxable in the year they are received.

Plan sponsors should monitor their companies’ turnover rates to ensure they are not experiencing a partial plan termination and, if they are, make sure they are adhering to IRS rules and regulations—otherwise they risk plan disqualification.

It’s worth noting that neither the Internal Revenue Code (IRC) nor the regulations define a “partial plan termination.” Instead, a partial plan termination is determined based on facts and circumstances. However, the IRS ruled in Revenue Ruling 2007-43 that if the participant turnover rate is at least 20%, there is a presumption that a partial termination of the plan has occurred. If the turnover rate is less than 20%, then all facts and circumstances are taken into account to determine whether a partial plan termination has taken place. Routine turnover during the year is generally not considered a partial termination.

We believe it’s important for plan sponsors to understand the rules to ensure terminated participant accounts are handled appropriately. IRS Revenue Ruling 2007-43, states the turnover rate is determined by “dividing the number of participating employees (active participants and eligible employees) who had an employer-initiated severance (generally includes all employee turnover, excluding retirement, disability or death) from employment during the applicable period (generally plan year), by the sum of all of the participating employees at the start of the applicable period and the employees who became participants during the applicable period.”

According to the IRS, factors relevant to determine whether the turnover rate is routine include:

  • Information on the turnover rate in other periods and the extent to which terminated employees were actually replaced,
  • Whether the new employees performed the same functions,
  • Whether the new employees had the same job classification or title, and
  • Whether the new employees received comparable compensation.

Classifying a partial plan termination as such is critical, since a failure to act can cause total plan disqualification. Notably, a partial plan termination can also occur for reasons other than employee turnover. For example, a group or class of employees who had been covered by the plan but were later excluded from participation can trigger a partial plan termination. Thus, an analysis should always be done in the event of significant workforce reductions.

If a plan sponsor is struggling to determine whether a partial plan termination has occurred, they can request an opinion from the IRS. This is done by filing IRS Form 5300 “Application for Determination for Employee Benefit Plan.”  Determining whether a partial plan termination has occurred is far from straightforward—it is important to remember that a partial plan termination can be triggered by a single significant event such as closing a location, or by a series of smaller events, that result in reductions in workforce over several years. Performing these calculations is not always straightforward because various determinations must be made and there is limited IRS guidance. Therefore, we urge business owners and their advisors to consult with the plan’s Third Party Administrator (TPA) and legal counsel.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY 

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

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