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What is a partial plan termination and how could it affect my plan?
What is a partial plan termination and how could it affect my plan?
Updated over a week ago

If you’re the plan sponsor of a 401(k) plan, it’s important to be aware that some normal employer actions may result in what’s known as a partial plan termination.

According to the IRS, a partial plan termination occurs when there has been a significant reduction in the number of employees covered by the plan. However, because there are many factors that can impact whether a partial plan termination occurred, and all the facts and circumstances must be considered, you should consult with legal or tax advisors who can make a legal determination. Note that if your plan does not impose a vesting schedule on employer contributions, incurring a partial plan termination will not have any effect on your plan.


What is a partial plan termination?

A partial plan termination occurs when 20% or more of employees who were participating in a plan are terminated or otherwise no longer eligible to participate.

Partial plan terminations are typically due to a reduction in force resulting from an intentional decision by the plan sponsor due to bankruptcy, insolvency, going out of business, change in ownership, or substitution of another type of retirement plan. However, it is important to note that it can also happen unintentionally due to corporate mergers and acquisitions or other events.

Note that if your plan does not impose a vesting schedule on employer contributions, incurring a partial plan termination will not have any effect on your plan.

Guideline has created a partial plan termination worksheet that can walk you through the steps to help your organization determine if there is a presumption of a partial plan termination.

You should consult a legal or tax advisor who can inquire into your specific circumstances and make a legal determination.

How is a partial plan termination determined?

According to the IRS, if the turn-over rate in a 12-month period is 20% or greater, then a partial plan termination is deemed to occur. This turn-over rate is calculated by dividing the number of terminated participants by the total of all participating employees during the applicable period.

In general, you should look at the total number of participants who were eligible for the plan but no longer are due to involuntary termination from service or a plan amendment to change eligibility or vesting that adversely affects participants.

As per IRS guidance, generally anyone who terminated from employment should be included in the calculation. Voluntary terminations or routine turnovers can be excluded. However, you should proceed with caution whenever excluding any termination of employment from the calculation.

This is because although an employee may have voluntarily terminated their employment, their decision to leave may have been influenced by the same factors that lead to the partial plan termination. For example, say a company shuts down a division, which resulted in a reduction in employees, any others who left employment during the applicable time period may have done so because of the division shut down.

While this is a rebuttable presumption, you would need to show evidence that their decision to leave was completely unrelated to the events that lead to the partial plan termination.

Another factor to consider is the time frame. Generally, the IRS considers a full plan year to be the applicable time period. As with most determinations where the IRS is looking at “facts and circumstances,” there are exceptions. For example, when a company has a series of related layoffs that take place over more than a plan year. In addition, if the plan terminates before December 31, the period will include the prior plan year plus the short, final plan year.

Does the size of my company matter when determining partial plan termination?

The size of your business does not impact whether a partial termination applies. As long as your plan meets the 20% reduction in eligible participants, then a partial plan termination is deemed to have occurred.

For example, if your company had 4 participants within the plan, and 1 was terminated during the plan year, this would account for a 25% reduction in plan participants. Therefore, a partial termination would have occurred.

However, if you then hired a new employee during that plan year (as long as they are eligible to participate or you can show that this was normal turnover), a partial plan termination would not apply.

Are there any exceptions to the normal partial plan termination rules?

There are several situations where a partial plan termination would not occur. One of the most common is when employees transfer from one entity of a legally related group to another, provided they are covered under a plan at the new employer.

Additionally, partial plan terminations typically do not apply for businesses that experience employee turnover on a routine basis, such as retail establishments or companies employing seasonal employees.

However, in the event of an audit of your plan, your company must be prepared to offer adequate proof of routine turnover. Acceptable forms of proof include human resources records and employee statements as evidence of the voluntary nature of the employees’ termination.

Factors to help determine how routine turnover has affected the turnover rate include:

  • Information on the turnover rate in other periods

  • The extent to which the terminated employees were actually replaced by new employees

  • Whether the new employees performed the same functions, had the same job classification or title, or received comparable compensation

In addition, when the COVID-19 pandemic hit in 2020, and a large number of employees were laid off or furloughed, Congress passed legislation which changed how a partial plan termination during the pandemic was determined. For a plan year that included the period beginning on March 13, 2020, and ending on March 31, 2021, you would not have had a partial termination if the number of active participants covered by the plan on March 31, 2021, was at least 80% of the number of active participants covered by the plan on March 13, 2020. This rule did not require that the same employee be rehired, it simply looked at the number of active participants at the beginning and end of the plan years.

Will Guideline notify me if I have a partial plan termination?

If we believe a partial plan termination may apply to your plan, we will notify you via email and dashboard notifications. We will also provide you with a “Partial Plan Termination” report within your Resource Library. That report will include the data from our records that can help you complete the partial plan termination worksheet.

Because the determination depends on the circumstances of each employee’s termination of employment, Guideline cannot complete this for you or confirm whether a partial termination occurred. It is up to you to verify if this applies and, if so, to notify us so the proper steps can be completed.

What happens when a partial plan termination occurs?

If it is determined that your plan incurred a partial plan termination, the following will apply to your plan:

  • We'll 100% immediately vest all participants who terminated employment in the applicable year.

  • If any of these participants have already taken a full distribution of their account, we’ll restore the funds previously forfeited to make their account balance whole. These funds will come from the plan’s forfeiture account. Affected participants can then request a distribution at any time.

  • If the plan’s forfeiture account balance is insufficient, we’ll withdraw funds from your company bank account to restore terminated participant accounts.

For participants who have not yet taken a distribution, nothing further will need to occur. Their employer contributions will simply remain within their account as 100% vested. If they decide to take a distribution at any point after the partial plan termination, they will be able to withdraw the full amount, including the 100% vested funds.

Which participants must be 100% vested?

If your plan has incurred a partial plan termination, the next step is to determine which participants need to become 100% vested.

The general rule is that participants affected by the partial plan termination need to get the accelerated vesting. This would include participants who:

  • Left employment for any reason during the period in which the partial termination occurred, and/or

  • Still have account balances under the plan on the date the partial plan termination occurred.

Note that determining affected participants for vesting purposes is different from determining who is an affected participant for the 20% threshold. When determining who must be 100% vested, it does not matter why they left service, even if they left for cause.

What should I do if I believe I have a partial plan termination?

If you have determined your plan has incurred a partial plan termination, you should contact us as soon as possible after the end of the applicable plan year. Once the date of the partial plan termination is determined, we will work with you to fully vest the necessary participants as well as to restore balances of any participants who may have taken a distribution before they could be fully vested.

The amounts that must be restored will be determined and funded from either your plan’s forfeiture account or by an ACH debit from the bank account on file with Guideline.

If you do not want to wait until after the end of the plan year to take action on your partial plan termination, it is also possible to amend your plan to have 100% vesting as of the first day of the partial plan termination. This will include all participants who were active employees in the plan as of that date and will not limit the class of participants subject to the accelerated vesting. If any participants have already distributed funds, they will need to be processed and adjusted manually.

Is there a cost to my business if there is a partial plan termination?

Guideline does not charge any additional administrative fees to help determine or manage a partial plan termination. However, if there is not enough money within your plan’s forfeiture account to cover vested funds for participants who have taken a distribution, we will pull the funds from the bank account on file.

How will participants know the funds have been applied to their accounts?

For impacted participants who previously took a full distribution from the plan, they will be made whole once previously non-vested funds are re-applied to their accounts. Participants will be able to see this balance on their next quarterly statement.

If you’d prefer to notify affected participants on your own, feel free to do so.

Participants can then request a distribution or rollover of the restored vested funds at any time, and there is no fee for this service.

What happens if I had a partial plan termination in the past and didn’t know?

If you discover that your plan incurred a partial plan termination previously, you will need to correct the issue by determining the affected participants as described above and granting them 100% vesting retroactively. You should determine if any of the affected participants took a distribution where assets were improperly forfeited and refund those forfeitures (along with any earnings).

What happens if I do not report a partial plan termination?

Information on your Form 5500 that shows a significant reduction in the number of plan participants can alert the IRS of a potential partial plan termination, which may trigger an audit of your plan. If audited before you voluntarily vest impacted participants, the IRS may impose penalties and sanctions.

Additionally, in severe cases, you could risk disqualification of your plan, which would result in the plan’s trust being taxed on all of its earnings due to loss of tax exemption. In this instance, plan benefits would be included in participants' incomes and the company would also lose employer tax deductions for all plan contributions.

Do you have any additional resources on partial plan terminations?

Guideline has a partial plan termination worksheet that can walk you through the steps to determine if there is a presumption of a partial plan termination.

No matter which result you get from the worksheet, you may want to consult an ERISA attorney who can inquire into your specific circumstances and make a legal determination.

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