One of the basic requirements a plan must meet in order to be eligible for the various tax benefits available is that it must be established with the intention of it being permanent. In other words, a qualified plan cannot be established as a short-term, temporary tax shelter.
The regulations do not include a “bright line” test for how long is long enough to be permanent, but the general rule of thumb is at least 2 years for 40(k)/profit sharing plans and 5 to 10 years for defined benefit plans (including cash balance plans). Plans with shorter lifespans may still be able to demonstrate they were intended to be permanent with other supporting documentation, including showing that unexpected events such as economic conditions, law changes or company re-structuring led to the decision to terminate the plan after only a short time. See Treasury Regulation section 1.401-1(b)(2) for additional information on the permanency requirement.
Once the permanency issue is addressed and the decision is made to terminate the plan, there are a number of moving parts to consider and steps to take.
The remainder of this article is divided into two parts – a plan termination FAQ and a plan termination checklist.
Frequently Asked Questions
I am considering terminating my plan. Apart from the permanency issue, is there anything else I should consider?
Generally speaking, if you terminate your plan, you cannot start another one for at least 12 months, so please make sure this is the best decision for company. If the plan is no longer meeting your objectives, it may be possible to re-design it rather than terminating it. We would be glad to work with you to explore alternative designs that may better accomplish your goals.
If you decide to proceed with the termination, be sure you understand the required steps in the process (outlined in rest of this article). Also, since most providers do not include plan termination services in their standard fee schedule, you should expect for there will be additional fees associated with the termination process.
What do I have to do to terminate my retirement plan?
You must adopt a formal resolution to terminate the plan. Amendments may also be required to update the plan document for recently enacted legislation/regulations.
Does that mean I can’t just stop making contributions and pay out all of my employees?
That is correct. Until the plan is formally terminated, all ongoing administrative obligations and distribution restrictions continue to apply. Simply discontinuing the plan and paying out distributions can subject the plan sponsor and the employees to significant tax liability and penalties.
When can my employees take distributions?
Employees become fully vested upon plan termination and can request distributions as soon as the termination resolution is adopted. Note that the immediate vesting also applies to former employees with remaining balances in the plan.
While there is no requirement to do so, some plan sponsors choose to postpone distributions to active employees until the Determination Letter is issued (See next question). In this scenario, distributions are usually paid as follows:
- Those no longer employed are able to request a distribution at any time.
- Those who discontinue employment during the plan termination process can request a distribution at any time following separation from service.
- Active employees will be able to request a distribution after receipt of IRS approval.
Do I have to get approval from the government to terminate my plan?
While there is no legal mandate that you get government approval, the IRS reserves the right to audit plans, even after they are terminated. Since such an audit is likely to occur 3 or 4 years after the termination, it is often more cost-effective to apply for the Determination Letter while all related information is readily available. DWC is available to prepare all the necessary documentation to request IRS approval of your plan termination.
How long does it take for the IRS to approve a plan termination?
The approval process normally takes 8 to 12 months after all required documentation is submitted. However, the entire process can take much longer if the IRS is backlogged with Determination Letter requests. DWC will work with you and the IRS to expedite this process as much as possible.
Do I have to continue ongoing administration of the plan during the termination process?
Yes. You must continue to file Form 5500 and continue ongoing administrative activities for each year until the termination process is complete. Note, however, that since contributions to the plan are discontinued at the initiation of the termination, administrative obligations tend to be less burdensome.
What if we are unable to locate former employees who still have money in the plan?
The Department of Labor requires you to take the following steps to locate “missing” participants:
- Use certified mail.
- Check other plan-related records.
- Check with designated plan beneficiary.
- Use commercial locator service or internet search tools.
- Use the Social Security Administration letter-forwarding service.
If you follow these steps and are still unable to locate the missing participants, you are permitted to establish IRAs on their behalf and roll over their plan accounts.
What should I communicate to my employees?
Since the circumstances surrounding a plan termination can vary significantly, the information communicated to employees can be quite sensitive.
DWC is available to work with you to develop an employee communication initiative that satisfies disclosure requirements mandated by the government and provides additional information you deem appropriate under the circumstances.
Can we setup another plan at a later date?
If you terminate a 401(k) plan, you must generally wait at least one full year after all accounts are distributed before establishing another 401(k) plan. Different limitations may apply to other types of plans.
Plan Termination Checklist
This section provides a checklist of the steps that must generally be completed to terminate a retirement plan. Since each plan is unique, this checklist is meant to be a guide rather than comprehensive documentation of every item that might need to be addressed.
Plan Termination Date: The plan termination date is the date on which the termination process begins. This date is included in the resolution the company adopts to formally terminate the plan. Please note that the IRS generally requires a plan to be fully distributed within one year of the termination date. The termination of the plan is not complete, however, until all assets have been disbursed and the final Form 5500 filed.
Elective Deferrals: Withholding participant elective deferrals should be discontinued as of the plan termination date. However, any deferrals withheld before that date should be deposited to the plan immediately.
Deposit of Employer Contributions/Accrued Benefits:
- Required Employer Contributions: This may include safe harbor matching or nonelective contributions as well as top-heavy minimum contributions.
- Discretionary Employer Contributions: The Plan Sponsor must decide if it will make any discretionary matching or nonelective contributions for the year and deposit any outstanding contributions for prior years.
Note that many of the compensation and contribution limits are pro-rated for the year that includes the plan termination date.
For further information regarding the deadlines for depositing employer contributions, click here.
Vesting: All participants who have not incurred five consecutive one-year breaks-in-service as of the plan termination date become 100% vested. This includes participants who are terminated but have not yet taken distributions from the plan.
Forfeiture Account: The IRS requires Plan’s to spend-down their forfeiture accounts each year. The following options are generally available for disposing of forfeitures:
- Pay Plan Expenses
- Offset company contributions
- Allocate to all eligible participants
Forfeitures that occur in a given year must generally be used to cover expenses and/or contributions for that year.
For additional information about the use of plan forfeitures, click here.
Participant Loans: Any outstanding participant loan balances are treated as distributions as of the termination date and become taxable to the participant. The plan’s custodian will issue Forms 1099-R for these amounts by January 31st of the year following the termination date.
Final Year Compliance Testing: The plan sponsor is responsible to make sure that the plan satisfies regulatory compliance requirements for each year the plan is in existence.
Participant Distribution Package: All participants are to receive this package, which includes the necessary forms and disclosures.
- Distributions resulting from a plan termination are eligible for rollover. If a participant requests a cash payment in lieu of a rollover, the distribution is subject to 20% federal withholding.
- DWC recommends that distribution packages for former employees be sent by certified mail, return receipt requested.
Sponsor/Plan Administrator Authorization of Distribution Forms: When participants return their distribution election forms, the sponsor is required to authorize the requests.
Plan Liabilities, Expenses and Fees: The termination of the Plan cannot be completed until all liabilities have been paid, including fees for final plan compliance and recordkeeping services.
Notification to Service Providers: Invoices related to ongoing administration and most plan termination services can generally be paid from plan assets. All fees that are to be charged to the participant accounts need to be allocated before distributions take place. Please request that all service providers issue their final invoices as soon as possible, so they can be paid/allocated in advance of the distribution process.
Final Form 5500: The final Form 5500 must be filed no later than the end of the seventh month following the month in which the Plan’s assets are completely disbursed. It is the plan sponsor’s responsibility to electronically review, sign and timely file the final Form 5500 by this deadline.
Plan Documents: The plan documents must be current for all regulatory or legislative changes as of the date of the termination. If not up to date, a remedial amendment will be required.
Plan Record Retention: Please retain signed copies of ALL plan documents as well as Forms 5500 and evidence of fidelity bond coverage from plan inception through the termination date. DWC does not require the return of any documents, nor does it retain any.
For additional information about record retention requirements, click here.
The content of this website is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances.