Key Takeaways:
- Partial 401(k) plan terminations occur when 20% or more of employees are involuntarily terminated, requiring full vesting for affected employees to comply with legal requirements. This can create a financial burden on your company.
- To mitigate the financial impact, you can utilize forfeiture accounts to fund the full vesting requirements. This will reduce the immediate cash flow impact on the business, but vesting adjustments can be made regardless.
- To avoid any plan disqualification or IRS penalties, you should implement oversight policies, document all terminations, monitor workforce changes closely, and be familiar with plan rules and forfeiture account management.
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Employee turnover often triggers a wave of issues for your company and its human resources department. Even 401(k) retirement plans — one of the most sought-after employee benefits — can be impacted when a substantial number of your employees are involuntarily terminated. This can constitute a partial 401(k) plan termination, where full vesting of the affected employees must occur to satisfy legal and regulatory requirements. Yet, partial terminations are often easy to overlook.
How You Can Identify Partial 401(k) Terminations
One key element of your 401(k) management is understanding how workforce reductions can affect the plan itself. This is extremely important as the IRS can issue a complete disqualification of the plan when partial terminations go unnoticed or are mishandled.
According to IRS regulations, a partial 401(k) termination may occur upon the involuntary termination of 20% or more of employees who are plan participants at the beginning of the year. Odds are, some of your employees will be fully vested while others may not meet the plan’s requirements for 100% vesting of employer contributions.
As an employer, you should ensure your HR department monitors fluctuations in employee headcounts, as well as be on the lookout for events that can trigger a large workforce reduction that could result in a partial 401(k) termination. However — and this is the confusing part — the 20% workforce reduction count is cumulative and can span more than one plan year. It can also be triggered by things other than layoffs and plant closings. These include:
- Business restructuring that decreases the size of the workforce.
- Amendments to the 401(k) plan where the number of eligible employee participants decreases.
- Employee turnover for positions that are not expected to be replaced.
The IRS calculates the turnover rate using a specific formula: 𝑇R = 𝐴 / 𝑋 + 𝑌. 𝑇R means the turnover rate equals the number of participants who were terminated (A) divided by the number of participants at the end of the prior year plus any added during the plan year (X+Y). For example, if 20 employees were terminated at a company that had 80 participants, the turnover rate would be 25%.
If it appears that your company’s workforce has dropped or is expected to drop by 20% or more, you, HR professionals, and plan administrators should closely scrutinize 401(k) plan documents and the laws and regulations governing such retirement plans.
Workforce Reductions and the 401(k) Plan
How does the termination of employee participants affect your company’s 401(k) plan? Between the complexity of 401(k) plan regulations and vigorous IRS oversight, it is crucial to understand that significant employee turnover and other workforce-related events can impact your retirement plan operations and forfeiture accounts.
If it is determined that a partial 401(k) termination occurred, your company must fully vest the affected employees regardless of plan requirements. For example, plan documents might require an employee to work six years to become fully vested in the employer’s contributions to the 401(k) plan. A layoff occurs which includes employees with less than six years of service. You must vest these employees at 100%, in part because they were not given the opportunity to meet that six-year benchmark. The same is true for other events, such as business restructuring and plan amendments that affect employee eligibility.
The immediate vesting of a large number of departing employees could potentially and negatively impact your business. The plan’s forfeiture accounts may be available to fund the vesting of employees without a significant immediate impact on cash flow. However, any required adjustments to vesting must occur whether the forfeiture accounts will cover the cost or not.
It’s important to identify and plan for any event that could jeopardize your 401(k) plan. Failing to recognize a partial 401(k) plan termination is common, but you can take the steps needed to enhance your monitoring procedures and increase awareness.
Avoiding Partial Termination Missteps
The IRS can completely disqualify your 401(k) plan if your vesting is not handled properly after a partial termination. Here are some of the practices you can consider to mitigate any risk:
- Learn the rules. Rules and regulations surrounding partial terminations tend to be complex, so you should consider consulting with an employee benefit plan professional or ERISA attorney to understand the rules.
- Know your plan. Become familiar with plan document provisions related to partial plan terminations, vesting provisions, and the use of forfeiture accounts.
- Establish your oversight policies and procedures. You should be consistently monitoring employee voluntary and involuntarily terminations by the plan sponsor — and management should be ongoing. Don’t forget to consider turnover trends during the plan year, as well as across multiple years.
- Document all your terminations. It may be necessary to prove to the IRS whether a departure was voluntary or involuntary for the turnover calculation. Note that the IRS could classify voluntary terminations as involuntary terminations if you can’t provide support for the nature of the employee’s departure.
- Manage your forfeiture accounts. The balance of forfeiture account can include a variety of sources, including funds previously forfeited from participant accounts that are affected by a partial plan termination. The funds in the forfeiture account may be needed to reinstate the accounts of the affected participants.
- Correct vesting failures. The IRS offers the IRS Employee Plans Compliance Resolution Systems that can be used to correct this compliance failure.
How MGO Can Help
Partial 401(k) terminations can bring additional challenges for your company. MGO can help you maintain the integrity of your plan, avoid penalties, and manage the financial impact of partial terminations.
Our team can assist in identifying potential partial terminations by monitoring your employee turnover and workforce reductions that could trigger these events. We can help you stay compliant with IRS rules to avoid plan disqualification and review your plan documents, vesting provisions, and forfeiture accounts to confirm they are aligned with current laws and regulations.