Is there relief from partial 401(k) plan termination during the pandemic?
Many businesses have been forced to make some tough decisions because of the pandemic—including laying off or letting go of staff. Normally, if a company lets go of a certain percentage of its active 401(k) participants in a plan year, the IRS can declare its 401(k) plan partially terminated, which triggers full vesting. But because of the COVID-19 relief package passed in December 2020, companies hurt by the economic slowdown may be able to avoid partial termination—if they meet certain requirements.
What's 401(k) partial plan termination?
The rules surrounding partial plan termination are meant to deter companies from trying to save money by firing employees with nonvested benefits. Generally, the determination of whether a partial termination has occurred is based on facts and circumstances. Subject to certain facts and circumstances, the IRS uses a presumptive participant turnover rate (due to employer-initiated severance from employment, including layoffs) of at least 20% to determine whether a partial plan termination has occurred. In a partial plan termination, all employer contributions made to affected (laid off and terminated) employees are immediately 100% vested, regardless of their years of service—or else the plan may lose its ERISA-qualified status.
To make a partial termination determination, the IRS examines a company’s participating employee turnover rate—the percentage of affected employees during an applicable period (usually a plan year)—by dividing the number of participants let go by total existing and newly eligible participants. If a plan’s turnover rate is at least 20% and subject to facts and circumstances, the IRS could find that the plan has partially terminated.
For example, if your 401(k) plan covered 100 employees at the beginning of the 2020 calendar year, and only 70 on December 31, 2020, the IRS might find that your plan has partially terminated because your turnover rate was at least 20%.
Partial termination results in 100% vesting of employer contributions for affected participants, which becomes an immediate expense for the employer.
For example, if your 401(k) plan covered 100 employees at the beginning of the 2020 calendar year and laid off or terminated 30 employees, each with $1,000 in nonvested profit-sharing contributions, the total non-vested benefits of the affected employees would be $30,000. The $30,000 would instantly vest, and you’d be responsible for paying it into their accounts.
What if COVID-19 forced my business to lay off or terminate employees?
The Consolidated Appropriations Act of 2021 (the Act), which became law on December 27, 2020, provides partial termination relief for businesses harmed by the economic consequences of COVID-19.
Under the Act, as long as your active participant count on March 31, 2021, is at least 80% of your active participant count on March 13, 2020 (the day the president declared a national emergency), the IRS won’t consider your plan partially terminated. And it doesn’t matter whether you rehire the same participants—provided an employee is covered and actively participating, they count toward the 80% rule.
Continuing with the previous example, as long as your plan has at least 80 active participants by March 31, 2021, the IRS won’t consider your plan partially terminated. This is true, regardless of when your plan year begins or ends, and regardless of how many employees were laid off or terminated in the interim.
Partial 401(k) plan termination relief could help your recovering business
To help your large or small business recover from a period of exceptional economic strain, Congress has made it easier to avoid plan termination and associated vesting costs during the COVID-19 pandemic—as long as you’re taking steps to bolster your workforce. If you think that your recovering business might qualify for partial plan termination relief, consult a tax, benefits, or financial professional. They can help you determine how COVID-19 relief legislation affects your plan and your business.
The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.
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