Terminating Your Plan? Here’s What You Need to Know

If your retirement plan no longer suits your business’s needs, it may be time to terminate it. Unfortunately, doing so is not as simple as simply ceasing contributions and distributing plan assets. Plan sponsors write us with questions about plan terminations all the time, so we’ve compiled answers to the most common ones below:

What Actions Must be Taken to Terminate the Plan?

The actions required to terminate your plan should be outlined in your plan document. Often, all that needs to happen is that the governing entity of the plan sponsor – the Board of Directors, Board of Managers, the partners, or the sole proprietor – needs to sign a resolution to terminate.

In some circumstances, the plan must be amended to formalize the termination. If the law or governing regulations have changed since the last time your plan was documented—as is quite common—you might also need to amend your plan to bring it up to date.  In short: see your document provider and/or lawyer to determine what needs to be done to formalize the termination.

What Happens to the Participants’ Accounts?

The law requires that all plan benefits be fully vested when a plan terminates.  This rule applies to anyone who has an account in the plan at the time of termination unless he or she has had at least five consecutive plan years in which fewer than 500 hours were worked.  So, recently terminated employees will still be subject to full vesting.

Are We Required to Fully Vest Only Recently Terminated Employees?

Not necessarily. If someone terminated employment during the prior five years and took his or her vested interest, the portion of the account that was not vested was likely forfeited.  The rules are a little vague as to when you must restore the unvested portion of the participant’s account when the person left the company within that period.

While the safest course of action may be to provide full vesting to anyone who left within the prior five years, this is likely overkill. It is more common and likely sufficient to fully vest only those participants who have not yet forfeited their non-vested interest.

However, if the employee terminated employment within the five-year period in connection with whatever events caused the plan to terminate—for example, a sale of the plan sponsor or a massive layoff—the IRS will likely take the position that the employee is entitled to full vesting.  The IRS also is likely to believe that anyone who left within a year of the plan termination should be fully vested.

In contrast, someone who left more than one year ago, and whose leaving was not connected to the motive for terminating the plan, should not need to be retroactively vested if the non-vested portion of the account was already forfeited. 

Do We Need to Involve the IRS?

You don’t necessarily need to involve the IRS in plan termination. Upon request, the IRS will give its approval of a plan termination in the form of a determination letter, but this is entirely optional for plan sponsors. This is a great option if you want to ensure that the termination is done in accordance with IRS regulations, but it’s not without a price:

  1. The IRS charges $2,300 to review the plan’s termination (fees can be updated annually)
  2. The TPA and/or attorney who work the submission will charge for their time as well
  3. The IRS review can take up to two years to make a determination, during which the plan must remain open

If you’re looking for a quick termination, the IRS approval process is probably best bypassed.

How Do Participants Get Their Benefits After the Plan Terminates?

Once the plan is terminated and has received the necessary approvals, the participants must be paid out.  If the plan is a 401(k) or other profit-sharing plan, this is a matter of following the necessary steps.  

The participants must be given the following options:  take their money in cash (and have 20% withheld for taxes) or roll it over to another plan or IRA. Once they make their elections, the money is paid out.  

Are There Any Last Steps That Must Be Taken?

Once everyone is fully paid out, and there is no money left in the plan, a final Form 5500 must be filed. The form is due within seven months of the end of the month in which all plan funds have been paid out, and must show a $0 balance as its bottom line.  Missing this final filing is not an uncommon error, and the penalties involved from both the IRS and the Department of Labor can be significant.