No Simple Task—Terminating a Retirement Plan the Right Way
Employers generally terminate their retirement plans when the plan no longer suits their business needs. Properly terminating a retirement plan is not as simple as ceasing funding and distributing the plan assets. Certain laws, regulations, and other guidance lay out miscellaneous guidelines for terminating a qualified retirement plan. Thus, there are a number of tasks an employer must consider and complete to properly terminate a retirement plan.
Once the decision to terminate has been made, the employer should take steps to formally terminate the plan (e.g., adopt a corporate resolution) and establish a termination date. Benefits and plan liabilities must be determined as of the termination date.
Notify Service Providers
The employer should notify all service providers (e.g., recordkeepers, third-party administrators, investment providers, attorneys, trustees, accountants) of its intention to terminate the plan and the date of termination. Service providers often assist employers in the termination process.
Update Plan Documents
Before an employer can properly terminate a plan, the plan documents must be up-to-date with all current laws and regulatory changes. Thus, an employer may have to amend its plan before terminating it in order to bring the documents into compliance with any recent law or regulatory changes.
Implement 100 Percent Vesting
All participants must become 100 percent vested upon plan termination.
Address Remaining Forfeitures
A terminating plan must follow plan provisions to allocate any required forfeitures to participants before the final distributions are made. Note that the forfeiture allocation cannot cause a participant to exceed her annual additions (i.e., IRC Sec. 415) limit (100 percent of compensation up to $55,000 for 2018).
Complete Final Testing
The employer should perform final nondiscrimination testing and should ensure participants don’t exceed their annual deferral (IRC Sec. 402(g)) limit ($18,500, plus $6,000 catch-up, if applicable, for 2018) and annual additions limit.
Notify Participants and Locate Missing Participants
All participants and beneficiaries must be presented with their payment options. If a participant’s notification letter is returned as undeliverable, the employer should attempt to locate the individual to verify whether he is missing or simply is nonresponsive. The Department of Labor issued Field Assistance Bulletin 2014-01 that provides guidance for employers on the best way to handle accounts of missing and nonresponsive participants. Additionally, the Pension Benefit Guaranty Corporation (PBGC) in December 2017 issued final regulations on missing participants and beneficiaries in terminating retirement plans. In addition to defined benefit plans, the PBGC final regulations apply to defined contribution plans and are voluntary for non-PBGC insured plans (e.g., 401(k) plans).
Distribute Plan Assets
Upon an election to terminate a plan, all plan assets must be distributed as soon as administratively feasible. A plan that distributes its assets within 12 months following the termination date is presumed to have distributed its assets as soon as administratively feasible. When a terminating plan’s assets are not paid out by this time, the plan is treated as a frozen plan instead of a terminated plan.
The employer must pay out assets according to the participant’s directions. All distributions—whether distributed directly to the plan participant or rolled over to another retirement plan or IRA—must be reported on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts, etc. If a participant is confirmed to be missing or nonresponsive, the employer must determine an appropriate payout method for the participant.
File a Final Form 5500
The employer must file a final Form 5500 series report for the final plan year. Depending on the time necessary to complete all distributions, the final plan year may not be the same plan year that contains the plan’s termination date. The final Form 5500 must be filed by the last day of the seventh month following the close of the final plan year. The end date for the final plan year is the actual liquidation date.
Employers are not required to file Form 5500 for owner-only retirement plans (plans that cover only an owner or owner and spouse) if the plan assets are $250,000 or less at the end of the year. But even if the assets are less than this amount, Form 5500-EZ is required to be filed for the final year when the final distribution occurs.
File for a Determination Letter (Optional)
Although the IRS does not require it, an employer may request an IRS determination of the plan’s qualified status to give assurance that the plan was qualified at the time of termination, thereby avoiding potential issues if later audited by the IRS. IRS Form 5310, Application for Determination for Terminating Plan, is used for this purpose. Such request could potentially extend the amount of time it takes to complete the plan termination. It should be noted, however, that the IRS has in recent years greatly reduced its emphasis on most plans seeking determination letters, exceptions being when individually designed plans are established or are terminated.
Other Termination Considerations
There also are issues an employer should consider before setting the plan’s termination date.
Mid-Year Termination Date – A mid-year termination date could affect items such as actual deferral percentage (ADP) or actual contribution percentage (ACP) testing, the annual additions limit, the compensation cap, compensation definitions, key employee determinations, and hours requirements for employer contributions.
Reversions – Employers should take steps to avoid a reversion of plan assets. A reversion occurs when unallocated plan assets are paid to the employer after the plan is liquidated. Reversions generally are subject to a 50 percent penalty tax. The options for handling unallocated assets depend on whether the plan has forfeiture accounts or suspense accounts.
- The disposition of forfeiture accounts must occur according to the plan document provisions. Forfeitures could be used to pay administrative expenses, reallocated to qualified participants, or used to reduce the employer’s plan-funding obligation. Plan document provisions and employer elections will dictate which options are used.
- Suspense accounts generated from past corrective actions under the plan (e.g., unallocated contributions of excess annual additions under IRC Sec. 415) are typically used to reduce funding of a contribution to the plan.
Successor Plan Rule – Employers that are terminating a 401(k) plan and intend to start a new plan in the future should be aware of the successor plan rule. A successor plan is an alternative defined contribution plan maintained by the employer during a period that starts with the date of termination and ends 12 months after the full liquidation of the plan’s assets. If there is a successor plan, then plan termination of the prior plan is not a distributable event for employee deferrals (or contributions treated like deferrals, such as qualified nonelective contributions, qualified matching contributions, and ADP/ACP safe harbor contributions). Therefore, if a new 401(k) plan is started within 12 months of the terminated plan’s liquidation date, certain 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.
The IRS provides miscellaneous information and frequently asked questions at its website on terminating retirement plans and partial terminations.