Terminating a retirement plan
We recently had a discussion with one of our colleagues at Hertzbach and Co. One of their clients planned to sell their business and terminate their retirement plan as a result. Meanwhile, COVID-19 came and thew a wet blanket of uncertainty on business cashflow. Many small businesses are rethinking whether continuing their employee retirement plan is a good idea or not.
Not so fast. Here are some interesting aspects of terminating a retirement plan.
First, you’re totally allowed to terminate a plan, it’s just…hard. Check the IRS website for the set of directions on what you will need to do. You’ll notice there are quite a few steps, filings, and notices that you will need to take action on in a particular order.
There are a number of unexpected items that can trip you up. Notice that step number 5 reads:
Vest all “affected participants” 100% (applies to any employees or former employees with an account balance as of the termination date);
Even former employees with an account balance will need to be brought up to full vesting. (Hope you’ve kept good records!) Once you’ve vested everyone, you need instructions for where they want their money to be distributed. And that also means locating lost participants. You’ll need to pay out everyone’s benefits according to their elections. Otherwise, you’re stuck with a plan that is still active and will still need to file tax filings and do all the normal plan sponsor activities until you can get all the dollars distributed.
Additionally, you’ll need to figure out what to do with forfeitures in the plan. Those either need to be spent according to your plan document or returned to participants.
If you have a 403(b) plan that you’re trying to terminate, this can be even more difficult. Unlike 401(k) plans, 403(b) plans often utilize annuity contracts and/or custodial accounts, which can be controlled by the employer (group contracts), the participant (individual contracts) or both (group contracts with individual certificates/rights). Thus, plan termination distributions in a 403(b) plan can be much more problematic, since the employer may not be in ultimate control of the amounts distributed. In other words, termination distributions for plans where individual custodial accounts exist are almost impossible to execute.
Let's say for some reason the employer is terminating a 401(k) plan and it intends to start a new plan in the future. Be advised that if a new 401(k) plan is started within 12 months of the terminated plan’s liquidation date (a "successor plan"), previously distributed 401(k) assets will be treated as having been withdrawn without a triggering event, which will cause an operational failure under the terminated plan. Note, however, that simplified employee pension (SEP), savings incentive match plan for employees of small employers (SIMPLE) IRA, 403(b), 457, and employee stock option (ESOP) plans are not considered successor plans of 401(k) plans. This is one reason this type of decision is hard during COVID-19; when things turn around, having a retirement plan will be an important recruiting tool again.
One last note regarding plan terminations is the “partial termination.” This can occur if more than 20% of your total plan participants were laid off in a particular year. Partial terminations can occur in connection with a significant corporate event such as a closing of a plant or a division, or as a result of general employee turnover due to adverse economic conditions or other reasons that are not within the employer’s control. This is of particular note right now during the pandemic.
The law requires all “affected employees” to be fully vested in their account balance as of the date of a full or partial plan termination. Is it a real partial termination? Facts and circumstances matter, so ask your employment attorney for guidance.
So, going back to our example of a business sale, if there will be an intention to reduce the workforce after the sale, merger, or acquisition, be aware of the partial termination. Sometimes the buyer wants to terminate the seller’s plan; be aware of the complications that can arise from plan terminations. And, in general, there may be more options than you think (especially during this time when Congress is churning out assistance) so seek help from your trusted advisors and carefully explore your options before choosing the nuclear one of terminating!
As always, reach out to book a call to discuss your situation. We’re happy to help.