Businesses adversely affected by COVID-19 may be considering terminating their 401(k) plans to end their contribution obligations. This may be an unnecessary response to what may be a time-limited problem, and it could have adverse consequences since the “successor plan” rule in IRS regulations currently prohibits covering the same employees in a new plan for 12 months following the termination. A plan termination also requires full vesting of all participants and distribution of account balances to the participants, usually within 12 months. A more measured response would be to temporarily suspend or reduce employer contributions. A temporary suspension does not require full vesting of all employees as a complete termination or discontinuance of contributions would require.
How a suspension or reduction of employer contributions works depends on the type of 401(k) plan currently in effect.
If the Plan Is Not a Safe Harbor Plan.
It’s not necessary to amend a plan with only a discretionary employer contribution. The plan sponsor can simply decide not to make a contribution for 2020. If the plan has a fixed match or nonelective contribution but does not satisfy safe harbor requirements, the plan sponsor should pass a resolution to suspend or reduce contributions, notify the participants and adopt an amendment changing the contribution formula. If the change is to a discretionary contribution, contributions can be resumed in the future without re-amending the plan, strengthening the argument that contributions have not been permanently discontinued so that full vesting of participants should not be required.
If the Plan Is a Safe Harbor Plan.
If the plan is a safe harbor plan, the regulations permit contributions to be suspended mid-year if either the safe harbor notice informed employees that the plan sponsor previously reserved the right to suspend or reduce contributions during the year or the plan sponsor is suffering an economic loss, as defined in the rules governing defined benefit plan funding waivers. In either case, participants must be notified at least 30 days before the suspension can be effective and have the opportunity to change their elections. The plan sponsor should pass a resolution suspending contributions and amend the plan. Again, if the amendment adopts a discretionary contribution formula, contributions could be resumed without re-amending. Of course, a further amendment would be required to convert the plan back to a safe harbor plan.
IRS rules require that safe harbor contributions be made through the effective date of the suspension and that non-discrimination testing be done for the entire plan year, and not just the portion of the plan year during which the plan sponsor was not making safe harbor contributions.
Suspensions Can’t Be Indefinite.
While IRS rules recognize that a temporary contribution suspension is not the same as a plan termination, IRS also recognizes that a plan sponsor could avoid the full vesting requirement if suspensions continued indefinitely. Therefore, the IRS established a helpful rule that a plan sponsor may suspend contributions for 3 out of 5 plan years without the suspension being treated as a permanent discontinuance of contributions. Plan sponsors who may want to have suspensions over more than one plan year need to be aware of this rule.
You Could Still Have a Partial Termination.
If plan sponsors elect to continue their plans but are laying off employees, they also need to be aware that this may trigger a partial termination of the plan. A partial termination is based on the facts and circumstances, but plan sponsors should look to the IRS rule of thumb that there may be a partial termination if more than 20% of their plan participants are involuntary terminated. In the event of a partial termination, only affected participants are required to be 100% vested.
While we hope that employer contributions to 401k plans will continue, we understand that business circumstances may require a plan sponsor to take cost-saving measures that could include suspending contributions or even terminating plans. A plan sponsor considering the suspension and termination options should make an informed decision based on an understanding of the technical rules that must be followed.