The owner of our company is retiring next year, and the business will close as a result. We sponsor a 401(k) plan that we know we need to terminate, and we want to get started right away so that we have plenty of time to wrap things up before the company is dissolved next year. There are several former employees who still have balances in the plan, but most of the plan accounts are for employees who will continue working for the company right until the very end.
Are there any special rules or restrictions about when we can pay participants their account balances as part of the plan termination process?
While we wouldn’t call them special “rules,” there are some best practices and fiduciary considerations. As with all things retirement-plan-related, a seemingly short question has kind of a longer answer.
For starters, the termination of a retirement plan is what is referred to as a distributable event. That’s just another way of saying it triggers the participants’ ability to take a distribution. So, as soon as the termination resolution is signed and effective, distributions can begin.
There are a few quick caveats to keep in mind. You will want to make sure you…
- Request that the recordkeeper updates the vesting for all participants to 100% so that benefits are correctly calculated and paid;
- Deposit and allocate any outstanding contributions that are due to the plan;
- Allocate any forfeitures that are left after payment of fees or offsetting of contributions; and
- Follow the plan’s normal distribution process, including providing participants with the required Special Tax Notice and other disclosures as well as distribution forms to complete.
Although a bit of a hassle, it’s not a huge issue if participants end up entitled to additional amounts and have to take residual distributions, but the last thing you want is to track down overpaid amounts just as you are approaching the finish line.
In some instances, a plan sponsor may decide to apply for an IRS determination letter on the plan’s termination. Though there is no requirement to do so, some sponsors prefer to hold participant distributions until the IRS issues the letter. In that scenario, distributions are usually paid as follows:
- Those no longer employed are able to request a distribution at any time, because they were already able to do so even before the plan was terminated.
- 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.
Now, let’s quickly turn our attention to some of the fiduciary considerations.
One is fees. It is not at all uncommon for service providers to require payment of all anticipated future fees as soon as they are notified of the intent to terminate the plan. If some or all of those fees are to be paid from plan assets, it is important to take care of that as quickly as possible before distributions start—usually concurrent with the effective date of the termination. Otherwise, you could end up with only a handful of participants left to shoulder the fees for the entire plan, and they are not likely to be pleased with that outcome.
A second critical fiduciary consideration is the impact of investment fluctuations. If a plan sponsor decides to hold distributions pending completion of any of the above-noted items and there are investment losses, participants could start looking for someone to make them whole. Short-term losses of 2% to 3% are not infrequent. While that might only equate to a couple hundred dollars for a single participant with a small balance, the aggregate impact to all the participants in a plan with over a million dollars in assets becomes a five-figure ordeal.
Because of all the moving parts in a plan termination, we suggest developing a project plan and timeline before the termination becomes effective. That delays the distribution process for active participants so that the items noted above can be addressed timely while minimizing the fiduciary concerns. Once the termination is effective, the participants’ distribution right is triggered, and any delays expose the plan sponsor and fiduciaries to greater fiduciary risk.
For more information on distributions, please visit our Knowledge Center here.