401(k) Plan Terminations and Successor Plan Rules
By Michelle Freiholtz, MBA, QKA, CIP
When an employer establishes a 401(k) plan, the IRS expects the plan to have longevity. If the employer terminates the 401(k) plan, the employer should have a good reason for doing so. Successor plan rules were created to avoid situations in which the employer could attempt to work around some of the plan rules, such as distributions of employee deferrals, ADP and ACP testing complications, and adopting a safe harbor plan design, by terminating a 401(k) plan and then shortly thereafter establishing a new plan to again enjoy the benefits of sponsoring a retirement plan.
Other situations in which an employer may face successor plan issues include acquisitions and transfers of employees between related employers, divisions, or departments.
What is a successor plan?
In most cases, a successor plan is described as any alternative defined contribution plan that exists during a period starting on the original 401(k) plan’s termination date and ending 12 months following the full distribution of the plan’s assets.
What is not a successor plan?
A plan is not considered a successor plan if
during a 24-month period that begins 12 months before the termination date, less than two percent of employees who were eligible under the terminated plan are eligible for the new plan, or another plan of the employer able to receive the terminating plan’s assets;
the plan is maintained by a different employer (controlled group and affiliated service group rules apply); or
the plan is a SEP plan, SIMPLE IRA plan, 403(b) plan, 457(b) plan, 457(f) plan, or an ESOP.
How does successor plan status affect distributions?
Plan participants may not withdraw their 401(k) plan assets until they meet a distributable event. Although plan termination is a distributable event, if the employer sponsors another plan or establishes a new plan that is considered a successor plan, then the employer cannot treat plan termination as a distributable event for deferrals (or for contributions treated like deferrals, such as QNECs or QMACs). In addition, if the employer cannot distribute the plan’s assets as soon as administratively feasible—generally within 12 months of the termination date, then the plan is not considered terminated, and future compliance requirements should be met.
Deferrals that are distributed before a distributable event occurs are treated as if they were from a nonqualified plan, making any rollovers invalid. To resolve this issue, the employer facing a successor plan situation should attempt to reclaim the funds by having the employees pay back the distributions into the successor plan. To avoid issues, the plan may transfer deferrals to a successor plan, or leave the deferrals in the terminated plan until there is a valid distributable event, or purchase a deferred annuity contract that will protect the optional forms of benefit in the plan.
How do the successor plan rules affect ADP and ACP testing?
The successor plan rules do not affect a new 401(k) plan if the plan is using the current year testing method and is not attempting to satisfy the testing safe harbors. A new plan (one that is not subject to the successor plan rules) using the prior-year testing method may use the “deemed 3%” rule (deeming the nonHCE deferral percentage to be 3%). A successor plan (defined for this purpose as a plan where 50 percent or more of the eligible employees for the first plan year were eligible employees under another 401(k) plan or profit sharing plan maintained by the same employer for the prior year), is ineligible to use the deemed 3% rule. The plan would need to use the actual ADP and ACP percentages from the prior year when the participants were eligible under the other plan.
Do the successor plan rules affect a plan’s ability to use the testing safe harbor?
Plans relying on the ADP and ACP test safe harbors must have a plan year that is 12 months long unless it is the plan’s first plan year. For a new plan, or a conversion of a non-401(k) plan to a safe harbor 401(k) plan, deferrals are only required to be in place for at least three months of the plan year. IRS Notice 98-52; however, prohibits a successor plan, as defined in IRS Notice 98-1 and 2000-3, from having a short plan year if the intention is to use safe harbor rules. For these purposes, a successor plan has the same definition as in the previous question. The successor plan will be subject to ADP and ACP testing as well as top-heavy obligations for the first plan year.
